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Alpha Theory Blog - News and Insights

July 31, 2020

Performance During The Pandemic (Part 1)

 

This article was co-written by Billy Armfield, Data Scientist of Alpha Theory, and Cameron Hight, CEO of Alpha Theory.

 

As major indices approach, and even surpass, their pre-COVID levels, we wanted to take a step back and look at how our clients weathered the storm. What can we learn from the managers who outperformed, and how we can avoid the mistakes of those who underperformed? Using February 19th, 2020, the all-time high of the S&P 500, as a starting point, we broke our clients into quintiles based on the alpha returns versus the SPY ETF over the period ending July 24th, 2020 (see below for total returns by quintile). We also narrowed our analysis to look exclusively at long/short clients to ensure an apples to apples comparison.

 

Returns

 

All quintiles stayed net long over the duration of the period (chart below). Looking at just the top (green) and bottom (red) quintiles, we get a sense of how important net exposure was over this period. Not only was the top quintile carrying the highest net exposure, but they were also the first to get their net back to pre-COVID levels (April 7th). In contrast, the bottom quintile has yet to exceed pre-COVID levels of net exposure.

 

Net exposure

 

Looking at the long exposure of the return quintiles (chart below), we see almost no difference between the long exposure of the best and worst-performing managers.

 

Long exposure

 

This means that the big difference in net exposure between the best and worst performers was due to higher short exposure for the worst performers. The worst performing funds in the fifth quintile had much higher exposure on the short side, which ate into their returns as markets returned to life. You can also see that their short exposure has only increased since the market bottom, further eroding returns as markets continue to climb.

 

Short Exposure

 

But this is only part of the story, as high long and short exposure with a small net positive exposure should have led to a small gain over the period. In order to understand what’s really going on, we need to look at gross exposure-adjusted returns on the long and short side.

Long Return on Invested Capital (ROIC – what was the return of the average position-weighted stock return over the period – excluding leverage = +15% for the highest quintile, -10% for the lowest quintile) was the major contributor to the difference in quintiles.

 

Long ROIC

 

Short ROIC for the period for all clients was tightly clustered compared to long ROIC, with the best performing cohort losing about 2% on their shorts and the worst performing losing 9%. In fact, the top and bottom performing quintiles from a total return perspective had almost identical short ROIC.

 

Short ROIC

 

The poor long return for the 5th quintile combined with increasing short exposure was a major cause of their underperformance. Investors in the top cohort, despite large losses as markets plunged, were willing to add exposure at the bottom and frankly, just picked better longs.

 

ROIC

 

June 19, 2020

The Short End of the Stick

 

Over the years, we have consistently heard that the short portion of clients’ portfolios have been a major drag on returns. The problem is that when we do portfolio performance reviews with our clients we see that the short book, which is consistently negative, is generally less negative than the S&P 500 and MSCI World.

 

To explore this further, we wanted to test a simple strategy of creating an aggregated portfolio of client short positions to see how they performed against the major indices. The absolute result was an average annualized loss of -4.02% which confirms the industry dogma that the short book is a drag. That being said, the short portfolios provided consistent positive alpha (short book return minus negative index return).

 

Short_end

Source: Omega Point

 

The total return for clients’ short portfolio is -23.74% over the 5+ year period or an annualized return of -4.02%. This compares to a 10.20% annualized return for the S&P 500 or 6.16% annualized alpha and 6.35% for MSCI World or 2.33% annualized alpha. If we take the midpoint, that is roughly 4% of annualized alpha that our clients have generated per year for over 5 years.

 

Breaking it down by year, the alpha contribution was consistent except for 2016 where it was roughly breakeven showing that Alpha Theory managers were dependable alpha generators on the short-side.

 

Screen Shot 2020-06-19 at 11.21.34 AM

 

The sustained positive trend of the overall market over the years makes it almost impossible to create absolute returns from shorting. However, for investors looking to generate a less volatile stream of returns, a short book that has a negative correlation with the long book and provides consistent alpha is extremely valuable. Alpha Theory’s clients are consistent short alpha contributors. This is, of course, because of their stock selection skill but I would posit that their process discipline is just as important and is one of the reasons their alpha returns have been so consistent.