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Alpha Theory Blog - News and Insights

September 11, 2020

The Benefits of Manager Aggregation


Long/Short equity investing has underperformed for over a decade (see below). Worst of all, it hasn’t protected investors in down markets, when they’ve needed it most. Investors increasingly struggle to justify their investments in Long/Short managers. This is fixable.




Long/Short equity managers are stock pickers at heart. Many LPs ask them to do too much. They want high return and low volatility. To achieve low volatility, Portfolio Managers must become risk managers and diversify. Risk management is not a core competency of most PMs and diversification causes them to hold more names than they have the mental capital to manage.


A growing group of LPs are recognizing that finding multiple great stock pickers with concentrated portfolios and creating their own risk management and diversification is the ideal strategy. Alpha Theory helped kick off this trend with their paper “The Concentration Manifesto” in May 2017.


As mentioned in the paper, concentrated portfolios have better batting averages than diversified portfolios. The benefit is that the average return of the concentrated strategy is higher (2.1% vs. -0.1% after fees). The problem is that concentrated funds have the “red tail” on the left where there is a higher probability of large loss.




If you could invest in several of these managers (10 in this example) you can get the same return and cut off the left tail.




And if you could find 100 of these managers then…




There is tremendous potential in this structure for savvy LPs. In an ideal world, we would overlay this multi-concentrated strategy (+2.2% of return) with Alpha Theory position sizing (average improved returns of +4% per year) to create a vastly superior strategy that would pull investors back into Long/Short equity investing.


August 21, 2020

Performance During The Pandemic (Part 2)


This article is the continuation of Performance During The Pandemic (Part 1) and was co-written by Billy Armfield, Data Scientist of Alpha Theory, and Cameron Hight, CEO of Alpha Theory.


Optimal Position Sizing During the Pandemic


Every investor uses mental models that dictate their investment process and portfolio composition. When investment managers join Alpha Theory, they work with our Customer Success team to make those mental rules explicit in the form of a model. This forces managers to think about their process, and to be honest with themselves when they are not following their own rules.


These models are defined by variables like position size, liquidity, investment checklist, and analyst price targets, to name a few. The output of the model is a suggested optimal position size (OPS), which allows managers to make sure their actual position size (APS) reflects their research and investment process. In the Concentration Manifesto, we outline our research on how managers would benefit by concentrating their holdings in their best ideas. The OPS models created for every fund tend to suggest larger position sizes for names with a higher probability-weighted return and can suffer from higher volatility when markets undergo a sharp correction.


When markets are as volatile as they have been this year, having a way to highlight dislocations between research and position size is more important than ever. The market has declined roughly 4.5% (as of 7/24) since the high in February, whereas our average long/short manager is up by 1.5% over the same period. Had our clients followed the model verbatim, they would be up, on average, by 5.9%.




Paying closer attention to the feedback loop provided by the optimal position sizing model would have led to significant improvement for the bottom quintile. The OPS models for these clients, based on their own research and investment process led optimal to outperform by roughly 20% 




Digging in a little further we see that the bottom performer’s actual and optimal long exposure moved in opposite directions. As markets reached their nadir in mid to late March, OPS recommended increasing exposure to the market while the managers were decreasing exposureAlpha Theory then recommended decreasing exposure as prices recovered. This resulted in their long book losing 14% while the Alpha Theory long book made +6%!




This is because optimal position sizes are based in part on the expected value of a security. If you liked a stock at $100, you love it at $70. As the market went down, expected returns went up, so the models increased exposure. This is one of the key takeaways for how Alpha Theory can help clients avoid emotional decisions, and to invest based on their own research. 


This remains a difficult environment and we believe that during times of stress, implementing protections against emotional investment decisions is critical to success. Investors in the top quintile used their research as their anchor, did not overreact, and added to their high conviction names when things seemed bleak.  Process-driven investing, as we practice at Alpha Theory, helps to mitigate the impact of emotions and helps managers harvest more of the alpha they deserve from their research.