The Race for Alpha
After five years of bull markets in core asset classes, we believe we are entering a new era, characterised by higher volatility and lower expected returns. A highly indebted global economy, less effective Central Banks, extended valuations in most asset classes and lower market liquidity are at the base of our conviction that the investment landscape will be significantly different in the years to come. With a mature risky-asset bull market and returns on government bond yields at historic lows, the opportunities coming from beta are fading and we project the expected returns for the main asset classes to be much lower than in the past.In this challenging new environment, being able to enhance diversification, using all the available uncorrelated sources of beta, and generating truly uncorrelated alpha in a risk-conscious framework will be at the forefront of value creation1.
This will be essential, in our opinion, not only in the hedge and liquid alternative space or in niche asset-class specialties, but also in the main asset classes in order to build an outperforming investment portfolio.
To generate more alpha, we believe a concentrated stock selection approach based on high conviction ideas is key. However, it may bring with it more volatility. In recognising that concentrated strategies tend to have higher volatility, the immediate concern is the threat of underperformance. To address this issue, it may be worth considering a fundamental question: how much volatility should active managers tolerate?
We believe we can sustain higher volatility if we understand the underlying risk factors driving each single security. That is why we put a lot of emphasis on decomposing the risk elements of each investment case. And we believe we can build an effective alpha strategy by carefully managing these idiosyncratic risks.
Measuring alpha is also one of our main goals. This means measuring our investment performance ex-post in order to understand whether the final return is materially linked to alpha. This is essential in assessing whether alpha is repeatable, sustainable and transferable across a multiplicity of solutions for clients.
We see alpha as a function of independent positions – investment ideas – and the skills of the manager.
The Alpha Function
In this endeavour, we have developed innovative measurement techniques to assess whether we have enough investment ideas, whether these ideas are right or wrong and whether we are effective in their implementation.
The hit ratio is key to judging the quality of our investment ideas. In our view, a good hit ratio should be higher than 50%, though not much higher. A hit ratio, for example, of 90% does not really exist over the long term. With our approach we aim to maintain a good hit ratio – 50-55% – on our ideas. This is why we encourage both our portfolio managers and research team to be free thinkers, so as to produce enough original and actionable ideas.
We believe the behavioural aspect of investing is another important element in generating sustainable alpha. Despite their ability to identify potentially winning ideas, most managers lack the appropriate discipline to manage losing positions. This is where the win/loss ratio is important. How much money did you make when you were up and how much money did you lose when you were down? It is one thing to pick winning assets, but knowing how to manage different positions, especially losing positions, is vitally important, as is the timing of ideas. One of the vital skills of the portfolio manager is timing the entry and exit of positions, as this will have a big impact on the win/loss ratio.
At Pioneer Investments, we focus a great deal on research and measurement so we can maximise the quantity and quality of ideas.
At Pioneer Investments, we focus a great deal on research and measurement so we can maximise the quantity and quality of ideas. We want to ensure we have enough sources of investment ideas and that we measure the ideas, not only in terms of being right or wrong, but also on the extent to which they are beneficial in our mission to deliver true and sustainable returns for our clients.
In this mature stage in the bull market, where we believe returns will be lower and volatility is likely to be higher, our approach will remain based on a combination of our long-held principles of active management, alpha generation and conscious risk management.
1Alpha — Measures risk-adjusted performance, representing excess return relative to the return of the benchmark. Beta — A statistical measurement of an investment’s sensitivity to market movements in relation to an index. A beta of 1 indicates that the security’s price will move with the market. Betas of less than 1 or greater than 1 indicate that the security will be less volatile or more volatile than the market, respectively.
2The hit ratio is the ratio between winning and losing investment ideas.
3The win/loss ratio is calculated as the average profit in winning positions divided by the average loss in losing positions.