Investment Managers: New Products, Alpha Generation?

Investment managers are increasingly turning to technology to improve alpha generation and maintain their competitive edge. Alpha, a measure of an investment's performance relative to a benchmark, is highly sought after by investors in mutual funds or ETFs. Leading investment managers are leveraging digital transformation and investing in new technologies such as artificial intelligence, data acquisition, and analytics to enhance their processes and gain an edge in the market.

The concept of alpha originated from weighted index funds, which set a new standard of performance by replicating the entire market and assigning equal weight to each area of investment. As a result, investors now expect portfolio managers of actively traded funds to generate alpha and deliver returns that surpass passive index fund investments.

While alpha is desirable, it is challenging to achieve consistently over the long term. Investment managers must continuously adapt and innovate to identify new sources of alpha and maintain their performance.

Alpha and Beta: measuring volatility and excess return

Alpha and beta are two key measurements used to evaluate the performance of a stock, fund, or investment portfolio. While alpha measures the excess return of an investment in comparison to a market index or another broad benchmark, beta measures the volatility of an investment, indicating its relative risk.

Alpha is often used in conjunction with beta to calculate, compare, and analyse returns. Both are historical measures of past performance, with alpha represented as a single number, such as 3 or -5, indicating the percentage above or below a benchmark index that the stock or fund achieved. For instance, an alpha of 1% means the investment's return was 1% better than the market during the same period.

Beta, on the other hand, is used to measure an investment's volatility, or risk, relative to a benchmark. The market as a whole has a beta of 1, so if an asset has a beta above 1, it is considered more volatile than the market, and if its beta is below 1, it is considered less volatile. Beta is also referred to as the beta coefficient and is one of the key coefficients in the capital asset pricing model (CAPM) used in modern portfolio theory.

Alpha is considered the "holy grail" of investing and is used to judge the performance of mutual funds and similar investments. Active investors seek to achieve alpha returns by employing unique strategies. However, generating alpha consistently over the long term is extremely difficult, and most actively managed mutual funds fail to outperform their benchmarks.

Beta is also an important consideration for investors, as it helps them assess the risk of an investment relative to the broader market. A high beta may be preferred by investors in growth stocks, while investors seeking steady returns and lower risk may opt for investments with a lower beta.

In summary, alpha and beta are crucial tools for evaluating investment performance and risk. Alpha measures the excess return of an investment relative to a benchmark, while beta quantifies the volatility or risk of an investment compared to the market as a whole.

CAPM: calculating expected returns

Investment managers are increasingly turning to technology to improve alpha generation. Leading investment managers are continually upgrading their processes by adopting new technologies to enhance their search for alpha.

The Capital Asset Pricing Model (CAPM) is a tool used to calculate the expected return of an investment portfolio. It takes into account the risk-free rate of return, the systematic risk of the portfolio (beta), and the market return per a benchmark.

The formula for calculating the expected return using CAPM is as follows:

Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

Here's a breakdown of the variables:

• Expected Return: The anticipated return on an investment, taking into account the level of risk associated with it.
• Risk-Free Rate: The rate of return on a risk-free investment, such as government bonds.
• Beta: A measure of the systematic risk of a portfolio, indicating its volatility relative to the market.
• Market Return: The return of the overall market, typically represented by a benchmark index like the S&P 500.

By using CAPM, investors can determine the expected return of their investment portfolio while considering the level of risk they are taking.

Example Calculation

Let's consider an example to illustrate the calculation of expected returns using CAPM. Suppose we have the following values:

• Risk-Free Rate (Rf): 3%
• Beta (β): 1.2
• Market Return (Rm): 10%

Using the CAPM formula, we can calculate the expected return as follows:

Expected Return = 0.03 + 1.2 * (0.10 - 0.03)

Expected Return = 0.03 + 1.2 * 0.07

Expected Return = 0.03 + 0.084

Expected Return = 0.114 or 11.4%

So, in this example, the expected return on the investment portfolio is 11.4%. This means that, given the level of risk (beta) and the market conditions, we can anticipate a return of 11.4% on our investment.

It's important to note that CAPM assumes that investors will choose investments that maximise their expected return for a given level of risk. Additionally, the model is most applicable to a well-diversified portfolio, as it assumes that specific risks can be eliminated through diversification.

Jensen's Alpha and CAPM

Jensen's Alpha is a measure of a portfolio manager's performance, taking into account the capital asset pricing model (CAPM) and including a risk-adjusted component in its calculation. It compares the actual return of a portfolio to its expected return based on its beta and the risk-free rate.

The formula for Jensen's Alpha is as follows:

Jensen's Alpha = Actual Return - [Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)]

By using Jensen's Alpha, investors can assess whether the portfolio manager has added value through active management, even after adjusting for market risk.

In summary, investment managers are indeed looking for alpha with new products, and technology plays a significant role in this pursuit. CAPM and Jensen's Alpha provide valuable tools for calculating and assessing expected returns, helping investors make informed decisions about their investment strategies.

Alpha's limitations: misleading numbers and benchmarks

Alphas Limitations: Misleading Numbers and Benchmarks

Alpha, a measure of an investment's performance in relation to a market index, has some limitations that investors should be aware of. One limitation relates to the type of fund being evaluated. Using alpha to compare different types of portfolios, such as those investing in different asset classes, can result in misleading numbers. This is because the diverse nature of these funds affects metrics such as alpha.

Alpha is most effective when applied to stock market investments, and when used as a fund comparison tool, it is best utilised to evaluate similar funds. For example, comparing two mid-cap growth mutual funds is more effective than comparing a mid-cap growth fund with a large-cap value fund.

Another consideration is the choice of benchmark index. The alpha value is calculated and compared to a benchmark deemed appropriate for the portfolio. The most frequently used benchmark index is the S&P 500 stock index. However, some portfolios, such as sector funds, may require a different index for an accurate comparison. For instance, when evaluating a portfolio of stocks in the transportation sector, a more suitable benchmark would be the Dow transportation index.

In cases where there is no suitable pre-existing index, analysts may use algorithms and models to simulate an index for comparative purposes. This further highlights the importance of selecting an appropriate benchmark to avoid misleading results.

Additionally, alpha does not directly assess risk. Instead, it evaluates performance relative to risk-adjusted expectations. Other measures, such as beta, are used to quantify an investment's risk relative to the market. Beta measures the volatility of an investment, indicating its relative risk.

While alpha is a valuable tool for evaluating investment performance, it is important to acknowledge its limitations and consider other factors, such as risk and the choice of benchmark, to make well-informed investment decisions.

Digital transformation: improving alpha generation

Alpha is a measure of an investment's performance in relation to a market index. It is the excess return or the abnormal rate of return in relation to a benchmark, when adjusted for risk.

Generating alpha is challenging over the long term. Most actively managed mutual funds fail to beat their benchmarks despite their extensive resources. However, investment managers are increasingly leveraging digital transformation to enhance alpha generation.

Stages of Digital Transformation

The Deloitte Center for Financial Services, in its "2023 Investment Management Outlook," outlined various stages of digital transformation, ranging from process improvements to new operating models. Investment management efforts typically involve process changes through the utilisation of new data sources and analytical capabilities to facilitate new product development.

Spending on Technology

The report also examined expected changes in technology spending. A notable difference was observed in blockchain and distributed ledger technologies, with 23% of finance executives anticipating a significant increase in spending compared to only 11% of non-finance executives.

Key Technologies for Alpha Generation

Deloitte identified artificial intelligence, data acquisition and processing, and data analytics as three key technologies that can directly contribute to alpha generation. North American respondents were found to be planning higher investments in these areas compared to their European and Asia-Pacific counterparts.

Application of Technology

Investment managers are applying these technologies to incorporate new datasets into the investment decision-making process and streamline front-to-back-office integration. This enables them to make better investment decisions faster due to improved systems and data integration.

Advantages of Technology in Alpha Generation

Historically, advantages in information access have allowed investment managers to consistently outperform their competitors. Advanced technology is becoming an increasingly utilised path to gain a legitimate edge in the market.

Tips for Generating Alpha

• Stay informed about market and macroeconomic developments.
• Study financial reports, SEC filings, and listen to company executive calls.
• Construct a portfolio that differs from the overall market to outperform it.
• Develop a process for screening and selecting the best-performing stocks.
• Focus on investments with the highest potential for outperformance.
• Learn from mistakes and monitor performance relative to the broader market.

Alpha for portfolio managers: adding value

Alpha is a measure of the active return on an investment, indicating the performance of that investment compared to a suitable market index or benchmark. It is a key metric for portfolio managers, helping them understand whether their investment decisions have added or subtracted value for their clients.

A positive alpha indicates that the investment has outperformed the benchmark, while a negative alpha suggests underperformance. For example, an alpha of 1% means the investment's return was 1% better than the market during the same period. If the alpha is zero, the portfolio is tracking the benchmark perfectly, and the manager has neither added nor lost any value.

Portfolio managers aim to generate a higher alpha by diversifying their portfolios to balance risk. Alpha is one of the five standard performance ratios commonly used to evaluate individual stocks or investment portfolios, with the other four being beta, standard deviation, R-squared, and the Sharpe ratio.

Generating alpha is challenging, and most actively managed funds fail to outperform their benchmarks over time. However, investment managers can improve their chances of success by leveraging technology to enhance their processes and gain a competitive edge. This includes using advanced technologies like artificial intelligence, data acquisition, and analytics to streamline operations and make better-informed investment decisions.

Additionally, portfolio managers can follow certain strategies to increase their chances of generating alpha, such as closely following market trends and macroeconomic factors, conducting in-depth financial analysis, and constructing a portfolio that is distinct from the overall market.

In summary, alpha is a critical concept for portfolio managers, representing the value they add to their clients' investments. By understanding and effectively managing alpha, portfolio managers can enhance their investment strategies and improve their clients' returns.

Frequently asked questions