What Is Alpha?

The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time. Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.

The concepts explained in the previous Macro Mechanics notes form the pillars of understanding macro investing. Today, we offer the final pillar that upholds the basic foundation of macro investing: Alpha.

Traditionally, alpha refers to an investment strategy’s excess return over that which its benchmark can explain. This definition has two key components. The first is the explicit criteria of outperformance versus a benchmark. The second crucial component is that the benchmark cannot explain this outperformance. For instance, to have to have alpha versus the S&P 500, you need to i) Outperform the S&P 500 and ii) have done so because your investments were meaningfully different than the S&P 500.

While we think this definition is good, we think we can add some further nuance. First, it needs to account for the source of alpha (skill) rather than the symptoms (excess returns). Second, we think a crucial understanding is that asset class diversification is not a source of alpha. Third, we think there is a significant difference between alpha overlay and pure alpha. We expand on each:

Symptoms vs. Sources: While we can use statistical tools to evaluate any investment strategy’s ex-post alpha, we think this is just symptomatic of potentially durable alpha. The source of durable, consistent alpha is manager skill. This skill is displayed by an understanding of economic and market conditions that are not already reflected in markets, allowing the investment manager to make prudent risk decisions to improve the risk-to-reward characteristics of the underlying beta they are trading. Manager skills do not depend on what happens to beta. This is what makes real alpha uncorrelated to market outcomes. Whether markets are in a bubble or crashing precipitously, an investment strategy’s ability to generate alpha is contingent upon its managers’ ability to anticipate developments not reflected in the underlying market. Alpha is a manager skill.

Diversification Isn’t Alpha: A common misconception amongst market participants is that asset class rotation offers alpha. While, indeed, there can be alpha when rotating from one asset to another, this needs to be controlled for the inherent beta in the asset being rotated into. For instance, if a strategy rotates between stocks and bonds based on business cycle conditions, it contains two dominant performance characteristics. The first is the benefit of having a more diverse beta of stocks plus bonds (as opposed to stocks only)— this is not alpha. The second return driver is the value generated from choosing to concentrate on stocks or bonds— which is the true alpha source. All alpha comes from the value generated by active decision-making, not simply expanding the investment horizon. As such, we think the best way to evaluate true alpha is to compare the returns of an investment strategy to a balanced beta portfolio to understand whether it has any persistent biases.

Pure Alpha vs. Alpha Overlay: For the purposes of illustration, we used the common trope of an alpha strategy that seeks to outperform beta. However, we think a more nuanced understanding is that this type of strategy that aims to outperform beta has two principle components: the returns on beta plus the returns generated due to active management. Said differently, a strategy that seeks to outperform a beta portfolio replicates the beta portfolio and adds a pure alpha overlay. The pure alpha component is almost entirely different from the beta component, seeking to add value only through market timing. Importantly, the pure alpha component should be largely unbiased in its exposure, i.e., it can go long or short without any preference and seeks to add value on both sides. Separating returns into these constituent drivers allows for a much more precise understanding of the drivers of investment returns.

Adding up these nuances, we define alpha as returns generated purely as a function of skill, independent of beta. A hallmark of alpha is positive expected returns, with a low long-term correlation to a balanced beta portfolio.

Adding this type of alpha to any portfolio is tremendously additive, as it is a true diversifier. However, this value is commensurate with its difficulty to find; durable alpha is hard to create and even harder to maintain.

At Prometheus, we spend all our time researching macro-dynamics to find durable edges, which we aggregate into our various portfolios. The best of our understanding is aggregated into our Prometheus Alpha Strategies program. Alpha Strategies reflects the best parts of our understanding of macro, markets, and portfolio construction. The purpose of Alpha Strategies is simple: to provide durable and consistent return streams independent of beta. These strategies span equities, fixed income, and commodities combined into a single portfolio accessible exclusively to Prometheus Institutional clients. Interested parties can email info@prometheus-research.com for inquiries about Prometheus Institutional.