In Active Management, Alpha Comes Down to One Thing

Portfolio construction and conviction are a waste of time if managers don’t pick the right stocks, according to Inalytics.

Illustration by II

Illustration by II

When it comes to generating alpha, nothing matters more than picking the right stocks.

The average alpha derived from stock research is 319 basis points, according to the latest study from Inalytics. In comparison, sizing, which refers to deciding how much capital to deploy to specific stocks, produced a small alpha loss of 11 basis points.

The results signify that “elite managers are highly adept at deciding what to own through the research process,” according to the study. But unfortunately, “all the effort that then goes into deciding how much to own” is not as effective in generating outsized returns.

Inalytics based the results on a study of 752 portfolios with more than three years of performance data. Eighty-four percent of the portfolios have outrun their respective benchmarks by an average of 397 basis points, while the rest underperformed by an average of 150 basis points. The average alpha for the whole universe was 308 basis points, according to the study.

Inalytics found that 88 percent of portfolio managers have demonstrated excellent research skills with an average research alpha of 383 basis points. The underperformers, however, had an average research alpha of negative 139 basis points, according to the study.

“Stock picking is the primary area in which managers demonstrate skill,” the study said. According to Rick Di Mascio, founder and CEO of Inalytics, that means allocators need to spend more time trying to understand the managers’ research process while conducting due diligence. “If the research process, for whatever reason, stops adding value, then it is quite clear that the sizing decisions and portfolio construction is not going to make up the difference,” he told Institutional Investor.

The Inalytics study found that only 46 percent of the participants delivered positive alpha from sizing. Over 400 portfolio managers generated an average sizing alpha of negative 93 basis points. The implication for asset owners is that they should be skeptical of “manager material written on portfolio construction, risk budgeting, and conviction levels,” according to the study.

Inalytics added that it also important for asset managers to “investigate why their sizing typically fails to add value.” According to Di Mascio, the sizing factor is more “idiosyncratic,” meaning the reason why it does not work varies across different portfolio managers. On the research side, “there is a huge infrastructure in place to actually get the best of the ideas into the portfolio,” Di Mascio said. And that’s why most managers have delivered positive research alphas.

Di Mascio added that the findings also signal there is a group of “elite managers” in the active management space. “Our numbers demonstrate that there’s an elite [group] and that fund management is a skill-based activity,” he said. “And just like sport, there is a cohort of people who are able to [win] their game.”