Alpha is a term used in the world of investing and finance to describe the excess return that a portfolio of securities generates over the benchmark index that it is linked to. It shows the investor the ability of the portfolio to get index plus returns on a consistent basis.
The reference is relevant in case of managed portfolios since investors pay a management fee. In the absence of ‘alpha’ or excess return, there is no reason for you to pay a management fee.
Where does this alpha come from?
Typically, there can be two sources one being the investment process followed by the asset manager. Usually, this process is significantly different from the process followed to construct the index itself. Secondly, a major source of alpha is also the skill of the fund manager who is responsible for security selection and portfolio construction.
The question is that if it’s the process or the person which matters more?
Security selection is indeed a skill. Two different fund managers, for example, can treat the same security very differently. The price they buy at, how long they hold and when they sell will define the final outcome.
Usually, a process to narrow down the universe of stocks will throw up 100-150 different options whereas a portfolio has, say, 40-60 stocks. Hence, there is a lot of room for individual fund managers to apply experience and skill in the selection of securities and in trading these securities to generate alpha. Another way a fund manager can influence the outcome is by choosing the individual security weights. It will matter whether a security is 2% of the portfolio or 10%.
Ultimately though, alpha is also a function of the market structure. In developed markets where information about individual companies is widely available in transparent formats, there is little room for asymmetry and hence, alpha generation from security selection is failing.
However, experts suggest that in developing economies like India where standards of published corporate information are still evolving and many smaller companies are constantly growing to take more market share, alpha generation through security selection is still a lucrative proposition.
Another way a fund manager can influence the outcome is by choosing the individual security weights. It will matter whether a security is 2% of the portfolio or 10%.
The importance of process
A well-defined investment process aims to narrow down the broad universe of stocks which the fund manager has to choose from. The filters in the process that prevent certain stocks to come through into the final selection basket are also defined by fund managers. The process is then vetted by others in the organisation and usually remains intact even with a change in the fund manager. Thus, the starting point is a well-defined process.
A well-defined, well-executed process has the ability to prevent mishaps thanks to fund manager biases. It helps put in place checks and balances which keep portfolios from taking on high-risk exposures.
This is just as important in managing portfolios as individual choices can be emotionally biased and sometimes subjective too, rather than relying only on objective facts about a particular company.
The jury is out on whether it is the person or the process which impacts the final return more and the outcome can vary from case to case. Relying on a process, however, is an easier and more transparent proposition rather than solely relying on the expectation that an individual’s skill will always result in a win.