I was speaking with a colleague recently about the most important initial steps in understanding how an active manager might attempt to outperform in a given asset class, and they responded:

“The first thing to work out is how someone might cheat.”

This sounds nefarious, but it isn’t. What they were saying is that for any asset class or investment strategy, it is critical to quickly work out the structural biases that might be adopted to boost returns.

Or, in other words:

Are there exposures that resemble alpha, but aren’t?

This is important because alpha or idiosyncratic returns are, by their nature, elusive and lucrative. It makes sense that investors might seek easier ways of increasing the probability of good performance.

These biases typically come in two forms:

1) Risk premia: Structural market anomalies where a persistent mispricing means that an additional return can be achieved without additional risk (think equity factors).

2) Just more risk: Simply holding greater exposure to assets or securities that are riskier and have higher expected returns.

Neither of the two are alpha in the purest sense. The first of these should be attractive (if you believe in them) but cheaper. The second is just a question of how much risk you are comfortable taking and should be transparent and low cost.

What are some examples of common ‘cheats’?

Investment grade bonds: Permanent BBB / high yield overweight.

High yield bonds: BB overweight and / or CLO exposure.

UK equities: Mid-cap bias.

General equities: Momentum, value, quality, size.

Tactical asset allocation: Long market beta (often masked by heavy trading and narrative spin)

Now, it is easy to look at such things and believe that they are easy to spot with a bit of attribution or maybe just a glance at a factsheet.* This might be true, but I am not sure it matters. For a start many investors don’t have sufficient knowledge to identify such biases, and also they will often be shrouded in beguiling stories about how alpha is being generated. 

But, more than this, when it comes to performance, investors – of all types – don’t seem to care that much where it comes from – just whether it is good or bad. For example, when sophisticated investors talk about private markets do they focus more on the return profile or the underlying exposure to small / medium sized companies and lower quality credit?

Is it important how performance is generated if it is positive? Yes. For any investor it is critical to understand both the risks being taken and the results being generated. We also need to know their worth. Paying alpha-like fees for broad factor exposure or just taking on more risk is giving away returns.

Also such biases won’t always add value. They might go through long periods in the doldrums (equity value) or it might turn out that they don’t exist in the way previously thought (equity size?). And if our bias is simply to run more risk, then we are always exposed to shocks and sell-offs.

Structural exposures that enhance returns can be desirable, but we should know what they are, take them on willingly and pay the right price. Assuming outperformance is not ‘alpha’ is always a sensible starting point.

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* Attribution, whether Brinson or factor or something else, is a useful tool, but it doesn’t tell you definitively whether something is ‘alpha’.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).