Investment Risk Guide - Part 5: Alpha
Remember beta? Well alpha, is something entirely different. Instead of buy, hold, and hope for prices to go up, what we are trying to do here is take advantage of opportunities that arise from inefficiencies in the global financial market place. But before we do that, let us first look at the mechanics of generating alpha. In essence, all one needs to understand is that in today’s world, it is just as easy to bet on prices going down as it is on prices going up. This involves a concept called “shorting”, whereby you borrow financial securities you don’t have from someone else, sell those in the market, buy them back some time later, and then return them to the owner. Any profit or loss depends on whether we chose the right direction of travel for the underlying instruments. Then there are financial derivatives which can be used for just about anything, and last I checked there were about $550 trillion of outstanding contracts in the market.
Taken together, the securities lending and financial derivatives markets have created a massive playing field as we can not only speculate on prices rising or falling, but also on how prices move relative to one another. We can buy and sell stocks at the same time, in the same size, and perfectly hedged against any form of market risk, when invested as a so-called “pair”. There are more than 46,000 stocks worldwide, imagine the many combinations of playing all of them against each other. But there is more, as we can also buy and sell bonds, commodities, share classes, calls, puts, futures, corporate structures, sectors, regions and even different asset classes against one another.
Alpha is a huge and complex category of investment risk. Ultimately though, the objective is very simple: we want to make money under any market conditions (or in non-layman terms: we want to take risk that is uncorrelated to beta). What’s an example of a trade that can produce alpha? Buying Vodafone and selling BT, because you think one has better fundamentals and the stock prices are indicating something different. You could also buy Crude oil versus Brent, copper versus aluminium, high yield bonds versus investment grade corporates or even a future versus a cash index. There are millions of different combinations and reasons to buy or sell one asset over another. Some people use fundamentals, others technical indicators and some look for patterns, but the only thing that really matters is whether we make money, or not.
What can go wrong? Well for one thing, you are holding two instruments and that means, they can both go wrong. I have seen grown men cry when that happens and all the reasons are cited as to why it would, could, or should not happen. But it does, because it can, and then there is leverage. In of itself that isn’t a problem. Using other people’s money to extract tiny individual returns from an arbitrage of one security with another, is the only way to make many of these strategies profitable.
But alpha risk was not created equal. Think of buying and selling the same security, which is listed on two different exchanges, but one trades at a discount to the other. The short-term mispricing may only last for seconds and only as large as pennies on the pound. But there is a big difference if we take down 10 or 100,000 shares in a particularly good opportunity. By borrowing money from someone else, we could get many pennies and pounds in the end. If you compare this to another trade, whereby you buy orange juice futures against Tesla shares, because the chart looks good, leverage can be a very bad thing indeed in case you get it wrong. So, beware of the false prophets and always ask yourself: why would a particular strategy produce alpha? If it is because there is a technological, structural or fundamental reason then that is fine. If it is, because the manager is “really smart”, you might want to give the strategy a pass.
Read our final post on Gamma > in this six-part series, as we look into all the core risk categories.