Part 1
The quest for alpha - An introduction to the problem
Equity markets are puzzles to be solved and different investment processes are used by market participants. From an active management perspective, the act of advising can be reduced to making choices. The spectrum on which we can choose from is broad, but this can be broken down to a simple question when selecting a stock to build a portfolio, defined as the following:
Is the expected returns of stock A higher than the average expected return of other stocks (benchmark)ยน?
To answer this question, we need to predict what the expected returns of the stock A and all its peers are for different specific time horizons.
This is where many styles of investment processes will use different approaches, from fundamental to systematic. Fundamental approaches use an in-depth analysis of a company's business, management team and market opportunity to determine the stock's attractiveness whereas systematic investing emphasizes data-driven insights, scientific testing, and disciplined portfolio construction techniques to seek varied portfolio outcomes. Both are focusing on predicting, with their owns advantages and disadvantages.
The definition of predicting is anchored into the basis of observations, experience, or scientific reasoning.
At Evovest, we are scientifically minded individuals, but we believe we operate within the randomness of the markets. This makes predicting a mixture of many phenomena and uncertainty. For us, the method, and processes to achieve usable predictions in investment are based upon a scientific process, but they are mainly based on observations and experiences.
The approach taken by one portfolio manager to predict can differ significantly from the one used by its competitors, but the goal is identical, the quest for alpha.
Alpha, or excess returns, is a reformulation of the question we asked previously. It is the difference between the expected returns of a stock A compared against the benchmark.
This quest has seen many investment processes translate into books, gurus, and theories. Keeping track of all of them is out of the scope of this series, but we can use some oversimplification in the listed equity markets to illustrate our thoughts.
In the next part, we will explore how market participants solve this question, or at least try to.
A benchmark is a standard or point of reference against which things may be compared. In investment we use indices as the S&P500, Dow Jones Industrial Average or the NASDAQ. We will be referring it as benchmark (BM).