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Alternative Market Briefing

New paper identifies room for improvement in alpha capture systems

Tuesday, June 29, 2021

amb
Francois-Serge Lhabitant
B. G., Opalesque Geneva:

A new paper has a few ideas on how to improve alpha capture systems.

Francois-Serge Lhabitant, professor of finance at EDHEC, and Denis Mirlesse, director at Steadfast Advisory Services, have teamed up to present an overview of the alpha capture systems (ACS) evolution from the first sell-side (such as brokers) to the more recent buy-side (funds) systems.

The paper, titled "Alpha Capture Systems: Past, Present, and Future Directions", investigates the differences between ACS, their input, and their limitations. It also looks at the improvements expected in the next generation of ACS, which should lead to higher alpha generation.

"A series of commercial and private systems have been developed to collect and track the performance of investment ideas," the paper explains. "These are generically called Alpha Capture Systems (ACS).

"Some are quite simple and limited to collecting lists of stocks and calculating their performance. Others require more sophisticated inputs, such as portfolios of recommended stocks including some weightings, and/or offer advanced tools to rank investment idea providers and ultimately create an optimized alpha-generating portfolio from their stock recommendations. Some are exclusively based on sell-side recommendations, while others explore investment ideas from the buy-side, with a universe including not only mutual funds but also secretive hedge funds and their regulatory filings."

Hedge fund ACS

With regards to hedge funds, the paper states there are two hedge fund alpha replicators in existence: the Global X Guru ETF (GURU) and the AlphaClone Alternative Alpha ETF (ALFA). Both were launched in mid-2012 and rely on similar proprietary rule-based methodologies using exclusively 13F Filings from hedge funds.

Following the initial marketing success of the idea of imitating the smartest investors, a large amount of ETFs using variations of their methodology was launched, sometimes with a particular focus on specific hedge fund strategies or segments of the equity market.

But the real game changer in hedge fund ACS was the creation of the Goldman Sachs Hedge Industry VIP ETF (GVIP) in 2016, which tracks the Goldman Sachs Hedge Fund VIP Index (* see more at the bottom of this article). This ETF has annualized 15% since 2001 (pro-forma until October 2016), outperforming the S&P 500 by about 80%. "This seems to corroborate the idea that the GS VIP index represents smart money, although some of its outperformance may be linked to a mega-cap bias," the paper says.

Improvements in ACS

The authors list several improvements they expect to see implemented in future ACS:

1. Broaden the universe of idea contributors beyond hedge fund managers
Many ACS limit their universe of idea contributors to one specific pool, for example, hedge fund managers listed in a database, and impose some key requirements. While convenient, these choices are highly restrictive and have important unintended consequences.

2. Use as many data sources for position data and update them as frequently as possible
Many ACS exclusively rely on Forms 13F collected quarterly from the SEC website. As a result, they only update their knowledge about investment ideas once a quarter, usually with a 45-day lag. While convenient, this choice is highly myopic.

3. Always validate and correct the data
A major issue with regulatory filings is the poor quality of the underlying data. The authors recommend that ACS challenge the accuracy of any information they use, even if it is provided by the SEC or collected, organized, and displayed by reputable third-party data providers.

4. Identify talented idea contributors, not talented fund managers
Having a large universe of idea contributors often creates more noise than information. On average, managers are average, and more than 80% of them have failed to beat the market over the past 10 years. Therefore, an ACS would do better with a small pool of talented ones.

5. Focus on highest conviction ideas
It is true that diversification reduces volatility and the risk of poor returns, and that concentrated portfolios are exposed to significant stock-specific ("idiosyncratic") risk, layered on top of the equity market risk ("systematic"). Idiosyncratic risk can be rewarding when there is a talented manager. Diluting it by adding lower conviction positions is therefore likely to result in performance deterioration.

6. Identify idea contributor skills and weigh their ideas accordingly
For example, an investment idea in a sector where a manager has proven stock-picking skills should be considered of a higher quality than if it comes from a sector where the manager has historically failed to deliver alpha or has never allocated previously.

7. Select standalone investment ideas
"Consider for example the case of a stock that is up for a takeover offer," the paper says. "An arbitrageur who believes in the success of the upcoming takeover will go long the target and short the acquirer and may size both positions large in his portfolio due to their expected convergence. If the ACS only collects 13F filings, the long position will likely be wrongly identified as a high conviction position, while the manager may have no positive view on that stock."

8. Identify leaders, not followers, and measure their ideas time decay
When analyzing a manager's position, an ACS should ascertain whether new high conviction positions are revealing new information, or if they are simply following a consensus trade. Before entering a crowded trade, ACS should try to understand the rationale behind the crowdedness and more importantly, avoid entering them too late.

9. Portfolio construction
The simplest approach to building a portfolio from investment ideas in the absence of any benchmark is the equally weighted portfolio.


Conclusion

On average, stocks are average, and only a few of them can generate a performance superior to that of the index. And the same goes for fund managers (minus the fees). But that does not mean there is no alpha to be found. ACS can succeed in delivering alpha when it finds valuable stocks and talented stock pickers.

"From there on, there is plenty of room for further research," the authors conclude. "For instance, one should look at the alpha generated and understand what drove it over time, e.g. change in factor exposures, sector or characteristics timing, etc. Another interesting direction would be the creation of long/short or even equity market neutral alpha-generating strategies from position data. This could be done shorting ETFs or baskets as hedges, but also by using data on large short positions where publicly disclosed (for instance in Europe), or even by shorting some of the positions that appear the least in the portfolios of the selected and supposedly talented stock pickers. At the extreme, one could also consider shorting the high conviction long positions of a pool of consistently non-talented investors. After all, shorting negative alpha may be a sustainable path to generating positive performance."


(*) GS VIP and SACS portfolios

GS VIP tracks the GVIP portfolio, while SACS tracks the portfolio recommended by the Steadfast Alpha Capture System, which was implemented by one of the co-authors of this paper. SACS tracks Notz and Stucki's AMC Steadfast Equity Portfolio since its creation on November 20, 2020, and uses a small group of 30 long-only investors and hedge fund managers as idea contributors.

When comparing the pro-forma performances of the GS VIP and SACS portfolios from 1 April 2008 until 31 December 2020, SACS has outperformed GVIP. This should not come as a surprise, according to the authors, given its more advanced analytics. SACS has also significantly and quite consistently outperformed the S&P 500.

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