Where’s the Alpha?

Originally published in the Brandywine Asset Management Monthly Report.

At a dinner in late 2013, Brandywine’s principals spent some time talking with the alternatives head at one of the large research firms. She made the comment that it appeared to be getting more and more difficult to capture alpha (excess returns over those earned simply by buying the “market”). We’ve continued to hear this refrain from others more recently as well. For readers of these reports, you understand that alpha is simply the term people use to describe Return Drivers that are not yet widely disseminated or accepted in the public domain. Which means that, almost by definition, alpha should always be difficult to find, as it’s only alpha if its not commonly known!

But that’s not the reason people state alpha is hard to find. The primary reason for those comments is that most people do not yet embrace a Return Driver based approach to investing and instead try to uncover alpha by looking in the same places that others are looking. Unfortunately, it’s over-tilled ground and unlikely to be fertile territory for new discoveries.

In contrast, it’s our belief that there are numerous sources of alpha available to be exploited. Brandywine has looked at hundreds of potential Return Drivers and we have been comfortable enough with a few dozen of them to incorporate them into the investment strategies used in Brandywine’s Symphony Program. Without getting into specifics (obviously, we need to be careful not to expose our sources of alpha lest we turn them into ‘smart beta’), let’s look at a recent example of two that have contributed to Brandywine’s positive performance this year.

A number of Brandywine’s investment strategies are based on Return Drivers designed to exploit people’s behavior. Over the past few decades, due to the excellent research conducted by people like Amos Tversky and Daniel Kahneman, what many previously suspected has been proven. For a variety of reasons, the average person is a terrible investor. The vast majority of people underperform the very funds into which they invest— by as much as 5% per year on average. This indicates the potential for an investment strategy based on a Return Driver designed to exploit this behavior by ‘fading’ the crowd. In particular, one of Brandywine’s strategies captures returns by looking at money flows into and out of bond and stock market ETFs. When the flows indicate irrational exuberance, the strategy takes short positions and in periods of despair, the strategy potentially enters into long positions. While many other futures managers have struggled in 2015, this approach proved profitable throughout the first half of this year.

A second strategy, also designed to exploit people’s behavior, uses measures that indicate people’s expectations for future price levels in a broad range of markets. It uses this information to selectively enter into positions in deferred futures contracts. Investment strategies based on this Return Driver have been Brandywine’s strongest performers to date in 2015.

Because these strategies are based on Return Drivers that exploit human behavior, we don’t expect them to be negatively affected by some of the ‘usual’ excuses assigned to the apparent decline in other sources of alpha, such as central bank intervention, high frequency trading or the globalization of markets.

But these are only a couple of the dozens of Return Driver based investment strategies employed by Brandywine. There are dozens, if not hundreds, of other relevant Return Drivers that can be developed into strategies to profit from the movement of hundreds of other markets. This provides the fuel for Brandywine’s ongoing research.

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