Alpha Beta Soup

The analytical revolution in sports is a natural byproduct of the information arms race. As teams become more aware of the importance of data, they develop new and innovative analytical techniques. Coaches and general managers then use this information to guide their strategic decisions to give their team an edge. This has led to what were once obscure stats becoming more mainstream (especially in baseball where we have BABIP, xFIP, and UZR just to name a few). The issue here is that to the casual fan some of these terms might as well be Greek. The investment industry is no different. Industry professionals will use terms that are common parlance in the investment universe but can unintentionally confuse the investing public. My goal today is to explain two of the most common terms while also discussing the factors that go into investment performance.

Let’s start with the holy grail of investing: alpha. First, let’s define what it is not: simple outperformance compared to a benchmark. This might leave some scratching their head as alpha is commonly used to describe the performance of an asset that is doing well. Ok, so what is it? It is simply unexplained, unexpected, or abnormal return when controlling for various factors. These factors can vary based on whom you ask in the academic community, but it is common to use value, momentum, size, and profitability as those factors that explain outperformance in the long term. To use an analogy from the sports world, assume there is a basketball league where every team is comprised of players whose average height is 6’0”. While scanning the standings, you notice an undefeated team that is winning all their games by a large margin of victory. At first glance, it would seem that this team has found the secret sauce. However, when looking at the roster, you notice that their average height is 6’10”! If you controlled for average height as a factor for winning basketball games, their performance would be quite expected. True alpha only exists after all known factors have been accounted for.

Early on, academics looked at returns in the market and concluded that one thing mattered in determining the expected return of a stock: beta. Beta is a measure of the sensitivity of a stock price to changes in the broad index. A stock with a beta of 1.5 should exhibit 1.5x the volatility of the market. Intuitively, it made sense to relate everything back to beta. Those stocks that exhibit higher risk characteristics should reward their investors with higher returns. To bring it back to our basketball example, assume beta is equal to the aggressiveness of the team as measured by pace of play. Those teams with a more aggressive game plan tend to put up more points, but also are prone to more turnovers and defensive lapses therefore leading to a wide variance in outcomes. As should be evident, there are more factors that go into winning basketball games than just pace of play.

What’s interesting is that as research evolves, factors that have shown themselves to work over long periods of time tend to go out of favor. There are a variety of reasons for this, but one of them is most likely that the knowledge of the existence of a factor leads to everybody doing it which decreases or eliminates the edge. If every team in our basketball league signed taller players to bring average height up to 6’10”, that factor would no longer bear fruit. Look at the NBA – teams don’t succeed by having taller players than other teams but rather focus on other areas like 3-point shooting (see: The Golden State Warriors’ recent performance). I can almost guarantee, however, that if the height factor became an afterthought and teams focused their attention elsewhere, those teams with significant height advantage would see their fortunes improve.

And so it goes with investing. The discovery of factors has led to widespread adoption by investors which causes short-term underperformance. Much like a herd of cattle moving onto greener pastures, the current factor is abandoned in search of future outperformance elsewhere. Once abandoned, out-of-favor factors begin to show what made them popular in the first place and the cycle is repeated. As investors, it is important to expose your portfolio to these factors with the expectation that they aren’t going to work all the time.