There are many roads to Rome. Like many things in life, this adage holds true for the world of investing as well. Multiple approaches have, and continue to, deliver risk-adjusted, absolute returns in the world of asset management.

Nevertheless, it helps to have a conceptual framework, based on one’s worldview and convictions, with which to approach portfolio construction and the resulting asset allocation.

 

Source of “Alpha”

For institutional investors aiming to generate uncorrelated, absolute returns in an environment of cheap liquidity and “easy money”, the concept of “true alpha” – the ability to produce incremental, risk-adjusted returns above market benchmarks – comes into play.

Such outperformance requires superior skills in terms of actively selecting investment assets/securities that are distinct from the market, and thereby hedging portfolios against the risk of dislocation in mainstream asset classes.

In order to unearth these investment managers with a proven track record of delivering alpha, we believe the following four filters or criteria are important:

• Skill
• Inefficient Markets
• Alternative Beta
• Inaccessible Risk Premium

 

Let’s look at each of them in detail.

 

Skill

Human skill and judgement, we believe, still matters in the world of asset management, particularly in the context of True Alpha – the continuing commoditization of several investment products, categories, etc. amid the “passive wave” notwithstanding.

Beyond the publicly available and discussed investment ideas and narratives, there are numerous, “under the radar”, niche themes that offer superior return streams on a risk-adjusted basis.

This is the white space investors should focus on. They should look out for those under-the-radar asset managers who bring unique skill sets and competitive advantage vis-à-vis their area of specialization, and focus exclusively on harnessing the same to deliver True Alpha for their clients.

This typically would mean seeking out skilled asset managers trading in public securities, assessing their track record threadbare to unearth various attributes of their factor profile, and the derivation of factor and stock selection skills.

 

Inefficient markets

Market inefficiencies have existed, do exist, and will continue to exist – irrespective of human beings or algorithms making the investment or trading decisions. These inefficiencies can arise due to several reasons, including information asymmetry.

Many times, certain valuable information that can significantly influence the price or risk of a tradeable asset is not transparently available – thereby creating an opportunity for managers who have access to that data to generate True Alpha.

For instance, insurance risk as an investment product may sound a bit arcane and weird to several investors – and understandably so, given the lack of any meaningful information around it in the public domain. But buying mispriced, undervalued insurance risk can potentially deliver superior returns.

Reinsurance companies have been buying insurance risk, spanning different categories such as property, casualty, commodities and natural disasters, for centuries. And, the list of reinsurance products continues to expand in the digital era, as new forms of risk such as cyber hacking emerge.

So, investors should look at avenues that enable them to tap into such esoteric products centred around different risk categories. For instance, the commercial risks associated with natural catastrophes can be built into differentiated investment products, factoring in the gap between insured losses and the much higher level of economic loss. In return for bridging this protection gap, investors in such funds can generate proportionately higher returns, while also contributing to global causes.

 

Alternative Beta

Alternative beta essentially means gaining exposure to the risk premiums associated with several hedge fund strategies, such as global macro, long-short equity and convertible bond arbitrage.

This investment strategy is designed to capture the systematic bucket of hedge fund returns by adopting an unconstrained approach, wherein fund managers have the flexibility to take both long and short positions across their portfolios.

It is worth noting here that alternative beta is not a measurement, unlike pure beta. Instead, it is an investment strategy crafted around the concept of beta.

Investors should look to unearth managers running niche alternative beta strategies whose returns are structured around either non-traditional benchmarks and risks, or around alternative investment assets which track alternative indexes.

 

Inaccessible Risk Premium

Market access is not universal and uniform in the investing world, for various reasons. And that is what gives rise to inaccessible risk premium, wherein regulatory constraints and other structural factors bar several market participants from gaining exposure to certain asset classes.

Inaccessible risk premium can be a gateway to unlocking True Alpha, and so, investors need to look at the underlying return streams as ones sitting somewhere between transitional alpha and alternative beta.

Take, for instance, illiquid private investment products such as Private Credit, which have boomed over the past decade amid a significant deleveraging of banks’ balance sheets. Private credit instruments such as trade finance and leveraged loans enable companies – particularly, small and medium sized businesses who find it tough to access capital markets – to raise funding.