“It is not the strongest of the species that survives, not the most intelligent, but the one most responsive to change.” – Charles Darwin, scientist, The Origin of Species
The Problem: When asked, “what is your sixth best idea?” a majority of fund managers do not have an answer. In fact, greater than 90 percent of asset managers do not have their five best ideas as their five largest positions (source: www.AlphaTheory.com). The problem is that as the correlation between position size and idea quality decreases, so does the portfolio’s risk-adjusted return.
Every portfolio manager’s espoused goal is to size positions based on idea quality, but in fact most funds do not have an accurate assessment of idea quality, which makes it difficult to build a portfolio based on it. Here is a quick example of how having a repeatable method of sizing positions using risk-adjusted return can solve this problem.
I recently asked a fund manager to name the best idea in his portfolio from a risk-return standpoint. He did, but after looking at the portfolio it was determined that his best idea was not the biggest position, a common source of lost alpha. I then asked the portfolio manager more specifics about the asset, including upside potential, downside risk, and probability of the thesis coming true.
Using the portfolio manager’s data I calculated a risk-adjusted return of less than 10 percent. He quickly agreed that he had several assets with better than 10 percent potential return. In essence, what he originally thought was his best idea was not his largest position and was also not really his best idea.
The problem was that the fund manager had determined his best idea from instinct, memory, and mental calculation. Instinct is no substitute for deliberate, logical decision making. Unfortunately these examples of alpha destruction by mental calculation occur all too frequently.
The Solution: Create a systematic approach to size positions so that idea quality and exposure are highly correlated. Imagine a portfolio where every asset has a dynamic risk-adjusted return that adjusts as prices and fundamentals change. Positions could easily be ranked from best to worst. If that simple process were in place, then the best investment based on current risk-adjusted return would be the largest position and the portfolio manager would be able to accurately identify it.
A firm must have a repeatable decision process that determines an optimal position size based on asset-specific analysis and limited by fund-specific parameters. Otherwise, positions will continue to be inefficiently sized and easy to capture alpha will slip away.
Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and CEO of Alpha Theory™, a risk-adjusted return based Portfolio Management Platform provider.
