Building Intuition around the Alpha Opportunity Ratio

In last week’s Factor Spotlight, we we introduced the notion of the diversification ratio as a way to quantify the degree of diversification opportunity across a universe of securities. Using this metric, we analyzed the level of diversification available across various segments of the US market.

This week, we continue our analysis by highlighting the application of this ratio and offering a heuristic guide for understanding the attractiveness of stock picking within an analyst coverage universe.

Let’s start by reframing the diversification ratio. Although it is true that this can be used as a measure to understand the level of diversification benefit available within a universe of securities, this measure can also point to where and when uncorrelated opportunities exist to benefit from successful alpha ideas. Generally speaking, when diversification is high, stock-pickers will naturally face less factor headwinds and have higher opportunity to align portfolio risk with their alpha ideas. In this way, the diversification ratio may be better understood as the “alpha opportunity ratio”, especially when applied to a stock picker’s coverage universe.

Of course, there are several implications the alpha opportunity ratio can have on portfolio management. For example, a higher alpha opportunity ratio may lead a portfolio manager to lean more heavily into their alpha ideas by taking on a higher level of gross exposure. However, a lower alpha opportunity ratio may indicate that the portfolio should have a larger hedge in order to mitigate potential losses from highly correlated factor moves. Either way, managers need to have some intuition around what a given level of the alpha opportunity ratio means for their portfolio.

Heuristics for the Alpha Opportunity Ratio

To gain intuition about the level of the alpha opportunity ratio, we can first revisit the definition of this metric.

Alpha Opportunity Ratio = (weighted average security risk / total universe risk)

If the weighted average risk (i.e. volatility) of all securities in the universe is equal to the risk of the total universe, this implies that there is little to no diversification benefit within the universe. In this case, the ratio will be equal to 1. As the opportunity for uncorrelated alpha ideas grows, the ratio will increase.

While it may be clear that it is desirable for the alpha opportunity ratio to be greater than 1, the range of good vs great ratios may be less obvious. To answer this question, we leveraged portfolios from Wolfe Research designed to proxy hedge fund alpha ideas within the broad US as well as 6 high level sectors (TMT, Industrials, Health Care, Financials, Energy, and Consumers). These portfolios represent the most highly crowded longs and shorts across hedge fund investors.

We calculated the alpha opportunity ratio using the various portfolios, assuming an equal-weighting scheme within each portfolio. For the broad US portfolio, we used the Wolfe Research QES US Broad risk model to calculate the risk of each individual security as well as the overall portfolio risk. For the sector portfolios, we used Wolfe’s sector risk models to calculate the security and total portfolio risks.

The chart below shows the trend of the alpha opportunity ratio for the broad US and sector portfolios since 2014.

The trend over time shows that the alpha opportunity ratio tends to range from about 1.2 to 2.5. Of course, this varies by sector. The Consumers portfolio has the highest alpha opportunity ratio across most of the period, ranging from 1.6 to 2.5; whereas, the Energy portfolio ranges from 1.2 to 1.5 and typically has the lowest alpha opportunity ratio of all portfolios. Though the Consumers and the broad US portfolios have generally enjoyed the highest alpha opportunity, they also suffered the sharpest drop in opportunity during the March 2020 COVID downturn, with the ratio plummeting from 2.3 in January 2020 to 1.6 in April 2020 for the Consumers portfolio and from 2.1 to 1.5 for the broad US portfolio.

To get a sense for where the current alpha opportunity lies, we calculated the annual average ratio and compared that to the current level as of August 31, 2021.

Again this analysis highlights the stark differences in the alpha opportunity across segments of the market. For example, for the broad US, TMT, and Consumers portfolios, 2017 had the highest average alpha opportunity ratio, implying that 2017 was one of the best years for those segments in terms of stock picking. However, for Industrials, Health Care, and Energy, the average ratio was highest in 2018. Financials went against the grain and had its most attractive year in 2015.

Interestingly, we see that the current level of alpha opportunity within the Health Care space is rivaling 2017 & 2018 levels and inching above 2019 levels. For the rest of the sectors, the current level of opportunity seems to be trailing behind the heyday of 2017-2018 (or for Financials, the heyday of 2015).

The above analysis has helped to provide a guideline for what levels of alpha opportunity are desirable for a portfolio depending on its home segment of the market. In a future Factor Spotlight, we will wrap up our analysis of alpha opportunity by introducing a new application of our ratio to identify differentiation between active and passive management.

US & Global Market Summary

US Market: 09/13/21 - 09/17/21

• The US market ended a choppy week slightly down, as stocks pulled back on Friday to their lowest levels in four weeks. Tech led the way, as the NASDAQ slipped by -0.5%, the S&P 500 ended down -0.6%, and the Dow ticked down -0.1%.
• Chief among investor concerns was the potential earnings hit from a hike in corporate taxes, as House Democrats detailed a series of proposed tax increases on Monday, seeking to raise the top tax rate on corporations from 21% to 26.5%.
• Some favorable economic releases (see below) will have all eyes on the Fed’s meeting next week, as investors wonder if the Fed might hasten the schedule to reduce its stimulus efforts.
• On Tuesday, the Labor Department reported that consumer prices in August rose 5.3% from a year ago and 0.3% from July. This suggests that inflation might be cooling off, as both totals came in below consensus expectations.
• Retail sales numbers also surprised on Thursday, up +0.7% in August vs. consensus estimates of -0.8%.
• Treasury yields responded in kind, with yield on the 10-year up to a two-month high of 1.38%.
• The University of Michigan’s preliminary September consumer sentiment reading suggested a light rebound to 71 from August’s 70.3. Economists polled by the Wall Street Journal expected a reading of 72.0.

‍Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

• Volatility was the week’s biggest winner as it crossed into positive normalized territory after bouncing off a recent 8/23 bottom of -0.92 standard deviations below the mean.
• Market Sensitivity also showed resilience as it also appears poised to follow Volatility back into positive space.
• Value appears to have hit a peak of +1.16 SD above the mean on 9/15, as it started to tick down at the end of the week.
• Size declined for the 7th straight week as it continues to head lower towards Oversold space.
• Growth officially earned an Oversold designation as it slipped down to -1.18 SD below the mean.
• Earnings Yield saw another significant downward move, falling deeper into negative territory at -0.61 SD below the mean.
• Profitability continued to fall further away from its recent peak of +1.56 SD above the mean on 8/17, now firmly in negative space at -0.53 SD below the mean.
• US Total Risk (using the Russell 3000 as proxy) decreased by 17 basis points.

‍Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• Exchange Rate Sensitivity topped the leaderboard and entered positive normalized space after a 3rd consecutive week of strength.
• Volatility continued to climb higher into positive territory, now sitting at +0.41 SD above the mean.
• Value saw sustained strength, albeit at a slower pace than in previous weeks, as it heads higher into Overbought space.
• Size started the week in-line with its historical trend, and then ticked down into negative territory as the week progressed (now at -0.17 SD below the mean).
• Weakness in Profitability continued as it fell by -0.24 standard deviations, now perched at -0.57 SD below the mean.
• Earnings Yield was again the week’s biggest loser as it continues to fall deeper into negative territory (now at -0.67 SD below the mean).
• Global Total Risk (using the ACWI as proxy) decreased by 9 basis points.

Regards,
Alyx