Is there Capacity In the Alpha Opportunity Ratio?

Over the past couple weeks, we’ve spent time analyzing what pockets of the market offer the most alpha opportunity for active managers. We found that the alpha opportunity ratio can be a useful metric to understand when and where managers have higher opportunity to align portfolio risk with their alpha ideas. This week, we’ll wrap up this analysis by using the alpha opportunity ratio in a slightly different way to answer the following question - can we put enough capital behind alpha opportunities?

Let’s quickly revisit our notion of the alpha opportunity ratio:

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

Again, we can calculate this ratio across the Wolfe Research US broad and sector hedge fund proxy portfolios using the respective Wolfe risk models on a monthly frequency from December 31, 2014 to August 31, 2021. For our prior analysis, we equally-weighted all of the stocks in each hedge fund universe. However, we can deepen our intuition around the alpha opportunity even further by incorporating varying weighting schemes in the calculation. For this week’s analysis, we’ll compare the alpha opportunity ratio calculated using the equal-weighting scheme to a market cap-weighting scheme in order to help identify whether (a) the alpha opportunity only exists in smaller cap stocks and (b) are there particular periods more suitable to finding alpha in larger vs smaller cap names.

Alpha Opportunity Capacity

To conduct our analysis, we calculated two versions of the alpha opportunity ratio for the various hedge fund proxy universes - one version assumes an equal-weighting scheme (“AOR EW”) and the other version assumes a market cap-weighting scheme (“AOR CapW”). For the market cap-weighting scheme, we used the square root of market capitalization to smooth out the impact coming from larger cap, FAANG-like companies.

Once we have our two AOR metrics, we can divide one by the other to calculate a relative AOR:

Alpha Opportunity Capacity (“AOR EW vs CapW”) = Alpha Opportunity Ratio equal-weighted / Alpha Opportunity Ratio sqrt market cap-weighted

This type of comparison allows us to measure the alpha opportunity per asset (AOR EW) vs the alpha opportunity per dollar (AOR CapW). If AOR EW vs CapW is significantly greater than 1, stock pickers may find it harder to put more capital behind their strategies as the alpha opportunity may concentrate more heavily in their smaller cap names. On the other hand, a ratio less than 1 may suggest that larger cap stocks offer as much, if not more alpha opportunity than their smaller cap counterparts.

Alpha Capacity Unaffected by Cap for US Active Managers

The chart below shows a view of the AOR EW vs CapW since 2014 for the broad US hedge fund proxy universe. On average, this metric tends to trend close to 1, indicating that generally speaking, the alpha opportunities in the hedge fund proxy universe are not affected by market cap.

Alpha Opportunity Ratio Capacity Varies Across Sectors

Most notable in the chart above is the level of dispersion in the AOR EW vs CapW across the sectors. For example, within the broad US universe, the comparison metric ranges from ~0.98 to 1.04 whereas the metric ranges from ~0.95 to 1.07 across the sector universes.

Striking results emerge for the Financials hedge fund proxy in particular, where we see that though AOR EW relative to AOR CapW has been decreasing over time, it has persistently remained greater than 1 for the entire period. This points to some potential capacity challenges for active sector specialists within the Financials space to scale their alpha.

In contrast, the AOR EW vs CapW for the Industrials, Health Care, and Consumers hedge fund proxies spent most of the period since the end of 2014 below 1, indicating that the alpha opportunity for active managers appears more scalable.

Further Exploration for Alpha Opportunity

Additional research can be done to further dissect the dynamics of alpha opportunity (or headwinds) within the active discipline. Rather than using a weighting scheme based on market capitalization, one could look to alternative methods to proxy capacity; for example, volume or market impact metrics could be used to create weighting schemes that more closely align with the costs of trading the alpha names.

The alpha opportunity framework presented here not only informs active investors around when and where it is best to align alpha ideas with portfolio risk, but can also serve as tool for capital allocation to active strategies.

US & Global Market Summary

‍US Market: 09/20/21 - 09/24/21

• Despite some volatile market news this week, the US market managed to end the week on a positive note, with 3 consecutive days of gains. The S&P 500 ended the week up 1.2% and the NASDAQ was up almost 2%. The Dow had a rough start to the week but came back to end the week up almost 1%.
• Fears over potential global contagion from the default of the major Chinese real estate developer Evergrande continued into the weekend. Though the company was able to meet one of the critical debt deadlines, a different deadline was missed on Thursday and there is little clarity on next steps to address the company’s debt crisis.
• China was popular in the headlines this week with news of severe crackdowns on cryptocurrency-related transactions and activity within the country. This had a ripple effect on the markets, particularly in the technology space where some companies’ revenues are highly exposed to crypto-related transactions.
• During the September FOMC meeting, Fed Chair Jerome Powell expressed future expectations of rapid growth ahead; nonetheless, he also that the committee will not be making short-term changes to interest rates nor begin the process of tapering down bond purchases.

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

• Market Sensitivity continued on its upward trajectory since mid-August, with the normalized return moving into positive territory this week.
• Volatility also continued to bound upward as the normalized return doubled throughout the week.
• Growth ticked up slightly, but remains squarely in the Oversold realm at -1.14 SD below the mean.
• Size inched closer towards Oversold space as it continued to decline.
• Medium-Term Momentum moved closer to the mean and looks ready to cross into negative territory.
• Value officially fell out of Overbought territory on 9/21 as it moves back toward the mean.
• Earnings Yield and Profitability dropped into Oversold space as they continued to slide on a steep downward trajectory.
• US Total Risk (using the Russell 3000 as a proxy) remained stable across the week with a negligible decline.

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

• Exchange Rate Sensitivity continued with the positive momentum as it moves deeper into positive territory.
• Volatility followed just behind Exchange Rate Sensitivity and seems determined to move into Overbought space.
• Market Sensitivity made the jump into the Overbought range, now at +1.05 SD above the mean.
• Growth appears to be tapering off in the negative normalized territory at -0.49 SD after falling from a recent peak of +1.56 SD above the mean at the end of July.
• Size continues the downward march, moving to -0.36 SD below the mean.
• Medium-Term Momentum remains neutral but has been trending downward over the past several weeks.
• Value fell out of the Overbought range this week after a recent peak of +1.16 SD above the mean on 9/16.
• Profitability and Earnings Yield followed in the footsteps of their US counterparts, with the latter diving into Oversold space at -1.12 SD and the former not far behind.
• Global Total Risk (using the ACWI as a proxy) decreased by 16 basis points.

Regards,
Alyx