The good news is that potential alpha is everywhere. Where do we look for alpha in an uncertain world? Consider that the aggregate performance of an index only shows part of its true performance. For example the return of the S&P 500 in 2010 was 15.1% overall, but 289 of the 500 companies posted a better return than the index, returning 38.3% on average. So alpha existed in the S&P 500 that year.
Similar analysis can be applied to prior years showing that a big spread between winners and losers. There is a tremendous amount of alpha potential in the market, yet most of the asset management industry does not correctly discriminate and the average manager fails to beat the benchmark. Why don't most managers beat the market? Let's examine the type of stocks that outperform, and then consider how managers look for those characteristics in the market.
There is substantial empirical evidence that outperforming stocks have an underlying set of common features, a “genetic signature.” They tend to be inexpensive, of high quality, and they have positive momentum. In other words, value, quality and momentum are three anomalies; factors which are mispriced in the market. Managers who consistently seek this genetic signature should succeed over the long term.
Most managers lose to the benchmark for three key reasons. First, they make forecasting the centerpiece of their investment process; they spend a great deal of time gathering information and trying to forecast better than everybody else. It is difficult to consistently outperform the market in this way. Knowing how Boeing constructs its 787 or how Apple builds the iPad offers no insight into whether these companies make good investments. Yet most industry analysts feel the need to delve into such minutiae. Conducting fundamental analysis in the Internet age is akin to drinking from a fire hydrant. Second, they ignore the genetic signature of a good investment — its basic characteristics — by getting lost in the details. Looking for this signature does not imply finding every piece of information about a company. It does mean focusing on the information that allows an investor to determine whether a stock has the essential characteristics of a good investment.
The third reason managers fail to meet the benchmark is that they have behavioral biases; the battle faced by managers and analysts every day is how to counteract those biases. Worst among these is “confirmation bias,” where investors spend most of their time gathering data that confirm their forecasts while ignoring data that contradict their theories.
Finding information and trying to forecast better is not the way to consistent success; rather it is filtering information and looking for the genetic signature that counts. Managers should be able to answer two questions very clearly and consistently: How do they identify good investments and why are particular names of stocks or bonds in the portfolio? The responses will determine how a manager finds the genetic code in those names.
The investment process can be top-down, bottom-up, quantitative or fundamental. Each approach has pros and cons, although some evidence does suggest bottom-up investing has an advantage over a top-down macro-thematic process, simply because the signal at the company level is more informative than the noise at the macro level. In today's environment, most people focus on the macroeconomic headline risks and ignore the favorable microeconomics of companies, particularly in the U.S. equity market. Empirical data show that microeconomic considerations ultimately will dominate over macroeconomic sentiment. Ideally a manager can combine the two methods to find the genetic code in a consistent way.
In conclusion, successful active managers focus on what they know and understand. They do not waste time on future predictions. They concentrate on micro, not macro factors, and tend to be very clinical and process-driven. Compound interest is maximized over the long run by avoiding large losses, not by beating the benchmark every single day, so a willingness to tolerate periods of underperformance is part of the package. Most importantly, they constantly seek the genetic signature of a good investment to tilt the odds in their favor.
Jay Feeney is chief investment officer and co-CEO of Robeco Investment Management.