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Method to the Madness: Alpha Chasing Beta

Posted By Barry Ritholtz On June 25, 2005 @ 7:26 am In Investing,Markets,Trading | Comments Disabled

A reader asks:  "What is your investment strategy based on? Do you have a specific model?"

Fair question: Here’s the short answer:

My investment strategy is a "Macro-Vector" approach.

Its based on the belief that markets are neither random nor predictable, but rather, follow trends, which often respond to different combinations of factors in a way that may occassionally be predictible over the short term. 

Essentially, markets – all markets — only do 2 things: They Trend, and they Reverse. Most Macro models are designed to get you on the right on the right side of a trend, and keep to keep you there, and as far as that is concerned, mine is no different.

Where I diverge from most Trend traders is the process of determining when markets reverse. My framework uses 5 key elements — Sentiment, Market Internals (Technicals), Monetary Policy (Macro-Economics), Valuation and Cycles — to determine the potential of a market reversal at any given moment.

Note that each of these 5 elements works on different time horizons, and they are presented from the shortest term (Sentiment, and then Internals) to the longest (Valuation and then Cycles).

Even within a well defined Trend, these 5 elements help determine what the relative risk versus reward of the equity markets are, and assesses the most advantageous investment posture — Long, Neutral, or Short.

~ ~ ~

“There are very few markets (betas) or managers’
performance numbers (alphas) that are not dominated by changes in the
macro picture. That is because almost all pricing reflects expected
future conditions, so prices change as a function of changing

-Ray Dalio, founder of Bridgewater Associates, which manages $120 billion in institutional assets.

I believe my approach is very different — and a bit of a throwback — than what seems to have become the dominant investing approach over the past few years:  The undue emphasis of Alpha over Beta.

What does Alpha over Beta mean?

It’s a bit of a tongue in cheek phrase, but follow it to its conclusion: The recent surge is hedge funds assets is the result of investors “chasing Alpha.” Money has been flowing to managers who have shown the ability to eke out a profit arbitraging away some of the inefficiencies in the market.

Over the past decade, the move to chase Alpha — rather than Beta — was perceived as the less risky, smarter strategy. But for obvious reasons, it couldn’t last forever. The underperformance of the alternative investment community shows the net result: With over 8,000 hedge funds, alot the Alpha opportunities have been wrung out. Many of the inefficiencies which were the basis for the strategies hedge funds have been pursuing (Alpha) have run dry.

The great irony is that a decade ago, Alpha was actually a function of Beta. The great hedge fund managers, — from Robertson to Soros to Druckenmiller on down — were Alpha males engaging in Beta trading. They made big, bold bets on macro events: Currency, Rates, Commodities, Indices, Sectors, Stocks. They hardly engaged in the genteel strategy of ekeing out a percent a month or so. Instead, these swashbucklers developed the tools and skills to read the macro enviroment. The good ones were successful, the great ones, wildly so. 

And then the meteor came. Like the Dinosaurs before them, the Beta players got pushed aside. A combination of smaller faster mammals — new managers offering reduced risk — and the dot com bubble did what the Bank of England couldn’t: They ended the reign of the Dinosuars.

The environment today presents a fascinating void, a place in the food chain for those who know that for most of investing  history, Alpha has been a function of Beta. That’s the spot where large gains can be had.

That’s where I want to be . . .

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