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The Return of Alpha

From the onset of the COVID pandemic through much of the year 2020, we saw the deterioration of alpha-driven stocks as common, systematic factors dictated performance. So this week, we’ll revisit a question we last posed at the beginning of the year: “Where’s the Alpha?”. Have opportunities for idiosyncratic, stock-specific outperformance returned? If so, where can we look to find it?

To explore the potential return of alpha, we will use the same interpretation we’ve used in the past. Stocks that are “alpha-driven” move because of idiosyncratic drivers that are primarily specific to the company. Conversely, stocks that are “factor-driven” move due to external forces that are systematic in nature, such as economic reports, geopolitical events, or sector impacts.

For this week’s analysis, we will define alpha-driven stocks as having 67% or more of their predicted risk coming from the idiosyncratic contribution defined in the Axioma US 4 Fundamental Medium Horizon Risk Model. Conversely, we will define factor-driven stocks as having 67% or more predicted risk from common, systematic factors.

The Return of Alpha-Driven Stocks

As noted in our previous edition of “Where’s the Alpha?”, the crisis period spurred by the COVID pandemic led to a sharp decrease in alpha-driven stocks. The chart below shows that the percentage of factor-driven stocks in the Russell 3000 index increased dramatically in March of 2020 while the percentage of alpha-driven stocks shrunk significantly. The external forces in the market began to overshadow stocks’ ability to outperform their respective peer groups. Despite a brief uptick in March 2021, alpha-driven names have continued to win back their share of the market.


How to Identify an Alpha-Driven Stock

So, with this newfound opportunity, where can we look to find stocks with higher potential for idiosyncratic alpha? As of July 30th, 833 stocks meet our alpha-driven criteria and 223 stocks we define as factor-driven. To understand the fundamental characteristics of these two groups, we created equal-weighted portfolios and observed the style factor exposures in the Axioma US 4 Fundamental model.


As we’ve seen historically and what comes without surprise is that alpha-driven stocks have a higher degree of exposure to both Market Sensitivity and Volatility. What we also notice is that stocks that are highly factor-driven today tend to be Value names with higher Earnings Yields and Dividend Yields than their counterparts that tend to be smaller-cap, less value-oriented stocks with lower Profitability exposures.

With these characteristics in mind, let’s take a look at how the Russell 3000 index breaks down in terms of both alpha vs. factor and GICS sector relative to what it looked like one year ago.

In July of 2020, the Health Care sector had the most alpha-driven names. Of the 497 Health Care stocks in the index, 215 had an idiosyncratic contribution to risk greater than 67%. Beyond Health Care, however, there were very few alpha-driven stocks to come by. Eight of the eleven sectors had fewer than 10% of their stocks identified as alpha-driven stocks. As expected, there has since been a positive shift across every sector. As of July 2021, three-quarters of the Health Care names in the index have an idiosyncratic contribution greater than 67%. Tech, Consumers, and Communication Services all have strong representation as well. As a result, managers focusing on these sectors can expect to see more volatility above and beyond common, systematic market factor influences going forward.


Communication Services: Increased Opportunity

Communication Services demonstrated a particularly dramatic rise. In July of 2020, only 19% of stocks were considered alpha-driven. By the end of last month, that number rose to 51%. The chart below illustrates the trend in the Russell 3000 Communication Services sector by plotting the percent of risk coming from idiosyncratic contribution across all stocks. The boxes represent the second and third quartiles, while the whiskers represent the first and fourth quartiles. Since March 2020, the risk driven by idiosyncratic sources has been on a steep upward trend. The median stock went from ~50% idiosyncratic up to ~67%, while the degree of dispersion also came down as we see much less variation between the top and bottom-ranked names.


Alpha Crowding

Although fundamental managers will be relieved to see the greater potential for finding alpha across the spectrum, they must also consider additional systematic risks. For example, as alpha-driven stocks become crowded, volatility can become increasingly exacerbated by news events, earnings, economic reports, and short squeeze events. To better understand the latter, we looked at the same list of alpha-driven and factor-driven stocks in the Russell 3000 index as of July 30th, 2021, through the lens of S3 Partners’ proprietary Crowding and Squeeze Risk scores.

The S3 Partners Crowded Score and Squeeze Risk Score are multi-factor, proprietary ratings that quantify the degree of crowding and susceptibility to short squeeze events on a scale from 0 to 100. Scores of 50 and above have a moderate degree of risk, while scores above 75 indicate a high susceptibility to event-driven volatility. Most factor-driven names have scored in the 0-25 range, while nearly all sit under 50. On the other hand, Alpha-driven names show a much higher percentage at the top of the board. About one-quarter of alpha-driven stocks have a Crowded Score and Squeeze Risk Score above 50, and 5% have a high degree of Squeeze Risk. Given the magnitude of recent meme stock squeezes this year and their broader impacts, crowdedness and squeeze sensitivity are particularly important to monitor while on the hunt for alpha.


While alpha appears to be on the rebound, we will continue to keep our readers up-to-date on the broader market landscape. In addition, if you are interested in discussing further and applying this research in your portfolio management process, please let us know!

US & Global Market Summary

US Market: 08/02/21 - 08/06/21

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US Stock Market Cumulative Return: 8/2/2021 - 8/6/2021
  • The market enjoyed another good week, with the major US indices up around 1% and the S&P 500 and DJI closing at new ATHs on the heels of an encouraging jobs report.
  • The US created 943k jobs in July vs. the consensus expectation of 845k - indicating that the economic recovery is continuing to chug along, even as we deal with the proliferation of the delta variant.
  • The jobs beat and slide in unemployment to 5.4% from 5.9% in June precipitated a bond sell-off, with yield on 10Y Treasuries jumping by more than 8bps to 1.3% on Friday.
  • Fed speakers this week, including Dallas Fed President Robert Kaplan, are starting to suggest the FOMC could be ready to begin a “gradual” taper in September.
  • 90% of S&P 500 companies have now reported 2Q earnings, with 87% of them beating consensus estimates according to Factset.

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

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Methodology for normalized factor returns
  • Value topped the leaderboard this week as it climbed 0.33 standard deviations and is poised to exit Oversold space at -1.01 SD below the mean. This factor recently hit a trough of -2.22 SD below the mean on 7/8.
  • Earnings Yield continued its recent surge as it crossed into Overbought territory, now at +1.16 SD above the mean.
  • Profitability headed higher into Overbought space after earning that designation last week.
  • Momentum surpassed its historical trend and climbed into positive normalized territory, now at +0.09 SD above teh mean.
  • Growth continued to slide from its recent peak of +2.12 SD above the mean on 7/23 as it heads lower and away from Extremely Overbought space.
  • Volatility continued its losing streak as it dropped deeper into negative normalized territory at -0.5 SD below the mean. We recently discussed this factor at length in a multi-part series - here’s the most recent article.
  • US Total Risk (using the Russell 3000 as proxy) decreased by 20 basis points.

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

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Methodology for normalized factor returns
  • Global Value continued to rally away from a recent bottom of -2.22 SD below the mean on 7/21, now sitting at -1.38 SD below the mean.
  • Earnings Yield is still heading towards Extremely Overbought territory, now at +1.79 SD above the mean.
  • Growth ended the week where it started after staging a mini-rally during the week. It remains an Overbought factor at +1.46 SD above the mean.
  • Market Sensitivity appears to have hit a bottom of -0.9 SD below the mean on 7/30 and has started to tick up as of late, avoiding an Oversold label.
  • Exchange Rate Sensitivity crossed into Oversold space as it is now at -1.08 SD below the mean.
  • Weakness in Volatility persisted as it fell into Oversold territory, landing at -1.14 SD below the mean.
  • Global Total Risk (using the ACWI as proxy) decreased by 8 basis points.


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