Case Study: Intentional Alpha

Every fundamental investor has a set of rules, spoken or unspoken, which informs how they construct their portfolio. These rules define how they measure their ideas, but when these rules are applied inconsistently, idea quality and position size can become misaligned. How does a firm ensure that their 6th best idea is their 6th largest position? When position sizes become out of step with idea quality, managers leave alpha on the table.

Position sizing is made more complex by the multivariate drivers of stock price. Stock prices are driven by stock specific and market-related information, and the degree of influence from each changes over time. Since 2020, market-related “factors” have had an outsized influence on price movement, diluting the importance of fundamental manager skill in identifying investments with stock specific return drivers.

The winners of the current era of portfolio management will have to incorporate risk expectations into consideration to effectively exploit their best alpha ideas and build portfolios that are resilient to factor-driven markets. For the portfolio manager trained in fundamental stock analysis, this task can be daunting.

To help managers overcome this challenge, CenterBook, Alpha Theory, and Omega Point have partnered to provide an integrated position sizing toolkit to help managers focus on their core competency – picking stocks with idiosyncratic drivers of return.

This case study aims to highlight how fundamental research and factor-based risk analysis can be brought together in a single workflow to construct portfolios with superior risk-adjusted alpha returns. We define alpha as the unexplained, or idiosyncratic, component of returns from a risk model. We “explain” this return by calling it what it is: persistent manager skill.

• First, we highlight how market-related factors have had an outsized influence on price, and how these unwanted systematic risk exposures have caused performance drag and additional volatility to fundamental investment strategies.
• Next, we analyze actual data from a real, top-performing fundamental global equity hedge fund to illustrate the power of combining workflows from Alpha Theory and Omega Point to create guidance on position sizing which aligns portfolio volatility with “good” risk exposures, i.e. risk that comes from repeatable skill
• Lastly, we introduce a heuristic framework for quantifying and incorporating the trade-off between expected return, expected volatility, and desirable vs undesirable exposures of individual stocks when deciding how to size positions. In other words, we’ll show you how to find risks you get paid to take.  

CenterBook Partners, a multi-manager alpha capture hedge fund, was created to optimize these tradeoffs systematically, isolating fundamental manager alpha from systematic risk factors. Specifically, the fund uses research and portfolio data from process-oriented fundamental investment managers to build strategies where risks are aligned with repeatable manager skill.

In partnership with Alpha Theory and Omega Point, CenterBook is pleased to share its position sizing methodologies with the investor community. Our belief is that the investment performance of fundamental managers can be materially improved in today’s markets with tools and insights that can offer guidance on constructing superior, alpha-driven, yet risk-aware portfolios.