The Search for Alpha

By Emma Black (Portfolio Manager at Tier One Capital) 11 November 2013

Coined in the late sixties, the pursuit for alpha became the ambition of investment managers around the world. Financiers sought to produce returns greater than those that compensated for the risk of the market, and academics termed this additional return “alpha” following Michael Jensen’s early research. For a time, many managers were able to deliver however recently this pursuit has been rendered worthless given advancements in technology that have left many unequipped to participate. Bloomberg terminals that provide information to track cargo and oil shipments for example cost £20k plus per annum meaning that for the most part, this information has remained predominantly in professional hands. High frequency trading has also indicated that speed is of the essence in today's trading world with research indicating that trades longer than 15 seconds post-announcement don’t generate meaningful returns. Is this really true? And if so, how can managers today look to deliver their difference?

Eugene Fama, the recent Nobel Prize winner, is considered the modern father of finance. His PhD and research throughout the sixties readdressed the random movement of stock prices. While early work in the thirties had indicated that the random evolution of stock prices indicated market inefficiency, Eugene Fama argued that it was exactly the unpredictability of stock prices that supports market efficiency. The premise of Fama’s Efficient Market Hypothesis (EMH) was that stock prices are driven by information arrivals, and specifically, new information entering the public sphere. He presented three forms of market efficiency – the first would hold when stock prices incorporated and reflected accurately all past information, termed Weak-Form efficiency; the second would hold when stock prices incorporated and accurately reflected all past and all public information, termed Semi-Strong efficiency; while finally the third would hold in situations where stock prices reflected all past, public and privately-held information, termed Strong-Form efficiency. The conclusion from Fama’s work is that it is information that drives stock prices, and the fact that this information arrives unpredictably renders stock prices also unpredictable and hence their random price evolution doesn’t refute market efficiency but is actually a key cornerstone of it.

An abundance of research to-date has quantified that markets are at least weak-form efficient in that all past company announcements will have been incorporated in today’s stock price. Moreover, there is a general agreement that stock prices do also reflect public information, such as earnings announcements, managerial changes, and so forth. The third and the most restrictive, strong-form efficiency is largely deemed unachievable for insiders at an organisation will undoubtedly hold private information that will not be incorporated into stock prices until the masses are aware, at which point it will have entered into the public sphere. Despite this, stock prices do not necessarily suffer as insider trading rules and regulations mean that legal frameworks are in place to prevent the exploitation of private information on the whole.

The results of Fama’s work led investment managers to focus on ascertaining what the fundamental value of a stock actually was. Time was spent investigating key financial and accounting indicators, combining this with qualitative analysis and visits to key personnel, so that the “true” value of a stock could be sought to then take a position to benefit clients. But then came the introduction of technology into the mix, and since the internet revolution of the late nineties, financial markets have gained access to an abundance of information. Not only are we governed by the printed word, but we also find suggestions and opinions on message boards, online blogs, online publications, social media and more. This has meant that instead of stock prices being driven by news that reflects action in the large part, stock prices are now being driven by news that varies in its substance and reliability (how can we be sure of the worth of a post on a message board?) and is largely a reflection of opinion.

To try to combat this, at Tier One Capital we follow a core and satellite approach for you. Our core positions are designed to simply track the market and give you exposure in a very cost efficient manner. We utilise a range of beta products including exchange-traded-funds that can offer a total expense ratio (TER) combined in a core portfolio for you ranging between 0.90% and 1.14%, while on a standalone basis ETFs can offer TERs even as low as 0.09%. This cost-efficient core significantly reduces your overall fees and provides you with a systematic return that is not designed to beat markets, but rather to track them. This is then complemented with the use of satellite holdings designed to allow for your overall portfolio to be balanced between a low-cost delivery of beta, and a careful exposure to alpha.

In our alpha positions at Tier One Capital, we utilise a range of alternative investments. We offer our clients access to segregated structured product portfolios comprised of listed securities that can be bought and sold on a daily basis hence providing daily liquidity. Peer-to-peer lending projects can enhance your returns via allocations into property-backed projects across the UK. We also then complement your holdings with traditional investments into funds that we qualitatively and quantitatively evaluate as being worth the higher fees. This means that we screen the quantitative performance of funds but for an allocation to be made, we meet with the fund manager to qualitatively reason with his or her rationale and strategy for managing your money. This allows for your overall portfolio to be cost-efficient in its delivery and bespoke to your personal liquidity and income requirements.

If you would like to learn more about how Tier One Capital can help you navigate stock markets then please contact a member of the team to arrange a meeting at your convenience on +44 (0)191 222 0099.