GLOBAL INVESTMENT RESEARCH Finding Consistent Alpha Seth J. Masters Chief Investment Officer—Style Blend Equities Drew W. Demakis Chief Investment Officer—Structured Equities With future market returns unlikely to match the high levels of the 1990s, generating incremental alpha has become crucial. Our research shows that it’s possible to do so with relative consistency by combining managers effectively. www.institutional.alliancebernstein.com For several decades, US pension plans have looked to the stock market to achieve high returns on their assets, and over time, this has been a winning strategy: The return on equities has exceeded the return on long-term government bonds fairly consistently. However, the recent bear market—the worst since the Great Depression—has contributed significantly to a disconcerting shortfall in the funding of pension plan liabilities. The market’s return is bound to revert to the norm over may not have seemed that important when the market was time, but the norm is nothing like the 16.4% returns that returning 16% a year, with the market returning 9%, that funds enjoyed in the 20 years that ended in 2000, when extra 1% becomes critical. equity returns were boosted by dramatic expansion of In this paper, we will discuss both why achieving alpha price-earnings multiples (Display 1). Without the benefit is possible and how it can be done with relative consistency. of multiple expansion, equities are likely to return about 9% a year on average, and bonds, just 5%. Therefore, a typical plan with 60% of its assets in stocks and 40% in WHY ALPHA IS POSSIBLE bonds would see returns of about 7.3% annually, less than Efficient market theory postulates that alpha shouldn’t the 8.7% average return assumption. This 1.4 percentage exist, and common sense suggests that since the market point gap spells trouble. sums to the index, for a large group of investors to beat There are several worthwhile strategies for bridging the the market, others must lag behind. Nonetheless, the gap. Since no single one is likely to do the job, median manager in Mercer Investment Consulting’s most plans should probably consider all of them: raise the universe of US large cap managers outperformed the equity allocation of the overall fund, globalize investment S&P 500 by 0.6% a year on average for the 10 years strategies, add hedge funds and private equity, and ending in December 2002; those in the top quartile increase the alpha on existing assets. outperformed by at least 1.9% (Display 2). How is this possible? Our answer is that alpha exists because not all Increasing alpha, of course, flies against one of the investors seek it, and many of those who do seek it face biggest trends in investing of the last 15 years: the shift to systematic obstacles. indexed equities. Our research, however, shows that increasing the alpha on existing assets offers great Many investors don’t seek alpha because they have potential: While picking up an additional 1% from alpha other goals for their equity investments. For example, Display 1 Display 2 Plans Face a Looming Return Gap Managers Have Delivered Outperformance Annualized Return Mercer Manager Universe* vs. S&P 500 16.4% (1993–2002) Information P/E 6.7 Expansion Gap Premium Tracking Error Ratio† 1.4% Top 1.9% 9.6% 0.3 8.9% 8.7% Quartile 7.3% Earnings Growth 6.2 6.0 4.9% Median 0.6% 7.5% 0.1 Yield 3.5 2.9 20 Years Forecast Forecast Forecast Average 1981–2000 Equities Bonds 60% Stocks/ Expected 40% Bonds* Plan Return Bottom (0.7)% 5.2% (0.1) Quartile As of March 31, 2003 *Stocks are represented by the S&P 500 and bonds by the Lehman Aggregate Bond Index. *Mercer universe of US managers with reported returns from 1993–2002 Source: Center for Research in Security Prices (CRSP), Federal Reserve Board, (351 managers eligible as of February 2003) Lehman, Standard & Poor’s Handbook and Bernstein estimates †Premium/tracking error Source: Mercer Investment Consulting and AllianceBernstein Finding Consistent Alpha 1 many individuals and corporations own large stakes in Display 4 companies for strategic reasons or to control them; such Consequently, Market Inefficiencies Persist non-floating positions make up 16% of US market (%) capitalization (Display 3). Obviously, Bill Gates does not 50 Low P/E Stocks actively manage his stake in Microsoft to add value 40 Outperform relative to an index on a month-to-month or year-to-year 30 Average basis. Smaller holdings by individuals, who also tend not 20 to be effective alpha-seekers, comprise another 26% of 10 US market cap. Index funds account for another 9%; 0 by definition, they do not seek to add alpha. (10) (20) The two alpha-seeking groups, mutual funds and other 72 77 82 87 92 97 02 institutional investors, represent slightly less than 50% of (%) 50 Positive Momentum Stocks Outperform market capitalization. That means there is opportunity for 40 them to benefit in aggregate at the expense of the other 30 Average groups. Of course, not all alpha-seeking professionals 20 succeed in delivering alpha, and many face systematic 10 obstacles to doing so. 0 One systematic obstacle is the tendency of investors to (10) (20) chase performance, as shown in the recent tech bubble. 72 77 82 87 92 97 02 Growth stocks’ massive outperformance during the tech Through December 31, 2002 Annualized hedged returns of most attractive quintile of stocks relative to the bubble in 1998 and 1999 led to a total of $400 billion in equal-weighted universe of global large-cap developed markets net flows from value mutual funds to growth mutual Source: Bernstein analysis funds in 1999 and 2000, according to Morningstar. Awash with cash, managers of growth funds were forced to add to their established positions at ever-increasing prices, once the bubble burst, soaring fund redemptions forced creating alpha opportunities for other investors. Then, them to sell positions at ever-decreasing prices, which also created alpha opportunities. Display 3 Thus, timing decisions by the ultimate investors, rather Why Alpha Can Exist: Not All Investors Seek It than alpha-seeking activity by fund managers, drove many purchase and sale decisions at mutual funds. Such Composition of US Market Capitalization $13.2 Trillion market distortions allow alpha-generating inefficiencies Non-Floating to persist even when they are well understood and Holdings* “Alpha Seekers” exploited by active managers. 16% Active Institutional 31% Managers Two well-known examples of such market inefficiencies Individual (or anomalies) are often associated with the value and Holdings† 26% growth style disciplines, respectively. The cheapest 18% quintile of stocks, ranked by price-to-earnings, system- 9% atically outperformed the MSCI World (Display 4, top). So did the quintile of stocks with the highest price Index Funds Active Mutual Funds momentum (Display 4, bottom). Of course, a key step in As of December 31, 2001 choosing an active manager is believing in the anomaly *Includes company founders and their heirs and corporate stakes †Includes company employees and other direct investments by individuals that the manager is seeking to exploit and checking that the are not professionally managed Source: Federal Reserve, Salomon Smith Barney and AllianceBernstein manager’s process and portfolios are consistent with exploiting that anomaly. 2 ALLIANCEBERNSTEIN FINDING ALPHA THE RISK/RETURN TRADE-OFF But will active mangers be successful? As our legal The extremely long time required to have confidence in advisors insist we always say, past performance isn’t a high alpha managers, statistically speaking, arises because reliable indicator of future results. This is true for several only higher tracking error managers tend to deliver higher reasons. First, anomalies such as the long-term alpha. While the highest-alpha decile of US managers in outperformance of low P/E and high momentum stocks Mercer’s universe with high tracking error delivered don’t pay off consistently, so a manager that is disciplined annual premiums of at least 3% over the last 10 years, the in exploiting such anomalies will tend to have fairly high best performing managers with low tracking error tracking error. The median tracking error for managers in generated only a 1.3% premium (Display 6, top). the Mercer universe of US managers for the 10 years Furthermore, the incremental risk needed to generate ending 2002 was 7.5%, as Display 2 shows; such a greater alpha is large enough that the information ratio manager would typically underperform in nearly half of declines. Thus, high alpha managers tend to have lower all one-year periods. This variability in performance information ratios; managers with high information tends to decrease investors’ confidence. ratios, however, tend to have both lower tracking error Second, even unskillful managers can be lucky. It is and lower alpha (Display 6, bottom). That is, the only with the passage of time that you can tell whether the managers in whom you can have greater confidence good periods outweigh the bad ones and decrease the seldom offer high alpha; you can’t have such confidence influence of random outliers. Statistical tests allow us to in managers with high alpha. establish when you can have confidence that performance To understand why there is a declining marginal utility was due to skill. A manager’s information ratio—the pre- to added risk, let’s look at a simple example: One dollar mium divided by tracking error—is a useful measure for invested in a stock rises to $2 in the next year as the stock such tests, because by definition it relates return to risk. Unfortunately, the statistical evidence indicates that Display 6 many years of performance are needed to develop a High-Risk Managers Have Higher Premiums..