Idiosyncratic Alpha — Not a Factor Bet

Idiosyncratic Alpha — Not a Factor Bet

With a large reversal in factor returns over the last two years, we’re hearing this question a lot:
Can active management deliver outperformance that isn’t dependent on systematic factors?

Alpha (2)

We believe the answer is yes.

In our focused domestic equity strategies, what are we trying to accomplish?

Our objective is to deliver strong, risk-adjusted returns in a portfolio of focused stocks invested across the business life cycle.

But if we dig a level deeper, what we’re really trying to do is generate idiosyncratic alpha — i.e. outperformance unrelated to sector or factor exposures.

In today’s world, beta is free. Especially in the US equity market, there are cheap ETFs that can get you whatever beta exposure you’re looking for.

Investors sometimes chase active strategies that have generated outsized returns driven by factor exposures. Inevitably, those factor returns reverse, and underperformance comes just as the strategy hits peak assets.

We aim to outperform based on our stock selection, not factor bets.

But how do we isolate stock-specific risk in our portfolios? When building a balanced portfolio, we utilize our basket structure.

What are baskets?

Rather than limit our exposure in a focused portfolio (20-35 holdings) to the sector weights in an index, we take a differentiated approach to diversification.

More important than lining up sector exposures, we believe the best approach to diversification is to focus on types of businesses — what we call our baskets:

Emerging Businesses: Companies in the process of establishing a leading position in a product, service, or market with the potential for above-average growth.

Established Businesses: Businesses that exhibit steady earnings growth or cash flow and above-average profitability. These often sell at above-average valuations.

Mature Businesses: Financially sound, economically sensitive businesses, usually selling at low valuations relative to net asset value or potential earnings power.

Our active approach to long-term stock selection, paired with our differentiated approach to balance, provides our clients the opportunity to capture idiosyncratic alpha. If you’re going to pay for alpha, make sure it’s idiosyncratic.


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