Alpha's Not Dead

March 26, 2020

Classification Matters

We all know that the holy grail of active investing is to consistently outperform SPX. What then is the holy grail of passive investing? To deliver the exact returns of the tracked index? Operationally yes, but if you talk to an average passive money manager, their holy grail is finding (or in some cases creating) an index that will outperform SPX.

If the target isn’t SPX, then guess what? Those managers want to provide their clients with the best representation of the chosen strategy. What strategy? Where do these investing ideas come from? How are they generated?


Where It Gets Interesting

One of the hallmarks of research and investing is the Global Industry Classification Standard (GICS), which was developed in 1999 by Standard and Poor’s and MSCI. When investors talk about “financials” or any of the other 10 sectors, they really mean to say, “listed equities of companies that generate revenue from activities determined by S&P and MSCI to fall into the category of financial services.”

Many investors have come to rely on GICS as the springboard for not just classifying companies but creating a framework for discussing those segments of the economy. What happens when the economy decides to start coloring outside the GICS lines?

To paraphrase, if a new economic sector emerges, and there's no mapping for it, does it make a sound? The answer here is that those companies end up getting misclassified, and that emerging segment of economic activity isn’t acknowledged at all.


Emerging Segments

In my career, I’ve developed a number of indexes tracked by ETFs focusing on emerging areas of economic activity, including wind energy (FAN), cloud computing (SKYY), cybersecurity (HACK, LSE:ISPY), e-payments (IPAY), video games (GAMR), big data (BIGD), immunotherapy (CNCR) and cyber/privacy (LSE:CYBR). Some of these were developed entirely from whole cloth and others with research partners, most notably Ted Pollak (on GAMR), Brad Loncar (on CNCR) and Tematica Research (on CYBR).

To be clear, when I say “emerging areas of economic activity,” I mean that there are now enough companies with high enough revenue exposure to support a diversified 1940 Investment Act or UCITS qualified investment vehicle at scale. What is important to also note is that, up until recently, tracking an index was essentially the only way to get an exchange-traded product approved and out to market.

The one thing all of these strategies have in common is that these segments did not (and still do not) have unique representation in the GICS framework. The other thing that these strategies share is the outlook that these groupings of stocks will outperform the market. These strategies are not GICS sector or SPX rebranding exercises. They are all alpha seeking. Some have been more successful than others, but the goal here is performance.


New Era

I think what some investors forget is that the end of the pre-Regulation Fair Disclosure (Reg FD) world not only coincided with the exponential growth of the internet but (especially in the last 10 years) the rise of the information age. In today’s Python-enabled world, your average investor has access to not only the same information but many of the same tools (or has the ability to develop them) as just about any investment firm.

The markets have become vastly more efficient, and as hunting for individual names has gotten easier, everything seemingly has become a crowded trade. If your definition of “alpha is dead” means everything is a crowded trade, you might as well be standing in the middle of the Frozen Orange Juice Futures pit shouting, “Turn those machines back on!”

Alpha seeking has evolved from those hard-to-find single-name high variance trades into one of two things:

1) Brute-force-optimized quant models (smart beta/factor investing)

2) Qualitatively focused thematic portfolios (macro trends/emerging economic activity)

For large firms looking to enter the ETF marketplace using the “bring your own assets” approach, the safest way to transition those assets is to model out their existing active approach (smart beta/factor). For newer or smaller firms, capturing lightning in a bottle with a novel strategy can be very rewarding. The (literal) trials and tribulations of small firms are best left for another article.

In any event, my point still stands that, regardless of label, all investors (even shareholders of defined outcome products) are alpha seeking, and that alpha—despite what you may have read and heard—is indeed alive and well.

Now who’s got tickets for any of the August Rage Against the Machine shows at MSG?


Mark Abssy is the founder of All You Can ETF, LLC, and can be reached at [email protected].

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