Building Modern Portfolios – Three Ways To Generate Alpha

In case you missed the first two segments of this series, the topic at hand is how to go about developing portfolios designed to outperform in today’s modern markets. More specifically, how does a manager attempt to provide outperformance in a world where trading is done at the speed of light and asset class correlations spike whenever an event or market crisis takes hold?

Recall that I had been working with advisors who wanted my team to create a series of risk-targeted, asset allocation strategies that would strive to “be around” the benchmarks during most calendar years and then try to “lose less” when the bears came to town.

At the outset of this series, I opined that while simplistic in nature, the first step in the process is to define the objective, then the benchmark, and finally, the time frame one wants to work in.

On the subject of benchmarks, we explored the importance of identifying and understanding the benchmark you are trying to best. I explained that after years of wrestling with the dilemma of which benchmark to target, I had concluded that benchmarks should be about (a) the risk level a client wishes to employ and (b) the alternatives an investor would have when deciding whether or not to use my investing services. And for me, this means utilizing Morningstar Target Risk Allocation categories.

So, with both the portfolio objective and benchmark established, it is now time to discuss the rubber meeting the road. I.E. How to deliver. In the business of investing, this is called generating alpha.

Seeking Alpha

In simple terms, “alpha” is the value a manager brings to the portfolio that goes above and beyond the “beta” a market itself provides. As an example, a stock market index generates a base-level return for a portfolio. If the S&P 500 gains 10%, then a stock portfolio starts with that tailwind. For investors that want a return equivalent to the market, they can just “buy beta” via an index fund or ETF.