How to Calculate Alpha (The Novus Framework)
For us, the holy grail of manager analyses is the Novus Framework, our hallmark analytic that helps investors isolate and measure alpha.
As investors demand better transparency, they are also searching for more effective ways to measure a manager’s actual skill. Luckily, receiving more granular data means investors can also start applying more powerful analytics tools to assess portfolio management abilities and validate otherwise-difficult-to-ratify superlatives. Advanced allocators are increasingly appreciating the need to move from an absolute-performance model to a more holistic alpha-based approach. Novus offers sophisticated portfolio analytics to help investors build both a more rigorous due-diligence process, as well as state of the art monitoring dashboards.
Novus clients use many approaches to gauge manager ability, including the Novus Framework, which we've refined to help investors isolate and measure security selection alpha through portfolio analytics.
What is Alpha?
Novus Framework decomposes contribution into four factors: market, sector, security selection, and trading.
Market and sector together determine the passive contribution, or beta, of the portfolio, while security selection and trading represent active contribution, or alpha.
Whether you are an institutional investor trying to pick your next partnership, or a fund looking to improve future performance, the Novus Framework allows you to quantify how much alpha is being generated and where it is coming from. By assigning both a broad market benchmark as well as category level benchmarks, this opportunity cost-style analysis can be run to isolate the sources of contribution on a security and total portfolio level.
Novus Framework and Performance
For the following examples we will draw on the public data filings (13F) of Matrix Capital Management during the Covid-19 pandemic (March 2020 to February 2021). This is what the Novus Framework shows for the whole portfolio:
As you can see, broad market exposure was partly responsible for the portfolio’s performance over the period. Out of the 6,641 bps of total contribution from March 2020 to February 2021, 3,216 bps can be attributed to relative, or “passive”, contribution (below in blue), which is a combination of market and sector performance. This means that 69% of their total contribution is due to market and sector factors.
The manager’s aggregate stock-picking skill is represented by the security selection factor, which is part of active contribution (teal). We can see that security selection (1997 bps) is adding to the manager’s overall contribution. In fact, we can attribute 31% of total contribution to the manager’s ability to choose stocks that outperform both the market and sector, factoring in how they traded around the name.
Can we Calculate Alpha at a Security Level?
Yes. After all, our discussion of security selection alpha at the portfolio level from above is simply the total outperformance measured when you consider every security in the portfolio and aggregate the results.
Let’s look at a few specific securities in the Matrix Capital book.
Positive Returns & Positive Alpha
Matrix was invested in Netflix (and 50 other positions) during the chosen period. The contribution of NFLX to Matrix Capital’s public portfolio is summarized below:
Out of the 1,997 bps of security selection alpha across the portfolio, 75 bps of security selection alpha came from Netflix. In other words, about 4% of Matrix Capital’s security selection alpha was derived from that name.
What if a manager is interested in how alpha has accumulated over time? To get a more detailed view, we can look at the historical contribution of these factors in the chart below.
Note that because we are operating with 13F filings, we don't have details into how the manager is trading around the name. Novus clients, however, are able to analyze how trading contributes to alpha as well.
Positive Returns & Negative Alpha
On the opposite side of the spectrum, Matrix owned Salesforce during the same period.
Even though the market and tech sector factors were performing well, the specific security did not perform as well. This lower performance detracted from what could have been even better returns had the manager chosen another name in the same sector. This is an example of how Novus Framework helps us identify opportunity costs. Without the Novus Framework, we may have just noticed a positive PnL for the security and moved on. But what is actually happening here is the market and tech sector are compensating for poor security selection. Positive returns are worth celebrating, but there are certainly payoffs to applying a more rigorous analysis—like portfolio optimization.
In the cumulative breakdown analysis below, we can see that the name only generated positive security selection alpha for around four months out of the 12-month period.
Negative Returns & Negative Alpha
Matrix was invested in Avidity Bioscience over the same period.
While the market contributed positively to the portfolio, the specific security performed so badly that it absorbed the market’s contribution, resulting in a negative PnL. In this case, the manager would have been better off sticking to a market (or even a sector) benchmark rather than choosing this stock.
Negative Returns & Positive Alpha
If we zoom in on the month of March 2020, we see that Matrix owned Adaptive Biotechnologies during the apex of the coronavirus downturn. In this case, security selection was actually creating positive alpha even while the market as a whole was suffering. So, although PnL was negative, the outperformance of ADPT relative to the market and sector resulted in positive security selection alpha.
Hedge funds offer value when they pick defensive stocks that continue to perform well during market declines. Investing in biotech is an example of how hedge funds have been able to thrive during recent economic downturns, as biotech stocks have been historically able to beat the market during recessions. This is especially true during the coronavirus downturn since biotech output was in high demand.
Novus Framework is the best way to derive alpha insights for a portfolio. Not all managers that enjoy positive returns generate alpha, and not all managers that have negative returns generate negative alpha. Skill should never be solely measured in absolute terms.