The holy grail of our analyses is the Novus Framework, representing the next generation tools to help investors isolate and measure alpha.
The investment management industry is going through an irreversible transition. As investors start understanding the need to move from an absolute-performance model to a more holistic, alpha-based one, and as more financial research is developing in the academic and professional worlds, the theories on how to generate the best risk-adjusted returns are being re-designed.
Novus is a product-oriented portfolio intelligence company. As such, we deliver the most comprehensive insights in the market. The holy grail of our analyses and methodology is the Novus Framework. This framework represents the next generation in tools to help investors isolate and measure alpha.
What is alpha?
The Novus Framework is very straightforward. It decomposes the contribution of a specific position, or the overall portfolio, into 4 different factors:
- Market contribution: It is the contribution attributable to the market. For this example, we use returns from the S&P 1500.
- Sector contribution: It is the contribution attributable to the specific sector of each position. We map each security in the portfolio to its respective sector benchmark (e.g.: S&P 1500 Financials).
- Security selection contribution: It is the contribution attributable to the active selection of each position within a sector. This is what we call “security selection alpha”, that is, the excess returns that any manager is aiming to achieve.
- Trading contribution: Managers can create or destroy alpha through their trading decisions. This contribution is categorized as the excess alpha from the intra-day or intra-month liquidation of positions.
Market and sector contribution together determine the relative contribution, or beta, of the portfolio, while security selection and trading contribution are considered the absolute contribution, or alpha.
Skill in Alpha
Each factor, besides the market, represents a different skill. If you are an allocator you would want to evaluate the skill set of the manager before committing to investing. Along the same line, if you are a manager you would want to evaluate yourself so as to improve future performance in the long term. This is indeed one of the added values of the Novus Framework: it not only quantifies alpha, but it also shows what skills a specific manager is good at. You can think of these skills in the following way:
- Sector contribution: For top-down managers, the selected sectors are part of the investment decision-making process and thus should contribute positively to the portfolio’s performance. By breaking down total contribution into sector contribution, it is possible to quantify the sector skill.
- Security selection contribution: For most equity-oriented funds, selecting the best names is part of why they exist. To achieve “absolute, risk-adjusted returns”, a manager needs to select those positions that will contribute the most to the portfolio given its risk profile. This is the skill of skills in investment management.
- Trading contribution: Depending on the investment strategy, trading could be an important factor in the alpha analysis of a portfolio. If a manager trades intra-day or intra-month, trading contribution gives a more transparent image of the trading acumen skill.
For Novus clients, alpha generation is neither the risk-adjusted excess return on the risk free rate or benchmark, commonly known as Sharpe ratio, nor the Jensen index. Alpha is far more granular.
Novus Framework and Performance
In the following example, we are going to draw on the public data of Viking Global Investors, an equity long/short manager. For the period from June 2014 to June 2015, this is what the Novus Framework shows:
How can we interpret these results?
- Market contribution: Had Viking invested all its market value dollars in the S&P 1500, its public book would have appreciated by 9.83%.
- Sector contribution: In addition to the market return, the specific sectors (benchmarks) that Viking chose to invest in during this period added 2.37%. The total relative, or beta, contribution was 12.2%.
- Security: However, the specific securities the manager selected during that period added 4.45% to total performance. When evaluating a manager, it is important to see 1. positive security alpha and 2. substantial security alpha relative to total contribution.
- Trading: The specific trading or investing decisions carried out intra-month added 0.28%. The total contribution from alpha was 4.73%
Can we calculate alpha at a security level?
Yes. After all, security selection alpha at the portfolio level is the alpha in every security added together
Let’s look at an example. Viking was invested in Allergan (and 148 other positions) during the selected period. The contribution of this equity stock to Viking’s public portfolio is summarized below:
Out of the 4.45% of security selection alpha, 0.45% came from Allegan alone. In other words, 14% of the Viking’s alpha was derived by a single name. In comparison, for the average Tiger Cub fund, the top winner contributed 37.5% to the total alpha generated over time.
What if a manager is interested in the TTM rolling alpha of Allergan in Viking’s portfolio? To get a more detailed view, it helps to look at the historical contribution of these factors.
During June 2014-June 2015, in addition to the overall outperformance of the health care sector, Allergan itself added increasing returns over time, beyond market returns.
Positive returns but negative alpha?
On the opposite side of the spectrum, Viking owned Thermo Fisher Scientific, also a healthcare name. During the same time range, while the market and sector contributed to the portfolio, the specific security actually detracted alpha. This would be an immediate red flag if it wasn’t because Profit/Loss was actually positive for the period. Sometimes, when there is positive returns, be it at the security or at the portfolio level, there is not necessarily positive alpha. Understanding this concept and how to derive it is what the Novus framework excels at.
The 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 not solely be measured in absolute terms.
What makes a successful hedge fund manager? We believe that studying performance alone does not adequately answer the question. By looking at thousands of active manager portfolios, we peek under the hood of managers’ investment process and recognize patterns that lead managers to consistent outperformance. These patterns can be viewed as investment skill, or managers’ ability to generate alpha through certain repeatable methods.
In this article we use public ownership data and the Novus Alpha platform to evaluate three very distinct money managers. The three case studies aim to identify the driver of these managers’ success: investment skill.
What’s in the report?
- Analysis of a top long-short equity fund
- Analysis of a top sector specialist
- Analysis of a top long-only manager