Method to the Madness: Alpha Chasing Beta

A reader asks:  "What is your investment strategy based on? Do you have a specific model?"

Fair question: Here’s the short answer:

My investment strategy is a "Macro-Vector" approach.

Its based on the belief that markets are neither random nor predictable, but rather, follow trends, which often respond to different combinations of factors in a way that may occassionally be predictible over the short term. 

Essentially, markets — all markets — only do 2 things: They Trend, and they Reverse. Most Macro models are designed to get you on the right on the right side of a trend, and keep to keep you there, and as far as that is concerned, mine is no different.

Where I diverge from most Trend traders is the process of determining when markets reverse. My framework uses 5 key elements — Sentiment, Market Internals (Technicals), Monetary Policy (Macro-Economics), Valuation and Cycles — to determine the potential of a market reversal at any given moment.

Note that each of these 5 elements works on different time horizons, and they are presented from the shortest term (Sentiment, and then Internals) to the longest (Valuation and then Cycles).

Even within a well defined Trend, these 5 elements help determine what the relative risk versus reward of the equity markets are, and assesses the most advantageous investment posture — Long, Neutral, or Short.

~ ~ ~

“There are very few markets (betas) or managers’
performance numbers (alphas) that are not dominated by changes in the
macro picture. That is because almost all pricing reflects expected
future conditions, so prices change as a function of changing

-Ray Dalio, founder of Bridgewater Associates, which manages $120 billion in institutional assets.

I believe my approach is very different — and a bit of a throwback — than what seems to have become the dominant investing approach over the past few years:  The undue emphasis of Alpha over Beta.

What does Alpha over Beta mean?

It’s a bit of a tongue in cheek phrase, but follow it to its conclusion: The recent surge is hedge funds assets is the result of investors “chasing Alpha.” Money has been flowing to managers who have shown the ability to eke out a profit arbitraging away some of the inefficiencies in the market.

Over the past decade, the move to chase Alpha — rather than Beta — was perceived as the less risky, smarter strategy. But for obvious reasons, it couldn’t last forever. The underperformance of the alternative investment community shows the net result: With over 8,000 hedge funds, alot the Alpha opportunities have been wrung out. Many of the inefficiencies which were the basis for the strategies hedge funds have been pursuing (Alpha) have run dry.

The great irony is that a decade ago, Alpha was actually a function of Beta. The great hedge fund managers, — from Robertson to Soros to Druckenmiller on down — were Alpha males engaging in Beta trading. They made big, bold bets on macro events: Currency, Rates, Commodities, Indices, Sectors, Stocks. They hardly engaged in the genteel strategy of ekeing out a percent a month or so. Instead, these swashbucklers developed the tools and skills to read the macro enviroment. The good ones were successful, the great ones, wildly so. 

And then the meteor came. Like the Dinosaurs before them, the Beta players got pushed aside. A combination of smaller faster mammals — new managers offering reduced risk — and the dot com bubble did what the Bank of England couldn’t: They ended the reign of the Dinosuars.

The environment today presents a fascinating void, a place in the food chain for those who know that for most of investing  history, Alpha has been a function of Beta. That’s the spot where large gains can be had.

That’s where I want to be . . .

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  1. wcw commented on Jun 25

    While I know what you’re saying about the statistical arbitragers chasing the macro cowboys out of the market, I wish you hadn’t abused the alpha/beta distinction to say it.

    You’re chasing alpha as well, after all — you’re seeking excess risk-adjusted return, which is all anyone should understand by the term. Alpha is and should be expensive, since getting it with timing, fundamentals, macro shifts or statistical arbitrage is hard. Beta, exposure to one or another market, is and should be cheap, since going long or short a futures contract is something a monkey can do.

  2. edje commented on Jun 25

    So did Barry’s Macro-Vector model call the “any given moment” market REVERSAL on Thursday?

    Or did the model have Barry follow his own advice and buy the “breakout” on Monday’s close above 10,610 … and then continue to “increase his exposure to equities” as the DOW descended to 10,400 (and beyond) on Thurs. and Friday?

    Inquiring minds want to know?

    [BLR: Edje: Short term Frothiness could lead to an Intermediate Top, June 1, 2005

    Note the rest of the subsequent post (which you omitted) Re: Dow 10,610, the very next sentence is: “I am watching the other major indices — Nasdaq and SPX — for confirmation. Its also worthwhile to keep an eye on the Dow Transports, given yesterday’s Baltic Dry Freight Index.”

    Similarly, the next market commentary (Monday: Will Rallying Oil Set a Bear Trap?) noted: This is why we believe Traders should increase exposure to equities as the market pulls back towards support levels of Dow 10,400, Nasdaq 2,000, and SPX 1,181 for a strong second half rally.

    We are below the support I mentioned on the the Dow, and almost at where I would buy into the SPX and Nasdaq.

    No new positions have been initiated since that Friday post.

  3. HBT commented on Jun 25

    In reference to your overall strategy that you kindly explained above:

    I just started reading B.Mandelbrot’s much-lauded, “The (Mis)Behavior of Markets.” Have you read it ?… thumbs up or down ?… anything in particular that you think is helpful?…. hurtful?

  4. Barry Ritholtz commented on Jun 25

    To Answer WCW’s question: Yes, I was being cute with the language. Alpha is a function of how you play what Beta presents.

  5. edje commented on Jun 25

    Thanks much for the clarification — although I think: “I plan to buy the breakout above 10,610, on a closing basis” is about as unqualified and unambigous as you can get. It wasn’t “I plan on buying the breakout above DOW 10,610 IF the S&P confirms by reaching #### AND the NASDAQ confirms by reaching ####.” There was only a chart of the DOW trading range. “Buying” and “watching” are two different actions.

    But again I’ll give you the benefit of the doubt and accept that your call was duly “qualified” by your follow on sentence — and your clarified call now is that you plan to maximize your profits by catching a near term bottom and you will increase your equity exposure somewhere between here and NAS 2000 and S&P 1181 (come hell or high water — because a strong second half rally is coming).

    Thanks again. Love your site. Keep up the good work. Hope you don’t mind a needle once in a while.

  6. fred krueger commented on Jun 26

    The idea of making 20% plus or minus 5% a year is a fantasy. The person selling you that idea either (a) has just been statistically lucky over the last three years or (b) has been in one way or another shorting volatility to produce those results.

    People make money by taking risks. Starting companies with a hope and a prayer. Buying illiquid securities when everybody is selling. Buying real estate when no one else wants it. In all of these cases, returns are concentrated on “liquidity events” and not slow, steady-eddy dividend accumulation; or investing in people who claim they can deliver libor times 5 with no risk.

    As Marty Whitman said, the point where a buy will produce the maximum long term expected value is also the point where you can expect the greatest short term losses.

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