The Third Alpha Source

There are three sources from which skill- (or luck-) based returns can be captured: security selection, tactical allocation, and strategic allocation.  While upwards of 90% of the industry is focused on either generating security selection alpha or arguing it doesn’t exist in great enough quantities to be worth seeking, the other sources of alpha are waiting to be exploited.

Benjamin Graham, Warren Buffett, and anyone who has sat for the CFA exam are likely to point out that buying quality companies while they are out of favor is an excellent way to earn above-market returns with comparable, or perhaps less, risk.  This is certainly true, but unfortunately the competition is fierce - as of July 2014, there were approximately 120,000 CFA members in 35 countries, all looking for inefficiencies in corporate valuations. 

Tactical asset allocation, or opportunistically allocating to out of favor sectors, capitalization tranches or other factor-based groups of stocks, is another way that alpha can be generated.  This alpha is a hybrid of security selection and opportunistic, in the sense that there is a “timing” element to larger clusters of securities with similar characteristics.  There are several professional services doing a great job of helping make recommendations between international and domestic equities, high-yield and emerging market government debt, etc., although this source is largely underutilized relative to traditional security selection.

Finally, strategic allocation is the most underrepresented alpha source of the three.  Purely opportunistic alpha, precious few services even exist to advise on mining additional alpha from the strategic allocation level of portfolios.  Bald-faced market timing, often pitched and historically a failed approach, is one way to try to access this alpha source.  However, a more sensible, risk-management based approach is through rebalancing. 

By employing a scientific approach to portfolio rebalancing (note: “once a year” and “when things are out of whack” are not scientific), investors are able to capitalize on outsized moves in market factors, ultimately retaining more of their profits from periodic up-markets, and growing the portfolio more rapidly with additional strategic allocations during periodic down-markets. This overlay can be easily implemented to add risk-adjusted returns, simply replacing existing rebalancing “strategies” that leave alpha on the table.

The good news is that these alpha sources are independent variables – that is, investors can derive alpha from each of the three sources within their portfolio simultaneously.  This could be done by hiring consistent active managers to manage individual sub-asset classes, researching or hiring a research firm to make recommendations on when to tactically shift assets within equity or fixed-income allocations, and finally, hiring a strategic allocation service to provide recommendations on allocating between equity and fixed-income allocations.

Most of the asset management world is busy chasing down the next great stock story and spending all of their 12b-1’s to convince you they have added 100 basis points of alpha each year (gross of fees, of course).  Tactical, and to an even greater extent strategic allocation services are being underutilized, and can generate far more alpha from the untapped sources while most of the asset management industry trips over themselves selling you their “unique approach” to large-cap value.


Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.