Better Returns Through Greater Clarity on Portfolio Management & Risk Control

By Gary Brode, Deep Knowledge Investing

Deep Knowledge Investing’s primary goal is to help our clients and subscribers earn better returns in the market, but in order to do that, you need to understand my view on complicated matters. This letter is going to be more technical than most, but I promise that if you stick with me, you’ll gain clarity on a key aspect of portfolio management and risk control including how to make money when you’re “wrong”.

 1. A Description of “Alpha

Alpha is a way to quantify risk-adjusted performance against the market. Simply stated, it’s a measure of a stock-picker’s skill. Let’s go through a few examples.

  1. Imagine the market is up 10% for the year and your money manager also returns 10% while staying fully invested. That manager has demonstrated no skill during the year and you could replace him with an S&P 500 index fund. Alpha generated is zero.
  2. Now imagine the market is up 10% for the year and your money manager also returns 10%. However, in this example, he’s 50% long and 50% short for net exposure of zero (50 long minus 50 short equals zero). This manager generated a 10% return with no market exposure and demonstrated excellent skill. He has generated return with less risk. Alpha generated is 10% or 1,000 basis points.
  3. Now assume the market is again up 10%, and your money manager also returns 10%. However, he used leverage and invested 500% of your money in long equities. This means that it took 5 times as much capital as you invested to deliver the same performance as the market. That’s a lot of additional risk to deliver the same return as the market. This manager has demonstrated poor skill in this year and has generated negative Alpha.

We’ll come back to this concept in a bit.

DKI’s Thesis on the Market:

Two months ago, DKI wrote that we believed earnings estimates were too high and that sell-side analysts were waiting for companies to issue weak first quarter and 2023 guidance to lower estimates. Subscribers knew we were hedging 75% of our equity positions excluding energy because we thought that a month of declining earnings estimates would be negative for the market. We were partially right and partially wrong.