The Alpha Lifecycle

15 nov. 2019

Dear investors,

From a partial resolution of the US-China trade dispute to an extension of the Brexit deadline, it is clear that easing geopolitical tensions helped financial markets in October. Investors also applauded the continuation of a dovish monetary policy by the Federal Reserve, which cut interest rates by 25 basis points for the third time this year. On the whole these events helped the MSCI All Countries index to gain 0.4% during the month, bringing its year-to-date return to 22.3% in Euro-terms.

While this year-to-date return is quite impressive, we feel that the risk of a global slowdown is still very real and political tensions are never truly far away. For instance, while a no-deal scenario seems to be off the table in the UK, who is to say that Trump will not reignite anti-China sentiment in the US to boost support prior to the presidential elections. This is why we are we are still advocating a more defensive allocation. Vector Flexible currently hedges 60% of the market risk – an “insurance” which admittedly has cost us dearly in 2019, but which should protect our investors from significant drawdowns if these economic and political risks materialize in the months to come.

With markets currently being so driven by macro-economic news, stock picking might not be the most important driver of alpha this year. Yet, we’ve recently stumbled upon an interesting paper by Essentia dubbed “The Alpha Lifecycle” which details where investment managers add value during the stock selection process. The researchers argue that “most of the time, managers add value early in the period they hold a position, only to lose it precipitously at the end”. This is beautifully demonstrated in the graph below: the alpha (+1.75%) gained by buying the stock at the right moment falls during the second half of the lifecycle and the return on investment ends up being negative (-2.0%) by the time the position is closed out. Put differently, investment professionals tend to fall in love with the positions they recommend and hold them past their sell-by dates.

While breaking up with people or investments might be hard for humans, a computer does not really have the same emotional attachments. Within Vector we use a quantitative investment style, which tries to exclude emotions from the investment process by levering computing power. One of the many advantages of this approach is that it prevents us from making the mistakes documented above (i.e. holding on to stocks whose fundamentals no longer warrant this)!

Nevertheless, no approach works all of the time and October was a more difficult month for Vector Navigator which lost about 0.8%. Vector Flexible, whose return is in part determined by the alpha of the selection model, had a return that was virtually identical to its sister fund.

Best regards,

Werner, Thierry & Nils