What drives Alpha in a volatile market?

Grant Watson, Co-portfolio Manager of the Old Mutual Managed Alpha Equity Fund at Old Mutual Investment Group.

As the local economy shifts to a low-inflation environment, there is growing concern that “Ramaphoria” may fast be losing its shine. This uncertainty, compounded by the intensifying trade war between the US and China – which continues to place pressure on emerging markets and their currencies – has created an increasingly volatile investment landscape for fund managers to navigate.

This is according to Grant Watson, Co-portfolio Manager of the Old Mutual Managed Alpha Equity Fund at Old Mutual Investment Group, who says that with so many conflicting local and global macroeconomic factors at play, fund managers can’t rely on a specific investment style or philosophy to consistently generate alpha - the excess return of a fund relative to the return of its benchmark index.

“Given the high level of uncertainty in current macroeconomic events, it is essential that an investment approach be dynamic enough to continually adapt and stay ahead of market movements, without getting side-tracked by market noise. A style agnostic factor-based investment philosophy is ideal in this respect, in that it isn’t fixed to any particular investment style and can adapt its equity and sector weighting to harness optimal levels of alpha in any given environment.”

Watson points out that the challenging current economic landscape, while pertinent to overall market performance, should not hinder an active fund manager’s potential to generate alpha. “It is quite the opposite actually, in that bear markets tend to historically be more conducive to the generation of alpha.”

This is because alpha is driven by a number of factors, he explains. “These factors include sectors’ effect, sentiment, value, liquidity, and environmental, social and governance (ESG) criteria – all of which play a vital role in the performance of a particular share.

“The current direction or trend of each of these factors, however, is not important in the generation of alpha. All that matters, in this regard, is a fund manager’s ability to adjust relative exposures in a portfolio according to the various factors that appear to be paying off at a particular point in time.”

This is where Watson says Artificial Intelligence (AI) is playing an increasingly important role in factor investing. “The world is data-driven these days, and a machine learning algorithm is able to process masses of information that would be impossible for one person to interpret.

“Human intellect, however, is still necessary in identifying patterns within this data,” he adds, summarizing that while AI has become an extremely useful tool in factor investing, there will always be a human element. “How we consume information has and will continue to change, but what doesn’t change is the irrationality exhibited by human decision-making, which is where sentiment comes in.”

With regards to which sectors he feels are currently well positioned to generate alpha for investors, Watson mentions financials and resources. “We are currently overweight on banks and, within resources, more general resources. However, this position will remain completely dependent on the factors we predict will be driving the market in the coming months.

“So long as our analytical insight allows us to remain on the correct side of these factors, in terms of being under- or over-weight in our exposure to particular shares, we will continue to maximize long-term capital growth for our investors going forward,” Watson concludes.