Smart Alpha
It is common knowledge that human cognitive or psychological biases can lead to inefficient decisions, and professional investors are no different. However, understanding these biases and their sources can lead to effective risk mitigation strategies and better decision making. Research shows that in their bid to generate higher alpha, fund managers become susceptible to biases like “Selection bias” and “Allocation bias”.
Smart Aplha
It is common knowledge that human cognitive or psychological biases can lead to inefficient decisions, and professional investors are no different. However, understanding these biases and their sources can lead to effective risk mitigation strategies and better decision making. Research shows that in their bid to generate higher alpha, fund managers become susceptible to biases like “Selection bias” and “Allocation bias”.
Selection Bias
This bias occurs when stock picking is based on the fund manager’s preference or judgement, rather than a scientifically driven process. Consequently, the fund manager might end up favouring high performing stocks/ deviate to under-researched stocks/ or even hold on to underperforming stocks against contrary evidence.
Allocation Bias
This bias occurs when a fund manager exercises his discretion on allocating more weightage to a particular stock/s. Consequently, the portfolio’s outcome is unduly influenced by the performance of that stock/s. On one hand, a larger allocation towards underperforming stock/s can negatively skew the portfolio returns, and on the other, a lower allocation towards high performing stock/s will fail to deliver any significant benefit to the portfolio.
Smart Alpha Strategy
Smart Alpha Strategy
Smart Alpha Strategy
A Smart Alpha strategy mitigates both, selection bias as well as allocation bias by mandating a disciplined process of stock picking and equi-weighted allocation, such that equal attention is given to each stock.
Mitigating “Selection bias” through a rigorous framework
Starting with the universe of all the listed companies, progressive filters are applied based on attributes such as market cap, earnings (strong past track record and future growth prospects), core investment framework (leadership team, management credentials), and valuations (market share, price/earnings to growth ratio). This discipline helps the fund manager to stay focused on his core strengths and avoid any distraction.
Mitigating “Allocation Bias” by using Equi-Weighted Portfolios
In an equi-weighted portfolio, equal weightage is allocated to companies irrespective of their market capitalization. The portfolio involves balancing the weight allocation on every performing stock by avoiding lesser allocation to high performing stocks. The portfolio is monitored with a forced cost averaging and regular rebalancing is done every six months.
Selection Bias
This bias occurs when stock picking is based on the fund manager’s preference or judgement, rather than a scientifically driven process. Consequently, the fund manager might end up favouring high performing stocks/ deviate to under-researched stocks/ or even hold on to underperforming stocks against contrary evidence.
Mitigating “Selection bias” through a rigorous framework
Starting with the universe of all the listed companies, progressive filters are applied based on attributes such as market cap, earnings (strong past track record and future growth prospects), core investment framework (leadership team, management credentials), and valuations (market share, price/earnings to growth ratio). This discipline helps the fund manager to stay focused on his core strengths and avoid any distraction.
Allocation Bias
This bias occurs when a fund manager exercises his discretion on allocating more weightage to a particular stock/s. Consequently, the portfolio’s outcome is unduly influenced by the performance of that stock/s. On one hand, a larger allocation towards underperforming stock/s can negatively skew the portfolio returns, and on the other, a lower allocation towards high performing stock/s will fail to deliver any significant benefit to the portfolio.
Mitigating “Allocation Bias” by using Equi-Weighted Portfolios
In an equi-weighted portfolio, equal weightage is allocated to companies irrespective of their market capitalization. The portfolio involves balancing the weight allocation on every performing stock by avoiding lesser allocation to high performing stocks. The portfolio is monitored with a forced cost averaging and regular rebalancing is done every six months.
