Trade A Strategy Not A Stock

I’ve said this over and over that if you are not reading Matt Levine’s free daily newsletter you are really not an informed market actor. The man writes so well about so many complex financial issues that his daily missive is often the highlight of my day.

This week in a riff on Bill Gross and the meaning of Alpha, Matt truly outdid himself and I am going to shamelessly quote a very large piece of his note because I think it carries so many important lessons to those of us who switched to algorithmic trading.

Levine writes, “Did Bill Gross generate alpha? Well, and what if he didn’t? What is “alpha”? Often you read that alpha is an investment manager’s return above a benchmark—if the S&P 500 returns 10 percent and a stock manager returns 12 percent, he has added 2 percentage points of alpha—but academics and allocators tend to take a stricter view. If he just bought riskier stocks to get that extra return, that’s not really alpha; he’s not demonstrating any extra skill or “really” outperforming the market.

One stricter approach goes something like this:

1. Look at the manager’s returns over time, and get a rough sense of what he actually did to get those returns.

2. Construct some smallish number of mechanical investing strategies that are sort of similar to what he actually did. These strategies could be as simple as “buy all the stocks in the S&P 500 index” or as complicated as “use an optimal trend-following strategy of buying lookback straddles”; they could involve a passive buy-and-hold approach or constant trading; but the point is that they can be totally specified in advance and a fairly simple robot could carry them out.

3. See how much of the manager’s actual performance could be explained by those mechanical strategies: That is, if you had just replaced the manager with a handful of simple robots programmed to carry out straightforward strategies, how close would the robots have come to his actual performance?

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