Alpha, Beta, Recessions and You

Recent investment manager performance is telling. Research shows that managers really set themselves apart from one another during recessions. Moreover, InvestmentNews reports in its November 16 issue, market timing trumps buy-and-hold investing amid big swings in economic activity. “Given that we are currently in a recession,” the author said, “our work suggests that individuals should be looking for a different type of investment manager – one that invests based on macro information.”

Marcin Kacperczyk, Stijn Van Nieuwerburgh, and Laura Veldkamp published a study called, “Attention Allocation Over the Business Cycle” in October 2009 which found, “that the data are consistent with a world in which some investment managers have skill, but that skill is often hard to detect. Recessions are times when differences in performance are magnified and skill is easier to detect.”

During the good times, the macroeconomic environment is stable so “market timing” adds no value. Instead, fund managers tend to cluster around the benchmark index and “stock selection” drives portfolio relative performance. Although stocks, individually, are more volatile than the macroeconomic variables, across a diversified portfolio the different managers tend to see performance cluster around the benchmark returns.

In times of macroeconomic volatility such as a recession, however, the large scale risk, though less volatile than individual stock risk, drives investor performance. The study showed that skilled managers add value by deviating more from the benchmark, focusing more on adjusting the portfolio asset allocation, so portfolio differentiation is much greater, both in portfolio construction and, ultimately, in performance. For this reason, it is easier to spot skilled managers during tough times. Alternatively, it is easier to significantly outperform during a recession, with the skilled managers employing market timing skills that other managers refuse – or are not allowed – to employ.

One way that I might summarize the finding is that in a recession, Beta matters more than Alpha. The sensitivity of the portfolio to the rise or fall of the broad market (i.e. the Beta) matters more than the ability to pick stocks that outperform their benchmark (Alpha). Even more simply, market timing is more important than stock selection in an economic downturn. In the more stable upturn, buy-and-hold is the way to go and portfolio managers should focus attention on stock selection.

The May-Investments portfolio building approach has always recognized this fact, although now we have a fancy sounding study with some really impressive mathematical equations to tell us what we already knew.

We have been implementing a “Flexible Beta” approach for several years now. Our willingness to take on risk varies over the course of the economic cycle. Call it “market timing,” or “tactical asset allocation,” or “staying in the way of what’s working and getting out of the way of what isn’t working,” or whatever you want. When market volatility increases, as it tends to do during a recession, it pays to be more conservative.

On the other hand, when the investing environment becomes favorable again, as it no doubt will at some point, we move to a fully invested position and focus more on industry research to keep us invested in healthy industries that are working well in the market. Though statistically this looks like a high Beta strategy (because it’s outperforming the market, which is also rising), it is focused more on stock selection (Alpha) when constructing a bull market portfolio.
 
Merry Christmas to all!

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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