Alpha vs. Fees

In a recent article, Morningstar’s Jason Kephart analyzed the performance of long/short equity mutual funds, and concluded that while many managers in the category exhibit stock-picking skill, that skill has been insufficient to make up for the fees charged by the group. Fair enough, as that has to be the case for active managers collectively, whether long-only or long/short. But what caught our eye wasn’t the conclusion, but rather the methodology employed to assess skill: multi-factor regression analysis using the Fama-French factor returns.

This technique isn’t new. Most quantitatively-oriented shops, 361 Capital included, have long relied on such approaches. But it is rare to see mutual funds analyzed in such a way. And when we say “rare” we aren’t implying that it is improper in any way. In fact, it can be a far superior approach to the customary single factor benchmark analysis.

As the 361 Global Long/Short Equity Fund recently reached its three-year anniversary, we thought it would be a good time to put it under the scrutiny of multi-factor analysis. To begin, the factor set that we use is a bit different from Mr. Kephart’s. Whereas he relied on the standard three-factor Fama-French set, i.e., Market, Size, and Value, along with Momentum, we used the five-factor global equity set plus Momentum. The two extra factors are “Robust minus Weak,” which is a measure of profitability, and “Conservative minus Aggressive,” which is a measure of how companies invest in their businesses. All of the factor descriptions and data can be found here.

So how did our fund fare over its first three years, from January 1, 2015 through December 31, 2017? Remembering that our Fund has an average net exposure of about 70%, quite well. Against its primary benchmark, the MSCI World Index, the Class I shares generated the following statistics:

Fund Index
Annualized Return 7.83% 9.26%
R-Squared 0.22
Beta 0.32
Annualized Alpha 4.58

And against the multi-factor benchmark:

MTM CMA RMW HML SMB Mkt-RF Alpha Annualized Alpha
Betas 0.11 -0.11 -0.04 -0.36 -0.30 0.32 0.37 4.49
R-Squared 0.45

Comparing the R-squared measures of the two analyses indicates that by employing a multi-factor return set, we can account for more of the variance in the Fund’s returns. By doing so, the alpha does decrease, as more of the variability of the returns is attributed to beta sources. However, the annualized alpha, which is calculated net of fees and the risk free rate, certainly suggests that investors are being rewarded for taking active risk.

To be clear, like all analyses, this one has its pitfalls. For one, it implies that factor exposures are relatively static, which may or may not be the case, depending on the underlying strategy. The 361 Global Long/Short Equity Fund utilizes a dynamic model that will result in factor exposures that migrate over time. And so, for example, investors shouldn’t walk away thinking that the Fund will always have a negative beta to size. The key takeaway is that there are many tools with which to suss out the value add of active management, and investors should use as many as possible when trying to determine if alpha exists. In this case, we are happy to say, it does.

Read our last blog post, Stay Sharpe! (By looking at Sortino) >

 

As of 12/31/2017 1 Year 3 Year Since Inception 1/6/2014
361 Global Long/Short Equity Fund (AGAZX) 15.24% 7.83% 8.84%
MSCI World Index 22.40% 9.26% 8.53%
Morningstar Long/Short Equity Category 10.74% 3.37% 3.39%

Expense Ratio: Net 2.10%; Gross 2.20%
Includes dividend and interest expense on short sales, acquired fund fees and expenses. When excluded, the net with limitation expense ratio is 1.49%. See below for more information.