Non-Idiosyncratic Alpha

Abstract

The definition of alpha as the difference between a portfolio's returns and those attributable to its expected beta to the market underpins a common belief of an almost axiomatic conviction that alpha and the market returns are completely unrelated. Yet, at least hypothetically, it is quite possible for alpha to be affected by the market returns if there are more opportunities to generate alpha in certain market environments. The article argues that this is indeed the case in the corporate bond market even if tactical beta timing is not allowed. In particular, when security selection is the only possible source of alpha, a consistently skillful corporate bond manager should generate higher alpha in the bear market. This is because cyclical downturns serve as a catalyst for greater credit re-rating which can be profitably exploited. Conversely, the alpha opportunity set consisting of all potentially profitable security selection trades shrinks when there is relatively less credit re-rating as the bull market becomes more entrenched. Unless the use of leverage is permitted, the counter-cyclical fluctuations in the alpha opportunity set support a switch from fixed to floating alpha targets for corporate bond portfolios.

TOPICS: Portfolio theory, risk management