Investors face a significant challenge:

Identifying and executing strategies that generate the elusive “alpha.”

Most people consider alpha outperformance against some benchmark. Which is true. But it’s only part of the story. True alpha is derived from asymmetric returns.

Asymmetric returns come from true skill.

Despite my experience, I don’t think I ever had a true grasp of alpha until recently. Yes, I could measure the intercept in a regression. Yes, I could determine it’s statistical significance. But it wasn’t until I focused on the concept of asymmetrical returns that I understood what really sets great strategies apart.

In today’s newsletter, we’ll discuss alpha what asymmetric returns are all about.

Unlock alpha: The best returns need superior skill

What really matters for a strategy?

Asymmetric returns.

Asymmetric returns happen when a strategy gains more in good markets than it loses in bad ones. This is a key indicator of true investment skill and is what separates successful traders from the rest.

In practice, this means finding true market inefficiencies that can you exploit over long periods of time. Market inefficiencies are temporary and repeated asset mispricings that can be consistently exploited for profit. Exploiting these market inefficiencies lead to an edge.

It’s our job to detect, predict, and trade these inefficiencies.

Alpha in turn, is generated by having the skill to continuously exploit market inefficiencies—trade your edge. This typically comes down to capturing more upside in bull markets and avoiding the full downside in bear markets.

Let’s dive in.

Defining investment alpha (technically)

The efficient markets hypothesis says asset prices fully reflect all available information at any given time, making it impossible to consistently beat the market. In this case, no investor will earn abnormal returns through expertise or analysis.

This can be represented by a simple formula.

Where r_p is the returns of a portfolio, r_m are the market returns, and beta is the sensitivity of the portfolio returns to the market.

In practice, we know people make money, which can be described as their alpha.

Alpha is the intercept term that relates portfolio returns to market returns which represents the excess return unexplained by market movements.

This is the “alpha” term in a linear regression which when coupled with beta, completely describes the returns of the portfolio.

There are of course other factors that contribute to the returns of a strategy (random luck is a big one) which is captured in the error term, epsilon.

The relationship between alpha and market inefficiencies

A market inefficiency is a temporary and repeated asset mispricing that can be consistently exploited for profit.

That’s where we find our edge. It’s how we can begin to generate alpha.

These opportunities occasionally present themselves against the randomness of the market. They usually occur because of trader psychology, economics, microstructure, or company events.

It’s our job to detect, predict, and trade these patterns effectively. Our edge comes from the ability to consistently buy “cheap” and sell “expensive” over and over again, exploiting these mispricings to generate profit consistently.

Alpha is generated by having the skill to continuously exploit market inefficiencies.

Describing asymmetric returns with an example

A strategy with asymmetric performance is one that captures more upside in bull markets, having more winners than losers, and avoiding the full downside in bear markets.

Let’s look at an example taken from my course, Getting Started With Python for Quant Finance where we discuss this topic in detail.

The slide shows the varying levels of performance among different strategies. It highlights the performance in different market regimes.

• Strategy A exhibits no asymmetry, with equal gains and losses (+10% in bull markets and -10% in bear markets), indicating no alpha (Beta = 1.0, Alpha = 0.0). You may as well invest in the index.
• Strategy B is conservative, with lower participation in both market directions (+5% in bull, -5% in bear). This shows a beta of 0.5, with no alpha generated.
• Strategy C takes on high risk, doubling gains in bull markets (+20%) but also doubling losses in bear markets (-20%). This strategy shows a high beta of 2.0 but no alpha. This is similar to a levered position.
• Strategy D shows asymmetry by outperforming the index during a bull market while limiting losses in bear markets. The strategy loses money, but not as much as it gains in the bull market.
• Strategy E also demonstrates asymmetry. This strategy does not outperform the index during a bull market, but it does much less worse during a bull market. It is a defensive strategy with alpha and a beta below 1.
• Strategy F outperforms the market in both directions (+20% in bull, -5% in bear), indicating strong positive alpha with a balanced beta of around 1.
• Strategy G is truly exceptional. It makes money in both market conditions (+20% in bull, +5% in bear).

Asymmetry shows up in a strategy’s ability to do very well when things go its way and not too bad when they don’t. It’s relatively easy to make money in a bull market.

But can you make money in a bear market, too?