The equity strategist’s guide to wealth management

Thoughts on the alpha portfolio

My alpha portfolio consists of 30 stocks which all play on themes with an interesting long-term potential. I have invested in the following themes: carbon capture, semiconductors, sports fashion, fuel cells, gene editing, e-commerce in Asia, cloud computing, energy efficient pressurizer pumps, social media, copper mines, cure for hearing loss, shipping, plant-based plastic, electronic trading platforms, 3D printing, gaming, enterprise software applications, robotics, and fertility.

I view these alpha bets as risky and I demand the risk-reward profile to be high. As I view the world of equity investing, the point is to get high growth in your alpha portfolio. The objective should be to pick some of the winners in the future. Equities should be a bet on the future, innovation and productivity growth. The "value" part of investing comes naturally from the global market portfolio and anchors the portfolio at a lower risk point compared to a risky 100% equity portfolio. Many retail investors also like dividend companies, but the facts are that dividend aristocrats (those that lift dividends constantly over time) have not outperformed high yield credit for many decades. The global high yield total return index has delivered 8.9% annualized since August 2002, whereas the global dividend aristocrats total return index has delivered 7.8% annaulized.

For me that confirms that equity investing is not about dividends. I would rather invest in a company that constantly finds growth opportunities and reinvest its surplus earnings into those ventures. My final observation is that if you work in a certain industry then this knowledge can be quite useful for finding opportunities in your alpha portfolio.

Thinking about long-term expectations and risk

So what is my long-term expectation for such a portfolio? The market portfolio is designed to deliver 6.5% annualized return over the long-term so that is my expectation for beta. I expect the alpha portfolio to deliver 20% annualized return which sounds outrageously high, but it is based on my high risk-reward framework, more concentrated positions around convictions, high-growth themes, and opportunity to invest in smaller market capitalization companies because of my small capital base. One has to constantly evaluate the alpha performance and reduce the weight on the alpha portfolio if it does not live up to expectations. Multiplying my alpha and beta portfolio weights I get to a long-term return expectation of 10.6% annualized.

Estimating the percentage allocated to the alpha portfolio is difficult. But a simple and useful heuristic is to ask a question about maximum loss and how you would feel about such a loss. My beta portfolio has experienced a maximum drawdown of 22% and an aggressive alpha portfolio in single stocks could experience a drawdown of 60% in a market downturn such as we have seen during the dot-com bubble and the Great Financial Crisis. Multiplying my allocation weights gives me an expected maximum drawdown around 33.4% (the average maximum drawdown is of course lower, but one has to contemplate the maximum pain). That fits well with my own risk tolerance given my personal circumstances.

If that drawdown sounds like too much, an investor should then think about changing the market portfolio to a slightly less risk profile (moderately defensive or something else), but not too much as you are then deviating from the global market portfolio and thus making an active bet on bonds relative to equities. One could also just reduce the allocation weight to the alpha portfolio.

I hope it gave some inspiration about how to think about investing. So start with the big building blocks and then slowly add an alpha component, if you want the extra risk, and think about which single stocks fit into that box.