At their highest level, investment returns can be subdivided into three components: the cash rate, beta and alpha.
return = cash + beta + alpha
The cash rate is the base interest rate controlled by central banks. Every other asset is priced off this rate, including stocks and bonds.
A majority of the time, stocks and bonds return more than the cash rate to motivate investors to take risk. This makes intuitive sense. Why buy risky assets if the same return can be earned in a bank account?
Pictured below are the average arithmetic returns for stocks, cash and bonds since 1928.
The data confirms the logic. On average, stocks and bonds earn more than cash, which is why investors are willing to take on the additional risks.
The returns for stocks and bonds are examples of investment betas. Betas are cheap and easy to obtain, especially in the modern market environment. All you need to do is purchase a cheap index fund and hold.
The harvesting of this risk premium does not require market timing. Nor does it require time and energy. It only requires the mental fortitude to hold through volatility. That is the real “cost” of market beta. Can you watch your nest egg lose 50% and still hold on? If you can, you will realize the beta returns.
Improving on these passive beta returns requires something called alpha. Alpha is the reward for good trading strategy. You capture it by making a series of tactical bets against other market participants.
But capturing alpha is a zero-sum game. If you win, someone else loses. In this sense, you are actually competing against others in the marketplace to grab alpha from each other. That is why the process takes far more time and energy than collecting beta returns.
At Macro Ops, our goal is harvesting alpha, not beta. This causes our portfolios to look drastically different than the standard asset-allocation mix.
Asset-allocation portfolios deploy 100% of their cash into a mix of asset classes, including large caps, fixed income, annuities, small caps and more. They always play to the long side and never bet on an asset depreciating in value. Their goal is to generate beta.
Macro Ops’ portfolios, on the other hand, are focused on alpha. They start from a cash position and use that cash to collateralize tiny tactical bets when the time is right. These portfolios are not constrained by market type or long-only mandates. They look for both bull and bear moves across all markets. Domestic equities, foreign equities, commodities, currencies, fixed income, volatility- it does not matter. These portfolios trade it all, long and short.
Sometimes stocks are boring and do not have attractive risk-reward setups. Sometimes currencies are the only markets moving. No matter the case, these portfolios’ flexibility makes it easy to avoid dead money markets and focus on the where the money is hot. Alpha is fleeting. Harvesting it is a constant chase. That means you gotta go where the getting is good.
There are two things we use the cash, beta and alpha framework for:
- Setting return expectations for the year.
- Determining our trading strategy.
We need to know the rate of return on cash to set our expectations for the year. If cash is returning 10%, then our return expectations should be well over 10%. But if cash is returning 1%, we will expect much less.
We alter our trading strategies based off this information too. For example, if cash rates are high, we may decide to collect interest and use those proceeds to buy out-of-the-money options on high-conviction macro themes. But if cash rates are near zero, this strategy obviously does not work.
Beta comes into play here as well. There could be times when a pure beta strategy looks great. After a large market crash, the total expected returns on stocks could warrant an index allocation. But if cash rates are low and bonds and stocks are expensive (low beta), then we would focus on making frequent tactical alpha bets.
Having an idea of this alpha, beta and cash return framework is vital to proper portfolio construction.
Do yourself a favor and bookmark the following links to keep track of cash and beta returns.
Awareness of these return metrics will help to hone your trading strategy and maximize returns in any market environment.
If you want to learn more about our trading process, check out our 80-page Macro Ops Handbook by clicking here.
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