In our intro piece on Conversational Alpha®, we discussed the genesis of the term and how we use it to promote meaningful discussions about portfolio construction. We believe Conversational Alpha provides relatable narratives that can help investors commit to allocations designed for their longer-term goals. But achieving alpha—or returns over a benchmark—is not an easy task for a variety of reasons. Correlated markets, competing ideas and market signals and, in some cases, fees charged to clients add layers of complexity. Here, we put alpha in context and talk about how we go about generating it, a process that is much more creative than most investors think.
What’s more important: Absolute or relative returns?
The answer is in the eye of the beholder. For individual investors, absolute return is typically more important. Absolute return is an asset’s actual return for a specific period. It’s a binary measure. Most investors who earn a good positive absolute return in a given year will be happy even if their portfolio hovers around their benchmark, be it above or below.
Relative return is the difference between an asset’s performance over a specific period compared to that of another index or benchmark. It’s more of a concept and much less tangible. 2019 was a strong year for markets. As such, an investor achieving an 18% total return on their U.S. Equity portfolio is likely to be disappointed due to the S&P 500 Index returning in excess of 30%. Conversely, a 5% return on this same portfolio during 2018 would be viewed as relatively good due to the market being down more than 4% for that year. The idea of how a portfolio performed relative to the overall market or its nearest peer group has the potential to say far more than the absolute return number in isolation. It can provide feedback on the factors that contributed or detracted during a specified period of an investment.
Unfortunately, that context is more clinical than many investors can appreciate. During periods of weak absolute performance, investors frequently struggle to stick with the mission of their portfolio created around long-term objectives. It requires commitment, a passion for the investment, or a full understanding of the investment process. That can be a difficult discussion for a Financial Advisor to have with their clients. But this is where Conversational Alpha can help pick up the slack.
How to explain returns and make it fun
Thematics are our muse. A good storyteller makes even the most complex subjects come alive, so we seek relatable, investment-oriented themes to talk through portfolio construction and the factors that contribute to positive or negative alpha.
It’s challenging to engage with investors just along the classic investment perspectives of growth, value and market-cap, it’s boring and not relatable. Introducing big ideas and themes that are exciting, relevant and relatable to an investor’s everyday life has the potential to make their portfolio more personal and its performance easer to relate with.
The ideas surrounding sector investing is the easiest way to get a handle on thematic investing and the benefits of Conversational Alpha. Within sectors, many stocks share common traits. This increases the correlation between those sectors. For example, Financials and Consumer Discretionary stocks depend on credit markets, interest rates and economic growth. Energy and Materials stocks often beneﬁt during economic upswings because they provide necessary raw inputs to many other industries. Where it gets particularly interesting is when we can combine sectors that have a low correlation.
Thematic equity transcends traditional sectors while being brought together by its disruptive growth potential. As such, themes like FinTech span the GICS Sectors of Financials, Information Technology and even Health Care. Similarly, the ideas of Robotics and Artificial Intelligence touch areas of Industrials, Information Technology and Health Care while Lithium and Battery Technology focuses on Materials, Consumer Discretionary, Industrials and Information Technology. While technological innovation and the changing investment paradigm goes across all these themes, each theme is driven by different market dynamics and consequently there are diversification benefits to combining multiple themes into a portfolio.
Thematic investing is boundless. The agnostic approach it takes to geographies and sectors often results in low correlations to other portfolio strategies. That trait can be particularly useful for investment managers seeking to diversify sources of growth. Add the potential for sub-industry diversification and thematics can create a differentiated route toward returns.
Attaching a story to where we can potentially find 100 basis points of excess return with a particular sector allocation and or a thematic tilt has appeal. It’s particularly useful when diving into sub-sectors, which may not seem straightforward to many investors.
Action required: Timing it right
The clock with a passive investment like an ETF ticks slower than more active investments. But it’s not a passive endeavor. ETFs are typically used to access less expensive returns, but it’s incorrect to say that buying an ETF doesn’t preclude investors from the same issues in active management: what to buy, how much, and when. To that end, we reiterate that when investing, Passive’s Not Passive.
And so the story goes….
Achieving alpha is difficult enough. Explaining its complexities is an entirely different matter. On its own, an absolute return can’t give a sweeping view of investment performance. And a relative return often fails to resonate with investors. We believe Conversational Alpha is a way for Financial Advisors to humanize discussions about returns, connect with investors over time and keep them focused on their long-term goals. It can also be a path toward incorporating thematics in portfolio construction. We believe thematic investing creates opportunities to relate the seemingly unrelatable and, in the process, to generate return potential in increasingly competitive, correlated markets.