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Allocators, Mind the Alpha Gap
What Institutional Investors Should Expect from Their Managers’ Position Sizing
Institutional allocators face one of the toughest environments for active management in decades. Despite a record abundance of data and analytics, many managers still struggle to consistently generate alpha for their LPs, while a select few continue to outperform. Many times, the wide dispersion in performance stems from differences in process.
What Allocators Care About Most
Investors are not only focused on performance, they also want to understand process. Process is used to gauge the repeatability of performance.
According to research from the Chartered Alternative Investment Analyst (CAIA) Association, investors are increasingly focused on what lies beneath the numbers. Performance is still a critical part of due diligence, but allocators now emphasize repeatability, discipline, transparency, and process quality as the true indicators of enduring skill.
CAIA notes that the best due diligence practices go “beyond the numbers” to uncover the story behind returns: the people, their operating principles, investment philosophy, and decision-making processes that produced them. Allocators are scrutinizing how managers generate results, not just what those results are. They want to know whether a manager’s process is consistent, adaptable, and continuously improved.
Moreover, investors don't just want to be “told” a story, they want to see it for themselves.
Institutional investors have been getting more sophisticated with manager research, and have themselves invested in data and analytics tools to better identify and quantify the value managers bring to the table. This new, more engaged and informed allocator is often collaborating, coaching, and even investing alongside the manager. But when does a more active role actually add value to both manager and allocator?
Institutional Investors Know That Alpha Is Still There. But Where Is It?
We see what the LPs see – alpha exists in portfolios of active managers. At Alpha Theory, we work with hundreds of hedge funds and long-only managers around the world. Through our unique lens, afforded by private data and a world-class analytics system, we see something that perhaps some allocators (and indeed even managers) might be missing. Sometimes alpha is hiding in plain sight.
Managers spend millions on alternative data, expert networks, and research technology. But in our analysis of hundreds of portfolios across millions of trades, we’ve found that a large share of alpha comes from simple position sizing.
The Hidden Alpha Inside Portfolios That Allocators Can Help Unlock
Here’s what we’ve learned from analyzing years of client data:
- Managers are generally good stock pickers. Their hit rates indicate that their price targets have predictive value.
- But when we compare “optimal” position sizing (based on each manager’s own research convictions) with “actual” sizing, we find more opportunity for alpha.
In our analysis of hundreds of managers over 10+ years, portfolios that followed optimal sizing would have improved their return on invested capital (ROIC) by over 400 bps annually.
And in our “Freshness” study, where we analyzed the effect of regular target price updates on ROIC, managers who updated price targets monthly rather than semi-annually generated nearly 4× more alpha on average.
This is not a genius breakthrough, it’s basic consistency and discipline – sometimes boring, repeatable process.
Why Allocators are Right to Ask About the Sizing Process
From an allocator’s perspective, this is a source of alpha that most diligence processes miss.
Everyone asks these important questions:
- How is your research different and where is your edge?
- How good is your stock selection?
- How do you manage risk?
But few ask:
“How do you decide how much to own of each idea, and how consistently do you follow that process?”
That decision on how to size ideas explains a large share of return dispersion between top-quartile and median managers.
The Theory of Alpha: Turning Judgment into Process
Our mission at Alpha Theory is to help managers turn good judgment into repeatable process. The idea is that a combination of the right tools, incentives, and accountability is all that’s needed to maximize the value of your research.
We don’t replace conviction or judgment, but we amplify it. By linking a manager’s own research inputs (bull/base/bear targets, probabilities, ratings) to systematic sizing rules, Alpha Theory helps managers ensure that:
- High-conviction ideas get sized appropriately.
- Out-of-date ideas are refreshed or removed.
- Portfolio liquidity and crowding limits are respected automatically.
- Every decision is tracked, auditable, and defensible during allocator due diligence.
This discipline has measurable effects: better information transfer from research to portfolio, less emotion, and more repeatable alpha.
Are your managers good at position sizing? Here’s how to tell.
Five Questions Allocators Should Ask Managers About Position Sizing
If you want to know whether your managers are truly maximizing their process or leaving some of their alpha on the table, ask these five questions in your next diligence meeting:
- How do you connect research conviction to position size?
Is there an explicit, documented framework linking expected return and probability to sizing? Most managers do not explicitly link expected return to size.
- How often are your price targets refreshed?
Our data shows monthly updates produce ~4× more alpha than semi-annual ones. Do you incentivize analysts keeping targets fresh? Most managers do not have a set schedule for updates.
- How closely does your actual portfolio match your “optimal” portfolio?
Can you quantify that delta and isolate the impact of the delta on overall performance?
- How do you monitor liquidity, crowding, and risk thresholds in real time?
Do you have system-level alerts to adjust size based on price movement? Expected returns and risk shift with prices. Most managers do not have a system that helps them rebalance or adjust size based on the new expected return.
- Can you show me the audit trail for sizing decisions?
Can you tell me why your 6th largest position is sized the way it is? A strong manager can show exactly why positions are sized the way they are because there is a formula based on inputs they know.
These five questions can tell you whether your manager treats sizing as an art, or as a process that is optimized to extract the most alpha possible from their research.
A New Kind of Partnership
As allocators take a more active role with their managers, the conversation is shifting. It’s no longer just about performance; it’s about process and repeatability.
At Alpha Theory, we’re helping bridge that gap, giving managers tools and structure that align with the standards allocators expect.
If you’d like to learn more, or if there’s a manager in your portfolio who could benefit from a conversation, we’d be happy to connect with absolutely no obligation.
After all, the alpha you’re looking for might already be in your portfolio. It just needs the right process to bring it to life.
Download the Ultimate Position Sizing Guide here.
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