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8 4 | BEYOND BETA The preceding results focused on alpha adjusted for one factor, market exposure, by including a modification of benchmark performance to account for each manager's beta, or the strength of its exposure to the relevant market or asset class. But beta is not the only component of the total return equation, and not all return earned over the benchmark is the result of idiosyncratic skill. Many other factors earn a risk premia as well. Reams of academic studies have focused in particular on rewarded style factors such as value, small size, momentum, quality and low volatility. Please refer to our whitepaper, The Impact of Strategic Beta on the Managed Product Landscape, for a review of these studies. Given our knowledge of these persistent sources of excess return, we are left to ask - are managers that show alpha adjusted only for market risk through beta really adding unique skill to earn their excess return, or are they simply earning the return from exposure to these well-researched rewarded risk factors? 4.1 | TRUE SKILL Traditional active strategies have long benefited from these known risk premia through their idiosyncratic stock selection. Strategies that look for undervalued, high quality stocks or stocks with persistent earnings surprises are prime examples that naturally lead to overexposure to the risk factors that have historically earned a premium, like value, quality and momentum in these examples. Any excess return they earn consists of the premia from these biases along with any true skill the manager possessed. In the past, the entirety of this return over the market was referred to as alpha (Figure 1), but the desire to delineate the true skill and risk premia components of excess return has grown stronger as cost compression pervades the industry. While investors had little choice but to pay active management fees to tilt toward factors in the past, the landscape has evolved. Systematic strategies that target the common asset classification schemes of value and small size have been staples of the investment landscape for decades. Today, the universe of cost effective, systematic strategies that target other rewarded risk premia is ever-expanding. The right-hand side of Exhibit 1 shows the philosophies that most efficiently capture the various sources of expected return. Efficiency in this sense refers to the strongest exposure to these sources for the lowest cost. In nearly any asset class, these less costly systematic factor-based strategies can be used to decouple rewarded risk factors from more expensive true manager alpha. Because investors now have choice in how they access factor returns, they are no longer tied to paying an active manager for them. A combination of systematic factor-based strategies and skilled traditional active strategies can lead to more cost-effective excess return. The onus is on active managers to earn their higher fee by contributing unique skill over and above factor premia, and the way to measure this true skill is by looking at multifactor-adjusted alpha. FOR ONE-ON-ONE-USE WITH A CLIENT'S FINANCIAL ADVISOR ONLY © 2022 Envestnet. All rights reserved. Figure 1 Advances in financial research, big data and computing ability have advanced our understanding of excess return. We now recognize that some of the excess return that used to be called "alpha" is actually earned through exposure to systemically present risk factors. Excess Return Past Present Alpha Alpha Beta Beta Systematic Market- Capitalization Passive Rewarded Risk Factors Systematic Factor-based Skilled Traditional Active Market/ Benchmark Return Academic Studies Data Availability Technology Most efficient way to capture Components of Total Return