Home Insights Equities The idiosyncratic advantage: Where unique insights drive unique returns
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The idiosyncratic advantage: Where unique insights drive unique returns

June 20, 2025 | 8 min read
Jonathan Price
Client Portfolio Manager, Equities
Matthew Peron
Deputy CIO, Portfolio Manager, Equities
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In the world of investing, the concepts of risk and return are fundamental building blocks. Yet, the systematic factors often overshadow even the best stock pickers. Understanding and harnessing the unique advantages of idiosyncratic alpha, i.e., stock picking, we believe are paramount for achieving attractive investment performance in today’s market.

Defining idiosyncratic risk

Idiosyncratic risk refers to the portion of an asset's risk that is unique to that specific asset, as opposed to market-wide risks that affect all assets. This risk is essential for active managers, as it encompasses the portion of performance that stems from a manager's specific skills, insights, and strategies, which can lead to excess returns, as opposed to market exposure, factor biases (whether intended or unintended) and timing. In essence, idiosyncratic alpha is the alpha that active managers genuinely generate through their own insights and investment strategies and, as such, cannot be passively captured or replicated. Style risks can be easily replicated via cheap passive or “smart beta” strategies.

The Capital Asset Pricing Model (CAPM) and the Fama-French framework have long emphasized the importance of systematic factors, such as market size and value. However, research over the last few decades also highlights the unexplained variables that can significantly impact returns—variables often overlooked in favor of broad market trends.

The value of idiosyncratic alpha

At its core, idiosyncratic alpha cannot be captured through passive strategies. In recent years, there has been a surge in the popularity of "smart beta" strategies, which seek to exploit systematic factors to generate returns. While these strategies can be effective, they often fail to account for the idiosyncratic elements that may provide true differentiation.

Recent market conditions underscore the value of idiosyncratic alpha. The last fifteen years have been characterized by high market-wide beta and persistent factor-based returns that are directionally persistent and low volatility, leading to a significant shift toward passive investing. However, the events of 2022 serve as a stark reminder of the limitations of these approaches. That year was marked by market volatility and factor rotations, serving as a sharp reminder of the value of the “idiosyncratic” element, which should be largely immune to these swings in market leadership. In fact, there were very few instances of managers delivering excess returns in 2022 by timing the change in factor leadership.

Repeatability: A key component of idiosyncratic alpha

One of the fundamental aspects of our belief in idiosyncratic alpha is its repeatability across varying market contexts. Historical evidence suggests that idiosyncratic returns are not merely a function of specific market environments; they can be generated consistently, regardless of prevailing conditions. This repeatability is crucial for actively managed investment strategies that remain robust over time.

Existing research demonstrates the persistence of idiosyncratic alpha. For instance, studies have shown that managers who have historically delivered alpha with a high degree of idiosyncratic risk are more likely to continue doing so in the future . In other words, research has shown that greater selectivity has historically produced higher alpha. This insight reinforces our conviction that an emphasis on idiosyncratic factors is not just a short-term strategy but a sustainable approach to investing.

A Distinct Approach to Idiosyncratic Alpha

Idiosyncratic alpha should be prioritized over systematic exposure. At Principal Asset Management, we employ a multi-layered approach that includes three key elements: a deep understanding of the stocks we invest in, a comprehensive grasp of the models we utilize, and an awareness of emerging trends that mainstream analyses may not fully capture.

  1. Understanding Stocks: A thorough knowledge of the companies in our portfolios is crucial. This involves rigorous fundamental analysis, assessing growth opportunities, and identifying potential mispricings. By focusing on essential value drivers, opportunities emerge that may be overlooked by the market.

  2. Comprehensive Models: A range of models considers both systematic and idiosyncratic factors. This dual focus allows helps to navigate complex market dynamics while maintaining a distinct edge in stock selection.

  3. Awareness of Emerging Trends: The market is continually evolving, and staying ahead of emerging trends is vital for capturing idiosyncratic alpha. Identifying shifts in sentiment and understanding the underlying drivers of these changes leads to informed investment decisions that capitalize on unique opportunities.

The two biggest challenges with idiosyncratic risk and return are, firstly, having an investment philosophy and research approach that can consistently generate idiosyncratic insights and, secondly, a portfolio construction approach that can combine these insights to maintain overall high levels of idiosyncratic risk. The first of these depends on having broad enough coverage to help ensure that enough rocks are turned over and opportunities are identified. In contrast, the second necessitates an understanding of how the systematic risks associated with any stock are related to those of others.

Generating idiosyncratic insights through independent research

Research shows that forward free cash flow yield is a powerful determinant of future return, is idiosyncratic, has efficacy across different style market environments, and cannot be passively replicated. Identifying and investing in companies where the market underestimates future free cash flow growth is the foundation of our proprietary research. This requires deep fundamental scrutiny of growth opportunities to assess free cash flow generation. It also requires an understanding of valuation, which involves identifying mispricing among stocks resulting from differences in growth expectations. Such opportunities arise by focusing on essential value drivers for each company and identifying material dislocations relative to market expectations.

A fundamental, forward-looking, free cash flow growth-focused discipline allows for an open-minded assessment of opportunities ranging from aggressive growth to deep value. By explicitly rejecting thematic approaches to investing, this strategy attempts to anticipate shifts in market sentiment by focusing on where and why dislocations exist.

A critical element of this stock selection process incorporates independent and uncorrelated sources of alpha. This requires a collaborative approach between our experienced fundamental research analysts, portfolio managers, and our advanced research and development team. The task is to assess the best ideas across all sources and identify those stocks where insights align with the strategy’s investment philosophy. Rather than employing a filter approach where the strategy predetermines the ideas, our independent approach seeks an unbiased review of opportunities. It is intentionally deeply resourced to help ensure open-minded and broad coverage across the investible universe.

If alpha sources are kept relatively independent and are not perfectly correlated, the intersection of these views should result in greater stock-selection efficacy than either resource in isolation. The results should yield higher and more consistent hit rates than would otherwise be the case.

Principal's process, a reliance on independent research

A critical element of our approach to generating idiosyncratic insights is our commitment to independent research. We believe that collaboration among our fundamental research analysts, portfolio managers, and advanced research teams is essential for uncovering unique investment opportunities. This collaborative environment fosters a comprehensive review of potential investments, ensuring that we consider various perspectives and insights./span>

This independent approach is designed to minimize biases and promote open-mindedness. Rather than relying on predetermined filters or themes, we prioritize an unbiased review of opportunities that allows us to identify stocks that align with our investment philosophy while remaining uncorrelated to broader market trends.

  • Risk Decomposition and Portfolio Construction

At the core of our portfolio construction process is a rigorous approach to risk decomposition. We understand that all stocks carry a combination of idiosyncratic and systematic risks. Therefore, we meticulously monitor the levels and sources of risk within our portfolios to help ensure that unintended systematic exposures do not impact our overall performance.

Risk decomposition also allows us to identify style factor biases that might otherwise go unnoticed. By breaking down the risks associated with each stock, we can better understand how they interact with one another within the portfolio. This understanding enables us to make informed decisions about position sizing and risk management.

Moreover, we acknowledge that systematic risk models are not always effective during periods of change. Past relationships may no longer be predictive, making qualitative assessments based on deep knowledge of company fundamentals an essential guardrail against unintended systematic exposure.

  • Proprietary tools for portfolio management

We leverage our proprietary Portfolio Management Workbench to inform our portfolio construction and minimize behavioral errors. This tool facilitates pro-forma trade scenario analysis, enabling us to assess the impacts on the portfolio profile, risk profile, and overall factor exposures.

Additionally, the Portfolio Management Workbench incorporates third-party tools that provide enhanced insights into factor exposures, factor attribution, and beta decomposition over time. By integrating these resources, we can refine our investment strategies and help ensure they align with our commitment to idiosyncratic risk and return.

  • Implied alpha analysis: A key determinant of position size

Within this process, we use implied alpha analysis as the primary determinant of position size. Implied alpha is an unbiased and independent check on stock conviction levels that considers not only the underlying risk of a stock but also the impact that the stock has on the aggregate portfolio’s volatility. It enables our portfolio managers to consider the multiple dimensions of a single stock, including the expected return, risk of the holding, confidence in the expected return, exposure to a range of systemic risks, and the correlation of these risks with other holdings in the portfolio.

The enduring importance of idiosyncratic risk and return

In a rapidly changing investment landscape, we feel idiosyncratic risk and return are not just important—they are essential for achieving attractive performance in an actively managed portfolio. The focus on idiosyncratic insights allows us to capture unique opportunities that the broader market may overlook. The results are portfolios with a high proportion of idiosyncratic risk and residual systematic exposures that are mitigated and understood to help ensure core, all-weather performance outcomes by design.
Equities

Footnotes

Mutual Fund’s R2 as Predictor of Performance by Yakov Amihud and Ruslan Goyenko. http://rfs.oxfordjournals.org/
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