As a professional investor, you always have to keep one thing in your mind- Your ultimate objective is to outperform the market.

There are primarily only 3 ways you can generate Alpha - security selection, asset allocation, or market timing. For more professional and experienced investors, these three factors are continuous and evolving.

Beating the index is not an easy task. It is very difficult (but not impossible) to outperform the market (eg. S&P 500 Index) for anyone thinking about buying individual stocks and bonds. You may know already that roughly 1 in 20 actively managed domestic funds beat the index funds they track (according to Standard & Poor’s research). Over the last 15 years, 92.2% of large-cap funds lagged a simple S&P 500 index fund. The percentages of mid-cap and small-cap funds lagging their benchmarks were even higher: 95.4% and 93.2% respectively. In other words, the odds you’ll do better than an index fund are close to 1 in 20 when picking an actively managed domestic equity mutual fund.

Simple Techniques

There is no magic to beating the index but you can use certain proven strategies that may work. For instance, you can beat the S&P500 or NASDAQ 100 by potentially slightly overweighting securities that you deem may outperform the index and conversely underweight securities that you believe will perform unfavorably. These criteria could be simple or complex. It is not that difficult to evaluate analysts’ ratings that encompass the overall outlook of the security as well as the outlook of the industry. You can apply your filtering criteria every month or quarter to rebalance your portfolio. Under this process, you can own the entire market (S&P 500) but your weights are different from that of the Index. Do keep in mind, depending on the strength of your criteria and the level of deviation from the index, you can materially outperform or underperform the benchmark.

Complex Technique

For the investors who are well acquainted with the market, tactical asset allocation should be considered from time to time. At such a time, a Core Holdings-Trading portfolio could be implemented. Core Holdings-Trading Portfolio Management is an investment strategy that breaks a portfolio into two portions: the "Core Holdings" and the "Trading".

The Core Holdings portion is meant to capture the markets returns as efficiently and economically as possible. The Trading portion comprises actively managed securities intended to boost the portfolios’ returns and capture market outperformance. These types of investments can be utilized via individual stocks or ETFs. The portfolio is designed in this way to reduce risk through diversification, while outperforming a standard benchmark for performance such as the S&P 500 Index.

There is no magic process to building your portfolio. However, if you own individual stocks in your core holdings, you should be diversified across 5-10 individual stocks that are general less correlated. Similarly, it is prudent to diversify your Trading Portfolio across 3-5 ETFs, 5-10 individual stocks or a combination of both. Bottom line is that you need to be diversified across your risk portfolio (Stocks and ETFs).

Generally over time your Core Holdings should represent the majority of your portfolio.

For generating alpha over the market, you need to focus mainly on the following:

1. Security Selection :

   As mentioned earlier, Security selection is the process of identifying individual securities within a certain asset class that will make up the portfolio. For identifying winners, you should conduct thorough fundamental as well as technical analysis on companies or ETFs. There are many ways you can structure your security selection process.

   Generally, to identify winners, you can conduct thorough fundamental analysis on companies in the following manner:

   1. Top-down investing is an investment analysis approach that involves looking first at the macro picture of the economy, and then looking at the smaller factors in finer detail. After looking at the big-picture conditions around the world, analysts next examine the general market conditions, followed by particular industrial sectors to select those that are forecasted to outperform the market. From this point, they further analyze the stocks of specific companies to choose potentially successful ones as investments by looking last at a particular company's fundamentals. Top-down approaches prioritize macroeconomic or market-level factors most.
   2. Bottom-up investing is an investment approach that focuses on the analysis of individual stocks and de-emphasizes the significance of macroeconomic cycles and market cycles. In bottom-up investing, the investor focuses his attention on a specific company and its fundamentals, rather than on the industry in which that company operates or on the greater economy as a whole. This approach assumes individual companies can do well even in an industry that is not performing, at least on a relative basis.

   Industry research and company research are important prerequisites for security selection.

   Industry Research

   Industry research is a very vital component of the fundamental analysis that you undertake for analyzing the stocks in your investment universe.

   Identifying a growing industry is important. The process of identifying a growth industry is not complicated. Just look at the products and services used today that didn’t exist a few years ago. From Amazon to Netflix, these are all examples of Industry trends. A changing world brings new challenges and opportunities to companies and provides investing opportunities for all.

   Factors to keep a close eye on:

   1. Industry growth – You need to analyze the growth of the industry in order to zero in on a good industry for your investments.
   2. Competition – It is very important that you analyze the competitive landscape of the industry.
   3. Market Share – This tells you about the strength and influence of the company.
   4. Customer base – Analyze the customer base in the context of the industry and its peer group.
   5. Regulation – Carefully watch out for new and existing regulations that may affect an industry drastically.

   Company Research

   In view of the fundamental aspect of stock investing, it is imperative to research specifically about the company, its business model, management, etc. You need to be on top of the qualitative aspects of the company. Factors to look for include but are not limited to the following:

   • Business model : A business model is a company's plan for how it will generate revenues and make a profit. It explains what products or services the business plans to manufacture and market, and how it plans to do so, including what expenses it will incur.
   • Strong leadership : Is management invested alongside you? Do they have a history of creating value for shareholders? Do they have years of relevant experience? Do they treat outside shareholders (business partners) with respect? Companies that focus on their stock price will eventually lose their customers. Companies that focus on their customers will eventually boost their stock price. This is a simple but forgotten rule by countless managers. Look for companies that are focused on the long term. In addition, you can also evaluate how the company is spending its dollars. Various ratios including Return on Equity (ROE) tells you how well management is using investors’ money. Anywhere in between 10% to 20% ROE is good; however the ratio should be above industry averages to demonstrate an edge over other competitors.
   • Sustainable competitive advantage: Competitive advantages are conditions that allow a company or country to produce a good or service of equal value at a lower price or in a more desirable fashion. These conditions allow the productive entity to generate more sales or superior margins compared to its market rivals. Competitive advantages are attributed to a variety of factors including cost structure, branding, the quality of product offerings, the distribution network, intellectual property and customer service. Some businesses have unique, lasting competitive advantages that allow them to earn outsized profits. The more durable a company’s competitive advantage, the larger the “moat” that surrounds its financial fortress. ADP’s scale and high switching costs, Facebook’s network effects, and Johnson & Johnson’s intellectual property are all classic examples of sustainable competitive advantages.
   • Valuation: Here’s another one from Warren Buffett. “It is far better to buy a wonderful business at a fair price than a fair business at a wonderful price”. There are always good values in the market. They aren’t always easy to find but they are there. Not long ago, Berkshire bought a lot of Apple stock during the 1st quarter of 2016. Was apple the cheapest company to buy? No. However, it is one of the world’s most valuable companies and it was trading at a fair price at the time. The long-term prospects of the company looked great and so far the decision to buy has paid off. Another company that Berkshire has bought in 2016 was Phillips 66 (PSX). Again, it wasn’t one of the cheapest stocks when you look at other oil stocks. But the company had a good business with several sources of revenue. The company can handle a range of market conditions, had a solid balance sheet and was led by great management. A company like this at a fair price is a bargain. Great companies at fair values will keep your portfolio growing.
   • Cash and Liquidity is King: Cash flow is one of the most important things when looking at a company. The cash that flows in and out says a lot about a company. Companies can use accounting tricks to change up things on their accounting statements. However, they can’t fudge the cash that is flowing in and out of a business. Cash flow shows how well management is doing. One important term to know about is liquidity risk. Liquidity risk is the risk that a company may not be able to meet its short-term financial demands. This is usually the result of a market where there aren’t many buyers or sellers. Think of expensive homes during a recession. They have maintenance expenses. If an owner does not have enough cash to fund the maintenance, the owner may be forced to sell the home at a significant loss. When evaluating companies, look at the liquidity risk it is exposed to. The financial crisis showed how important liquidity is. Companies held on to a lot of assets but as the crash happened, these companies were in trouble, as they didn’t hold enough cash on hand to meet their needs. As a result, the government had to step in and inject liquidity into the market.
     
     When investing, consider your own liquidity. Do not keep everything in investments. Always keep some cash aside for emergencies. What if you lose your job? How long will it take to find another one? How long can you stay afloat? You do not want to be forced to sell your assets at an inopportune time.
   • Sustainable Debt: It’s nearly impossible for a company to be bankrupt when they’ve got more cash than debt. It’s completely normal for companies to borrow money to fund their operations. However, it is important to evaluate relative indebtedness within the industry as well as the sustainability of its operations in the future given its level of debt.
   • Corporate governance: Corporate governance is the system of rules, practices and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, the government and the community. Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.
2. Asset Allocation :

   Experienced investors can apply a dynamic and more robust Dynamic Asset Allocation process. Dynamic asset allocation is a process by which an investor dynamically allocates across assets or securities. These factors may include: economic views, industry views, risk factors, or anything that the investor determines provide early indications for certain outlook or expectations. For instance, if certain economic news favors certain industries, the investor may over-weight the target industry and simultaneously add more stocks that represent the market leaders within the industry. Alternatively the investor may just look at the sector ETF. As mentioned earlier, generating Alpha is hard work but it is certainly possible for individual investors to do so by setting up certain processes that include tracking key factors that facilitate dynamic asset allocation in order to improve performance over the benchmark.

3. Market Timing :

   similar to dynamic asset allocation, the investor can set up various market timing factors that can be utilized, not only to change allocations to sectors for a cross asset class, but also individual security selection or exclusion. These techniques could be fairly simple or complex. Individual users can set up these market timing parameters based on performance. Market timing is difficult and requires thoughtful evaluation as well as more frequent monitoring.