Killing the Myth About How Hedge Funds Generate Alpha

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The following is a guest article from Leigh Drogen, founder of Estimize.

Sometime in the 1980’s, around the time when “hedge fund” entered the common vernacular, something strange happened to the perception of how institutional market participants make money. The press, financial and otherwise, in all of its infinite wisdom (because why wouldn’t a recent journalism graduate understand the intricacies of how financial markets work), created a wide reaching myth about how alpha is generated on the buy side.

Origins of the myth

The genesis of this myth comes from the insider trading scandals of the 1980’s, leading to one of the most famous movies about financial markets of all time, Wall Street. Even a recent college graduate from Columbia School of Journalism could comprehend the advantage taken by a small number of funds by obtaining non-public information, ahead of everyone else, and moving quickly to capitalize on it, or manipulating the market with it. Wave after wave of similar high profile scams have hit market over the following two and a half decades dealing with everything from earnings info being passed to traders, to order flow manipulation, principal research violations, on and on and on.

All of these violations have one central theme, if you have information that no one else has, you can make a lot of money. And herein lies the genesis of the myth that most if not all alpha created on the buy side comes from an informational advantage, and because of that, communication between and sharing of information amongst the buy doesn’t take place.

This myth has been perpetuated by the press for largely sensationalistic purposes (read pageviews). Yes, there have always been bad actors who have created alpha in this manner, and no matter how hard regulators work (not very hard), there will always be a few of them one step ahead.

New crowdsourcing startups

Over the past few years, a crop of startup financial technology companies have worked to both dispel this myth, and level the playing field in terms of access to information and research. My company, Estimize, which crowdsources forward looking estimates for the fundamentals of public companies and economic reports from buy side, independent, and amateur analysts, is just one of them.

There are others, such as Slingshot Insights, which is like a crowdsourced and crowdfunded Gerson Lehrman Group, where both institutional and noninstitutional community members collaborate and share the cost to set up primary research calls which are recorded and then sold on the site, returning some of the cost of the call to those who organized it.

There is the massive StockTwits platform, which is the Twitter of finance and acts as a one-to-one and one-to-many communication protocol for all financial commentary, news and information.

SumZero crowdsources investment research from buy side analysts and PMs who are looking to both talk their book and get access to ideas from their peers. SeekingAlpha is its broader cousin comprising research and editorial from thousands of participants.

At Estimize we even built something called Mergerize as an experiment, a platform to crowdsource expectations around mergers and acquisitions.

These companies are not pie in the sky unproven ideas with no traction. They have collectively raised tens of millions of dollars in venture capital funding and have millions of users, including large swaths of buy side and sell side institutional traders, analysts, and PMs.

Exploding the myth

The central theme amongst them is that they rely on the willingness of market participants, and in some cases exclusively buy side professionals, to share information and analysis with each other. A panoply of academic and industry papers have proven that not only are these platforms gaining massive traction, but using the information they provide can reliably produce a ton of alpha.

But wait, doesn’t that go straight up against the myth that buy side professionals don’t share information because it is their asymmetric informational advantage to their peers which leads to alpha creation? Yes, yes it does mi amigos, it smacks that notion straight in the face and doesn’t apologize.

The true source of alpha

The truth is that the buy side has always shared information with each other, from idea dinners, to pre earnings calls to gauge group expectations, to shared google docs. It not only happens, it is imperative that it does happen.

Why?

Because the vast vast vast majority of alpha is not created through information asymmetry, and the vast majority of alpha is not created illegally. It is created by having a differentiated view and exercising a strategy to take advantage of that differentiated view. That might mean that I believe Apple is going to earn $7 this year instead of the consensus of my peers at $6, or that Biogen’s new Alzheimer’s drug isn’t really as good as the market perceived it to be after the recent phase 1 test result were released. We all look at the same numbers and come to different conclusions about the future, and about how our peers will react to that future. We need to understand their views in order to understand our own.

This sharing of information is happening at a higher rate today than ever because of philosophies born on the web. Pseudonymity is an important one, allowing buy side professionals to shield themselves from being gamed in their positions, and the web which enables anyone to access information without downloading a plugin through a firewall. Predictive analytics and community ratings systems allow these platforms to scale and trust to be built within them.

It’s high time that we put this information asymmetry myth to bed and focus on what actually creates alpha, having a differentiated opinion about the future based on the mosaic of available information.

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About Author

Leigh Drogen is the founder and CEO of Estimize, an open financial estimates platform which facilitates the aggregation of fundamental estimates from independent, buy-side, and sell-side analysts. Prior to founding Estimize, Leigh ran Surfview Capital, a New York based quantitative investment management firm trading medium frequency momentum strategies. He was also an early member of the team at StockTwits where he worked on product and business development. When he's not staring at rectangular lightboxes, Leigh can be found on the ice rink playing hockey, behind a grill, or off in search of waves to surf around the world.

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