Friday, June 01, 2007

Alpha *is* Real

Some weeks ago I was reading a post over at My Money Blog and I saw the words efficient and market in the same sentence. Reading those two words in such close proximity always sends alarms off in my head.

Now, I might be totally out of it on this one, but it seems clear to me that "alpha" does really exist and can be captured by capable market operators. The simple reasons are [1] even though all information may be in the market (which is a generally false assumption to begin with), the market may not be pricing that information correctly and [2] there may be non-public information which some operators are using to their advantage in public markets.

A classic example of the first case would be Enron. How many analysts, whose job it is to read financial statements and create analyses of companies, missed holes in the Enron cash flow statements that pointed to the company's demise? They all had access to the same information. So what happened? Obviously the information did not carry the same weight with these analysts that it did with the hedge funds that were short Enron.

Same information, different eyes, different interpretations.

As for the second problem, witness the options or share activity on acquisition targets prior to the announcement of the purchase (a frequent occurrence recently). If it were true that price moves were due to public information exclusively, then how is it possible to have insider trading? If everyone is an insider, then there can't be any insiders. Right? Someone has to know something that someone else doesn't AND they have to use that information against other operators in the public market. In this case, the information is not anything that could be gleaned from research, inquiry, observation and investigation. It is material, non-public information that is supposed to be shared with the public at large when it is made public.

A friend of mine used to have the following quote in his e-mail signature back in college:
"Information - the currency of the future."
It was a very prescient statement. I love the title of Roger Ehrenberg's blog because that is exactly the explanation of how alpha is generated - information arbitrage. More data, of greater quality, with better analysis applied to it, and generating actionable information which is then used to originate trades in which the operator has the utmost faith in the information (and the process which led to it). As Joel Spolsky said, you have to use tools which you can trust or tools which you can fix.

Now, there's nothing you can do about use of material, non-public information by insiders (whether used against you or in your favor). I just hope you are positioned to execute your trading plan if the price goes in your favored direction. If it goes against you, then hopefully your trading discipline will stop the situation from spiraling out of control. You can, however, have better information based on publicly available data and observable facts, and act on it.

So then it really comes down to the information and the process. If you can find the leak in either of those (usually someone else's but also in your own), you can find the alpha. Just make sure to move on it before it moves away from you!

Until next time...

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