At Alpha-Sci were all about dogs: not bitches, but alpha dogs IE the investors that demonstrate stock-picking ability whose return outperforms the S&P500. It’s been a rough past few years though for both mutual funds and even hedge-funds, as my friend Kerry Yan shows in his article on the Intercollegiate Finance Journal. Why is it that the overwelming majority of hedge-funds and mutual funds are getting owned by the S&P? Don’t we pay them to be good? Didn’t they go to Harvard???

The data seems to clearly support a modern re-evaluation of the efficient market hypothesis: prices adjust so quickly to news and speculation that it is hard to profit from inefficiency to consistently extract value. Bubbls and irratinal exuberance create such huge inenfficiences and crashes that clearly the traditional view that it’s impossible to consistently beat the market is wrong: if you go long on a bubble and short it at the right time you can eat the market for dinner (just look at John Paulson’s $4.9 billion short). But how do we reconcile the imperfection of the tradtional efficient market hypothesis (EMH) with how overall accurate it tends to be?

The data seems to suggest that mutual funds are pretty much hopeless (the Journal of Finance reported that 99.6% of mutual funds failed to deliver a positive alpha from 1976 to 2006), an a large albeit minor chunk of hedge-funds takes it home (around 30%). The more interesting part is the kind of financial activities that return positive alpha: private equity, algo-analytical trading, illegal stuff, and activism.

Private equity makes sense because the market is much more closed than the public market. After all, everyone gets to buy and sell on the NASDAQ and NYSE, but not everyone gets to acquire medium sized companies on the edge of bankrupcy and turning them around. PE includes bankrucpy acquisitions, LBOs, liquidation and all that kind of activit that you can only do if you work for a fund that finds a way to get private economic actors to do something. The risk is really high, but the volatility is also really high, and because of the lower number of players that can co-opt your strategy and steal alpha from you is much lower. The stock market is simply much more streamlined, accessible, and efficient. PE ain’t that kind of beast.

Algo-analytical trading differs from regular algo-trading or computerized trading (I won’t get into the nuances because I am assuming my audience either doesn’t care or doesn’t understand). What makes this kind of trading different is the speed and effiency of it because it’s computerized, and the precision and uniqueness of it because it’s predicated upon algorithms that figure out things about companies that most humans analylists have still to notice. It’s also not speculative, unlike most kinds of high frequency trading, because they are capitalizing on hidden trends or hidden opportunities. It’s close to value investing, except it’s not bullshit XD

Illegal stuff gives great alphas: just ask Steven Cohen and his buddies at SAC! I won’t spend too much time on this because the reason is pretty intuitive: you get to take the advantage of PE (IE capitalizing on activities closed off to most of the public) to a whole new level. Illegal stuff includes bribes, insider trading, illegal market manipulation, and all sorts of other activities that give you an edge over the general public.

Activism is my favourite though, because as Ackman and Icahn prove, you can just wreck the market if you take an active role in it. That’s because you capitalize on events made by you. It’s basically insider trading, but it’s not illegal because you are allowed to profit off of privileged information that you acquire by yourself. Every activist seeking to change something in management knows in a way before everyone else that such management change will happen. In a way you are also manipulating the market, by creating an event of your own that will affect equity prices. There is one why it’s ok it’s because not only it requires a whole lot of skill to pull off, but also because it tends to be a longterm action that advances the value of a particular company, benefitting the American economy in the process.

Notice I did not include the good old fashioned “value investing”, because I am soooo not a believer in Buffet’s “magic”; but that’s for a different post. I also rejected other forms of HFT and algo-trading because despite the fact that they return appealing margins I have yet to see any evidence that such returns are meaningfully superior to the S&P in the long term.

As I always say, just because you make money it doesn’t mean you actually know what you are doing!