Fresh and Unique Alpha

For some alpha is the measure of one’s edge over others. If you are in the business of trading, it is everything. The presence of this edge is the only valid reason for actively managing a portfolio versus casting money into an index fund. If one is unable to clearly identify and implement such an edge (and continuously validate it) it is best to have somebody else manage your capital and spend time on another endeavor.

Known by many quants as the Truth, it is the ability to recognize what the actual price of an asset will be in the near future and evaluate that price in comparison to the market expectation. The difference between the realization of the trader’s expected value and the market expectation is the Truth. This gap in pricing expectation may be the result of expertise in a particular company or industry. It may be a proprietary trading method or portfolio strategy. Often the Truth is found in obscure, illiquid markets.

For example, finding a distinct advantage in a broad market such as the S&P 500 is near impossible. In such a liquid market, the bid and ask spreads are a penny wide and there are so many participants that the pricing is extremely accurate. Branching out into certain credit markets or lesser-known derivatives with less efficient pricing can lead to a lucrative niche. When seeking alpha, liquidity and efficiency are not necessarily the trader’s friend.

The danger of Alpha is believing it is present when it is not. In the financial markets, it is possible to experience positive results while making poor decisions. The opposite is also true. This may be the largest risk to any trader.

It is crucial to have resources and processes in place to continuously challenge assumptions and strategies. Traders should always be aggressive in the quest to disprove their hypothesis. Results may not always match up with the quality of the investment decision, but over time the probabilities will come home to roost. Decision quality over outcomes is a difficult yet necessary principle to master.

Building a successful business is all about finding the Truth and validating assumptions regularly. A critical component of effective risk management is using third party software to test strategies. Internal models can often contribute to confirmation bias. Testing methodologies using third parties will eliminate such bias, help challenge strategies, and provide unbiased confirmation.