Where Does Alpha Come From?

In Finance, Asset managers often hit this wall: “Alpha Is So Hard”

Everyone knows everything. All the information is in the price. All the ideas have been explored. All the data has been discovered. The market is impossible to beat. Alpha is dead…

This is the essence of investment management. Everyone who manages money at some point has faced it, and only a few make it over this wall. Alpha has been so hard to find that is has become almost a ‘dirty word’ in the industry.

And then there is the rest of the economy outside of Finance, the proverbial Main-Street. And it is even harsher. In the free markets all profits should go to zero. Competition should eat them away. So how do businesses stay profitable? How does a new (and assuming successful) start up in Silicon Valley make money? How does Apple compete with Microsoft, or Citibank with Wells Fargo? They innovate or monopolize. Or rather, first they innovate, and then monopolize. The later is ‘technically’ not allowed, so we’ll focus on the prior.

Innovation is the main reason businesses become and stay profitable in the first place. New products, new solutions, new strategies - all resulting in new value to customers. Looking at the companies in the S&P500, I can only imagine the competitive pressure these firms face from each other and all the newer entrants. Yet, they somehow manage to stay profitable, at least on average. The ones that succeed, have a culture of innovation, constantly making things better. They avoid the ‘too large to innovate trap’ and continue to live on edge of discomfort, making every inch count towards creating value for their customers - Are asset managers willing to do the same for Alpha?

What about a layer higher? How do economies grow? In the classical Solow Macro Economic Growth model, GDP Growth is a function of Capital, Labor and Productivity, which coincidentally (or maybe not) is also called Alpha. Asset managers, just like economies, can invest a lot into acquiring Capital (software, hardware, data, alternative data), and Labor (PhD’s, CFA’s, Data Scientists, Pure Mathematicians and Physicists) - but Alpha is something else. It’s the part that is unexplained by the increase in Capital and Labor alone. Alpha is increased productivity, driven by innovation. There are many cases of investment firms with impeccable capital and labor resources that lost their Alpha edge. They stopped innovating. Their process became the routine. Nothing new was getting solved.

What about another layer up? How does all life on earth grow? Animals and plants that survived - all evolved and adapted too! Would you rather rediscover your investment Alpha edge or compete for food at the bottom of the oceans? For an inspiring case study check out Blue Planet on Netflix - it’s about where all life-innovation started! In short, it seems that life is pre-programmed to innovate in order to survive. So…Alpha is Life?

Innovation is not just novelty. It has a practical side too. It solves a problem that hasn’t been solved before. What percent of the day are investment professionals solving problems that haven’t been solved before? Answering questions that haven’t been answered?

Instead, even after excluding their ‘busy/admin time’, consider the percent of the ‘pure research time’ that the investment professionals spend on reading other people’s ideas like the sell-side reports and academic papers; plugging in numbers into static templates and repeating the same failing process over and over again? Is that what innovation looks like?

So where do Alphas come from? - Perhaps a blank piece of paper and a pen.

Start by writing down some great questions, starting with: What does your innovation style look like?