Generating Alpha In Financial Markets: A Framework
As my investment strategy has gradually shifted from passive investing to active investing, I want to share some of the ways of thinking that have helped me beat the market over the past decade.
- What Is Alpha?
- Categories Of Alpha Generation
- Be Patient
- Think Independently
- Never Trade
- Don’t Overtrade
- Beware The “Underdog Premium”
- Beware Frothy Markets
- Limit Risk
- Know When To Fold
What Is Alpha?
The primary objective of any trader is to generate alpha, otherwise known as “beating the market”. If a trader cannot beat the performance of the broad market, then they would be better off quitting as a trader and parking their money long-term in an index fund, where they would match the performance of the market.
To consistently beat the market, a trader needs a system of uncovering information that other market participants do not yet have access to, information that will affect the asset’s price once it becomes general knowledge.
Categories Of Alpha Generation
Here are some categories of techniques that market participants use to gain an edge over other market participants. Usually this edge takes the form of esoteric or otherwise inaccessible information, which is then used to form calculated opinions on the value of certain assets, which in turn inform investment decisions that ultimately generate alpha.
Maintaining subject-matter expertise in the operation of certain industries
Warren Buffet famously stated that investors should stick within their circle of competence, or in other words, invest only in assets they understand well: “Know your circle of competence, and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital.” Buffett further elaborated on this mentality in his 1996 letter to Berkshire Hathaway:
What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence.
Depending on your own circle of competence, you may be more apt to evaluate financial assets within a particular industry. For example, a person with software expertise may have special insight into whether a company’s software is substantial or vaporware. A person with manufacturing expertise may have insight into whether a company has access to the proper assembly line tools required to mass-produce its product at an affordable price. A person with biochemistry expertise may have insight into whether the mechanism of action of a pharmaceutical company’s new drug is realistic or promising. A person with blockchain systems experience may have insight into whether a particular cryptocurrency network is credibly neutral and robust against attack. Whatever the investor’s expertise is, that expertise can be groomed to give the investor an edge in investment decisions.
If you already have deep expertise on a particular subject, consider the mistakes that less informed laypeople might make in valuing financial assets related to your area of expertise. When the market is undervaluing a certain asset compared to your model, consider buying it.
Maintaining expertise in the workings of the markets themselves
If a trader understands enough about the markets to be able to determine when certain financial instruments are relatively mispriced, and correctly predict that they will undergo a repricing event at some defined point in the future, they can place trades to take advantage of the difference. Classic examples are the traders who anticipated the 2021 GameStop short squeeze based on the stock’s unusually high levels of short interest and rising retail popularity, or the traders who anticipated the financial crisis of 2007-2008 based on the mismatch between the quality ratings of credit rating agencies and the actual quality of the rated securities.
A more mundane application of this technique is in value investing, where an investor uses fundamental analysis to come up with an independent valuation of a company based on its assets, liabilities, earnings, competitors, and growth prospects. If the investor determines that the asset is undervalued on the market, they can generate alpha by purchasing the undervalued security and waiting for the market to value it properly. Value investing is the main strategy Warren Buffet uses in managing Berkshire Hathaway.
Maintaining proprietary software that can take advantage of small market inefficiencies
The field of quantitative analysis is the application of mathematical and statistical methods in investment management. Software is often used to facilitate and automate strategies based on these methods. These algorithms often analyze assets within milliseconds, performing high-frequency trading to take advantage of microscopic opportunities in price.
In the realm of cryptocurrency, the closest analog to high-frequency trading is Maximal Extractable Value, in which miners or stakers of a blockchain use software to identify opportunities to frontrun, backrun, sandwich, and otherwise manipulate the order of cryptocurrency transactions for their own profit.
These routes of gaining alpha require you to have programming skills and an excellent understanding of the financial markets or the blockchain.
Maintaining privileged streams of information that other market participants do not have access to
Insider trading, the trading of financial instruments based on material, nonpublic information about a company, is illegal in many countries including the United States. However, cases of trading on nonpublic information often go unpunished, either because they don’t fit the strict definition of the law, or because the consequences of breaking the law are lax in certain cases. One example of this is congressional insider trading, where US congresspeople use privileged information that they learn on capitol hill to inform their stock trading decisions. According to Wall Street Journal’s Jon Hartley, this practice is widespread:
Congress has enormous influence on corporate stock prices, whether by potentially regulating Big Tech, subsidizing electric vehicles, or changing copyright law … Members of Congress on average tend to be wealthy and have large portfolios with many different stocks, further complicating enforcement. On Feb. 3 Insider published a catalog of 55 Stock Act violations by sitting members of Congress. The penalties for such violations are so small (usually around $200 a violation, which can also be waived by House or Senate ethics officials) that Congress hardly takes them seriously. So shady trading by public officials continues.
By trading on privileged information, congresspeople have been able to beat the market by one to two percentage points on average:
On average, House Democrats and Republicans had returns at +14.7%. Meanwhile, Senate Democrats were at +15.4% and Senate Republicans just under +13%. Independent Senator Angus King’s two trades yielded a +16.5% return rate (excluded from the charts above).
To compare, we can take the same transaction periods and estimate $SPY returns (ie. instead of trading those tickers, we trade SPY instead). Using this method, SPY returns were found to be only +13.6%.
This means that in 2021, on average, Congress beat the market.
Most people do not have the connections required to collect privileged information relevant to trading, or to personally affect the trajectory of companies in legal ways. Of those who do, most of the information accessible to them is of such a nature that by trading on it, they would be clearly violating securities laws. For these reasons, this method is both the least accessible and least advisable way for the average person to generate alpha.
What I will say is that if you work for a company that provides stock options as part of your compensation package, consider what you’ve learned about the company in your valuation of those options, and consider whether going above and beyond in your work may or may not help contribute to their value.
Creating new streams of information through private investigation
When an investor has already learned as much about a company as possible from public information sources, in some cases the investor can deepen their edge through private investigation. This might take the form of personally visiting a company’s office to see whether it is real, monitoring the foot traffic of a coffee shop’s franchises to determine whether its sales are fabricated, or tracing blockchain transactions to see where a blockchain company is spending their income.
Private investigation can be as simple as personally assessing a piece of software’s quality, or as involved as flying to another country to mystery shop a company’s branches.
Investing in opportunities that others are legally barred from
In the United States, the sales of certain securities are limited to accredited investors or qualified purchasers, who typically qualify for the designation by having a high net worth (starting at $1 Million) or a high income (starting at $200,000). If you qualify for one of these designations, you will have access to investment opportunities that are not available to ordinary investors. The law intends to prevent “unsophisticated investors” from losing their life’s savings to shady securities dealers, but a consequence of them is that ordinary people are locked out of certain types of investments that have the potential to generate alpha.
In 2015, the SEC adopted rules allowing certain companies to issue securities to non-accredited investors pursuant to a federal exemption created by title III of the JOBS Act. This was a small step towards narrowing the gap between non-accredited and accredited investors.
In 2020, the SEC broadened the accredited investor definition slightly to include investors who hold certain financial licenses. In particular, the Series 65 exam does not require you to be sponsored by a member firm, so it may be a viable way for an enterprising individual to qualify. However, the truth is that with less than a $1 Million portfolio value, the complexity and risk these types of investments add to your portfolio may not justify the returns.
As an accredited investor, keep your eyes out for investment opportunities that may not be open to the general public. The exclusionary regulatory requirements mean that until this antiquated law is reworked, you will have a small edge over investors who are legally prohibited from investing in the same vehicles as you.
Taking On Leverage
Leverage is the technique of financing asset purchases using debt. As with any type of debt, leverage should only be used when the expected return of the long position exceeds the cost of financing the short (borrowed) cash position. In cases where that’s true, and risk is properly managed, leverage can be a viable way to enhance returns.
The safest way for the average person to take on leverage in their portfolio is to finance a real estate purchase for their primary residence using a mortgage. Mortgage debt is typically not “callable”, meaning that the mortgage lender cannot repossess your real estate if your loan is underwater, as long as you continue to make timely payments. The real estate market’s low-risk leverage, low interest rates, tangibility, and relatively straightforward valuation process are big reasons why real estate is considered such a high-quality investment by the general public.
Another relatively safe way to take on leverage is to replace your emergency fund with margin once you have a large enough portfolio. If your portfolio is invested mostly in equity index funds, you should be able to comfortably draw 20% or more of its value as a margin loan without too much risk of liquidation, even during a market downturn, especially if you have a portfolio margin account.
Yale economists Ian Ayres and Barry Nalebuff take their margin recommendations even one step further, recommending that young people should be leveraging their portfolios up to 2:1. This increases the investor’s market exposure in their younger years, allowing them to reduce their exposure in their later years. Nalebuff summarizes the strategy like this: “The increased market exposure when young allows you to have less exposure later on. And while the total market exposure is the same, it’s better spread out. Therefore, it has less risk.”
Leverage can enhance returns, but it also enhances the potential drawdown of your portfolio’s net value, so it’s prudent to fully understand its behavior before you add leveraged strategies to your portfolio.
Create-Your-Own Shares Of Stock (Entrepreneurship)
If you’re particularly good at a certain trade, consider starting a business. If your business turns a profit, it will have a market value on business flipping sites, even if that market value is small. When you no longer wish to run your business, you can sell it and move the proceeds into other investments. I am a fan of online businesses, because they often involve little financial risk outside of investing your own time in honing your skills and assembling/coding/knitting/drawing/writing your product. The holy grail is to eventually transition the business to a model where hires are doing most of the work, and you’re just overseeing the operation and extracting value.
As with investing, niche expertise is a big plus in starting businesses. But even then, starting a business is often easier said than done.
Alpha comes in many different forms. However, finding alpha is only the first piece of the puzzle. If you find a market inefficiency to exploit, there are several pitfalls you need to avoid to be able to follow through properly.
If you have limited means of generating alpha, you may be waiting a while for good market opportunities to come along. In the meantime, consider parking your investment money in a “default” investment such as a traditional three index fund portfolio, or with a robo-advisor. This ensures that your investment performance will at least match the market.
It’s better to wait and invest confidently than to go all-in on the first opportunity you see.
The biggest sin a trader can commit is to blindly follow the lead of another trader (or book, or system) without questioning it. Do not trust what other traders say - verify whether what they are saying is logical and rings true to you. If a trader says that a particular strategy can generate alpha, ask yourself why there is a market inefficiency, and ask yourself why they are sharing that information with you (oftentimes they are trying to get you to buy a course from them).
You should only move forward with a strategy if you can independently articulate why you believe the market is inefficiently pricing the assets involved. Imagine yourself shaking your fist at the sky and shouting “Market, you are wrong about how you are pricing this asset, I’m sure of it, and these are the reasons you just can’t see!”
If the asset you are trading in is popular, you should be able to find several analysts whose opinions you vehemently disagree with, and whom you would theoretically feel comfortable engaging in a written debate. The goal is to use your own logical process to arrive at your own conclusions about the market, and resist the easy yet potentially alpha-crushing shortcut of trusting and copying others.
The bottom line is that the only way to generate alpha is to do something that most other traders are not doing, either because they haven’t thought of doing it or because they mistakenly think it’s a bad idea. A good indication that you have a proper alpha-generating portfolio construction is when other people tell you that your portfolio construction is bad and risky and you are an idiot, yet you confidently and articulately disagree with every reason they give you. (If they give you a valid reason that you hadn’t thought of, that’s your cue to rework your portfolio!)
The biggest mistake I see in new traders is to flip-flop and second-guess their trades, and end up entering and exiting positions emotionally out of fear and fomo, before they have matured according to the criteria they set. Even worse, a trader may not even set entry or exit criteria at all, trading on pure whim. For this reason, “you” should never trade. You should come up with logical rules, then trade strictly based on those rules.
Examples of strategies with clearly defined, unemotional rules:
- I will buy Cryptocurrency X, but not so much that I am overinvested. I will hold it for at least three years unless one of the following occurs:
- I need funds for a prolonged, unexpected emergency.
- The fundamental value of the cryptocurrency changes due to newly foreseeable negative legal or technical developments.
- The price hits my predefined exit target.
- I will invest my extra capital in an index fund. I will hold it until one of the following occurs:
- I need funds for a prolonged, unexpected emergency.
- I come across a more favorable investment opportunity.
- I retire.
- I will buy some shares of Private Equity Fund Y with money that I am sure not to need for many years. At each liquidity event, I will reevaluate my plan in light of my personal financial situation and the company’s new fundamentals.
- I will invest part of my spare cash into a ladder of CDs or Series I Savings Bonds. I am sure to not need that money until the instrument’s maturity. If I want to draw on that money in the future, I will stop investing and wait for maturity.
Examples of strategies with poorly-defined rules and clouded by emotion:
- A trader sees Bitcoin plastered over the news, so they spend most of their modest savings on it. Next week, the price of Bitcoin drops significantly, as cryptocurrencies are liable to do. The trader begins to panic that they “lost a lot of money,” so they close their long position at a loss and kick themselves for investing in the first place. Several months or years later, the price of Bitcoin rises again, leaving them behind.
- A trader is an enthusiast of trees, and they hear on the WallStreetBets internet forum that growing is a hot industry, so without doing any further research they purchase a bunch of Canopy Growth Corporation stock. A couple of years later, the stock is not hot anymore, and the trader is no longer emotionally attached to the investment, so they exit their position at a loss. At no point did the investor ever really investigate Canopy Growth Corporation, nor did they understand their financials or even their business model.
- A trader wants to invest in private equity, and the fund they want to invest in has a very high minimum, so they scrape together just enough money to qualify. They didn’t consider that they might want to purchase a house within the next few years. When the time comes to buy the house, their private equity shares are illiquid, so the money is completely tied up. They have to wait to buy the house, have to spend extra money on PMI, or are stuck with a house that’s smaller than they really wanted (and perhaps need to go through the trouble of upgrading houses later).
- A trader sees some random canine-themed cryptocurrency rise 120% in price over the past 24 hours. The trader feels an overwhelming sense of fomo after seeing others brag on twitter about making millions of dollars, so they buy the dog currency with more money than they should. They go to sleep with fantasies of becoming an overnight millionaire. Three days later, the dog coin dumps in price and they sell, realizing that the whole concept of a pet-themed cryptocurrency was probably a waste of good investment money.
Try your best to anticipate well in advance what developments might affect your assets and your own personal financial situation, and to the greatest extent possible, make sure you have rules-based contingencies for any foreseeable occurrence.
Unless you really enjoy sitting in front of your computer all day, don’t try to micromanage your positions. Come up with your hypotheses, set your entry, exit, and reevaluation points, and then sit and wait. If your strategy has a timeline of several hours, go take a walk around the block, or pause to get a bite to eat from the fridge. If your strategy has a timeline of several weeks, recognize the point of diminishing returns in your market research each day, and switch gears to a different activity. If your strategy has a timeline of several years, there should be entire weeks to months-long periods where the idea of modifying your position doesn’t even cross your mind.
Beware The “Underdog Premium”
The “underdog premium” is the tendency I’ve seen for the market to overvalue underdogs in comparison to an incumbent. Here are some examples:
- The “up-and-coming” cryptocurrency Solana being valued at nearly 10% of Ethereum by market cap, while generating only 0.01% of the total protocol revenue and with no good plan to increase that number.
- In 2020, the “up-and-coming” electric auto manufacturer Nikola Motor Corp being valued at 19% of Tesla by market cap, while having almost nothing material to show for it.
- In 2000, the “up-and-coming” Pets.com being valued highly compared to its brick-and-mortar competitors, despite no indication that they could actually drive sales
Ask yourself if what you’re invested in is truly an Uber or Netflix with an industry-shattering new business model that the market doesn’t fully understand yet, or whether the incumbent can afford to ignore them (or copy them) and continue business-as-usual. Sometimes it makes less sense to invest in that hot new designer ketchup, and more sense to invest in Kraft Heinz. Great investing is rarely sexy.
Just like sports fans, investors love to tell themselves a good underdog story. But the cold truth is that the company with more money, better connections, and stronger industry footholds wins more often than not. If you hold an underdog, and it’s starting to look frothy in comparison to the incumbent, don’t be afraid to take gains.
Beware Frothy Markets
As some random person in my Twitter feed said last week, The best moment to take profits is when you start taking screenshots.
- If that crypto moonshot pays off and you’re paper rich, why not lock some of that in?
- If your Gamestop options are way in the money, why not stop rolling 100% of your profits?
- If the S&P 500 is hitting record highs, why not take the opportunity to reduce your leverage?
- If your friend’s friend is texting you to ask whether they should invest in an asset that you’re up 20% on in the last 24 hours, why not sell some, and then tell them that you believe today is a selling opportunity rather than a buying opportunity?
Froth will try to blind you in euphoria, but you need to fight it and keep your eyes open. The worst time to exit your position is after the bubble has already popped, so be emotionally prepared to leave potential profits on the table. For this reason, I recommend that for every one of your high volatility open positions, you set your exit points in stone far before those exit points are hit, ideally setting a good-til-canceled limit order. It’s much more difficult to come up with sane exit points when you’re dopamine rushing near market close while you watch your asset make new highs on the 45-second chart.
Your portfolio’s drawdown potential is the amount of value your portfolio could foreseeably fall, given that nobody can predict the behavior of the markets entirely accurately. Your personal risk is the risk due to such a drawdown that your portfolio would not be able to support your investment goals. A well-constructed portfolio should have an effectively zero chance of going completely bust. The “YOLO” plays on WallStreetBets, where people go all-in on short-term options positions, are a great example of what not to do.
At first, you should start off playing with a paper account or, even better in my opinion, a small but non-trivial amount of real money. Having a small amount of real money invested will help draw out your emotions, so that you will have practice managing them if you decide to trade with larger amounts of capital later on. As you gain confidence and develop emotional temperance as an investor, you should aim to be making kelly bets with your portfolio - bets that are large enough to add up and make a difference, but small enough that a string of bad bets won’t wipe out your portfolio before you can change strategies.
Know When To Fold
No strategy for alpha generation lasts forever, because the nature of information is such that little-known information tends to become well-known information over time. When the market has “priced in” a particular strategy that you’re using, that’s your cue to begin unwinding your position and putting your money back into an index fund. This is an important step, as remaining in stale strategies will expose you to unnecessary risk.
The vast majority of traders do not beat the market, so the only path to success is to behave differently from the vast majority of traders. As discussed, this essentially boils down to gaining access to information that the majority of other investors do not have, then using that information to execute rules-based trading strategies that the majority of other investors are not executing.
If I told you the strategies I’ve had success with, you would probably believe that my successes have been due to luck. Alternatively, we would need to sit down for several lectures so that I could adequately explain them, assuming a pre-existing basic understanding of finance and computer science. All I can say is that I’ve been doing this for about a decade now, and I’ve turned a substantial profit. Some of the best strategies look like reckless gambles to those who don’t fully understand them, so the best strategies are the ones you tailor to your own strengths and your own financial situation. Good luck!