Hedge Fund managers are rewarded billions of dollars for producing Alpha. However, as most people have learnt in business school about the Efficient Market Hypothesis (EMH), pioneered by Eugene Fama. His thesis was quite simple, in an efficient market where information is shared equally, share prices reflect all information, and thus it is impossible to beat the market returns. As such, the best thing to do with your money is to buy SPY and hold it forever. However, Hedge Funds are not interested in this, because how can they justify charging 2 and 20 to their clients for simply buying an ETF? As such, Hedge Funds are tackling the EMH dilemma in 4 ways. 1st, is by getting information that is not easily accessible by most people. 2nd, is by doing business in markets that are not efficient. 3rd, is by entering markets that most Robinhood traders can’t access. 4th, is simply classic arbitrage, similar to LTCM but without Russia defaulting on the Ruble.
Method 1: Hard to get info.
How does Visa make money? Besides the points system, Hedge Funds have figured out a new lucrative deal that benefits both credit card companies and them, by using Data. Think about it, every time you swipe your Chase Unlimited Card at Walmart, the purchase is saved in Visa’s Database. Visa will then sell this data for millions of dollars to a Hedge Fund. If the Hedge Fund will see a decrease in sales, they will short the stock. They can even see if for example, revenue is flat but there were more purchases in higher profit items, then they can purchase call options. So, while we can all read the same Bloomberg article about Walmart, Hedge Funds will have data that none of us can see.
Another example, is so crazy that it actually works. Have you ever wondered how when you’re in traffic, Waze is able to tell you how long a traffic jam will take? The answer is in an amazing feat of technology. Right now, a few hundred miles above your head are hundreds of GPS satellites, that are able to scan big areas for cars. Then they analyze that info and send it back to you. However, these satellites can also scan parking lots to see if a store is getting more traffic. Then the satellite companies sell this info to Hedge Funds that make predictions based on this info. This technique has outperformed the S&P (expect for 2020).
Method 2: Inefficient Markets.
While many people disagree if the Efficient Market Hypothesis (EMH) is accurate, people on both sides agree that if there is one market that is closest to EMH, it is the American Markets. In America, we have a strong SEC that is the most efficient market regulatory body in the world. Additionally, America has the largest number of financial reporters reporting on the markets. As such, in order to beat the EMH, Hedge Funds are trying to move away from the under-the-microscope NYSE and looking abroad especially to India and China. There they are finding inefficient market opportunities that used to be in abundance in 20th century America.
Crypto is another inefficient area that Hedge Funds are entering to generate Alpha. There are currently thousands of crypto currencies, which most exchanges don’t service. This has created new arbitrage opportunities for Hedge Funds to make money.
Method 3: Inaccessible Markets.
One of the biggest opportunities to generate returns is in the personal debt industry, which in America is valued in the trillions. However, these opportunities are not accessible for the average investor. This is an area where Hedge Funds are starting to operate in, and are getting returns that are outpacing the market. For example, if someone is credit worthy, but due to an incident 2 years ago, that person’s credit score is 660. That person’s credit card interest will be 20% even though the person should be at a credit score of 780. This has created an opportunity for Hedge funds to lend money with low risk and a high yield.
Method 4: Classic Arbitrage
Since John Bogle’s invention of Index Funds, over 10 trillion dollars has moved into index funds. This means, when a stock is added to the S&P, this will force index buyers to purchase that stock, causing it to go higher. Now, every year, a few stocks are added and removed from the S&P, and if you can know which ones, then there is Alpha to be made. Hedge Funds try to arbitrage this information. The same way hedge funds try to assume which companies will be acquired, they will do the same for companies being added to the index. For example, there are many stocks out there, but Hedge Funds know that a 300 Million Cap company will not be added, so this narrows down the list. They can then look for characteristics of the companies, for example, if the Dow Jones is overweight in financial companies and underweight manufacturing, Hedge Funds will try to short possible Financial company candidates and go long manufacturing candidates. At the end of the day, the passive investor doesn’t care if one micro portion of their portfolio is replaced by a new company. However, for Hedge Funds this can be a great way of generating Alpha
Are such opportunities available for me?
Hedge Fund Managers make billions from generating Alpha that none of us can’t get. However, this is starting to change, more and more people are able to access these strategies without a billion dollars seed capital. Companies such as Morgan Stanly and UBS are offering access to smaller investors. This increase in competition is making Hedge Funds need to innovate even quicker. Recently Hedge Funds have started to use AI and Machine Learning, to remain competitive.