Generating alpha is the name of the game in investing, but where to find it?
That question is explored in a report by Richardson GMP, in which the authors explain that alpha must be taken from someone else. After all, when you buy a stock, someone else—with a different viewpoint—has to sell it.
“To take alpha from others, best we know with whom we are dealing,” says the report, which breaks the equities market down by ownership.
Generally, owners consist of active and passive traders. The former aim to buy undervalued assets and sell overvalued ones (price discovery). The latter aren’t as price sensitive, and trade based on flows and their basket portfolios.
A decline in active traders’ market share (or a rise in passive traders’ market share) may have implications for market pricing efficiency, and on where and how to find alpha.
For example, it’s possible that the rise of more passive trading increasingly causes distorted asset prices. That’s because “fewer dollars are at work bidding up undervalued assets and bidding down overvalued assets,” says the report.
To generate alpha in such an environment, you need an edge over other participants to find misplaced assets, plus you need the market to agree with you and fix the mispricing.
“Finding instances where investors are behaving irrationally, causing an asset to be mispriced, may prove to be a long-term source of alpha,” summarizes the report.
That means capitalizing on the mistakes of both active and passive traders, respectively—when, for example, earnings are released or when ETF flows push the price of some companies artificially higher.
For more details, read the full report.