Monday, July 16, 2012

The Death Knell of Traditional Research

First came the 8 track, then the cassette, and then the CD. Now new cars don't even have CD players. Technology moves forward at an exponential rate. That is why Hedge Funds are finding it harder and harder to make money and why Hedge Fund Withdrawals have jumped to the highest rate since 2009.

I have to admit I really didn't understand research when I first got into the business of trading in 1993. As professional traders, trading our own accounts, we made our bets based on momentum. Later in 1999, when I was CEO of FutureTrade Technologies and we were trying to bring Direct Access technology to Hedge Funds, we realized that Hedge Fund managers did not make decisions the same way we made decisions as traders.

Old School

Let's break it down: traders look at price action and make a bet that the move continues or reverses direction. Traders who acquired a feel for the market succeeded and those that didn't “get it” failed. When we showed Hedge Fund managers the tools that we used and how we made decisions, we often got a deer in the headlights look from the fund managers. Our prospective customers would say,
"What are you guys looking at? This is crazy."  
Surprised, we conducted more research and discovered most Hedge Fund managers shared the same opinion. To them trading based on price action without knowing "what was going to happen" was gambling. Talk about the pot calling the kettle black.

Here's how I explain the Hedge Fund world of 1999 to my business partner's 8-year old girl, oversimplified: Client pays the broker very high commission rates, 5 cents or more per share and buys maybe 500,000 shares of something let's say, DELL computer. Broker booking the trade has a relationship with the covering research analyst.  The analyst does her homework/channel checking and expects DELL to beat earnings. The broker who talks regularly with the analyst tells the client, 
"We think DELL is going to beat earnings." 
Broker tells the client the analyst's news because the client paid 5 cents a share on the previous trade. The DELL call is termed a 'Trade Idea' and - voila - the inspiration behind how we named our business. :-)

So if the DELL call worked out the broker wins more business from the client Hedge Fund and the client who bet on the earnings won by placing the trade ahead of the news coming out publicly. That is how it all worked for a long, long time. There is even a business arrangement called "soft dollars" that evolved to support aspects of this trading.

Well, one could certainly see that there were more than a couple of moral issues with this type of business. This behavior demonstrated that those who were able to get the information first were the ones who made more money. It was a hierarchy that favored those with better connections and deeper pockets. Fast forward.

Breaking News is Stale News

Today the speed at which information is disseminated is so much faster than it was just 4 or 5 years ago. Hedge funds who relied on this relationship type business model are simply finding that the research today is already out. Whatever it is that the analyst has told the broker has been told and retold several times over on StockTwits or Twitter or the blogosphere. 

Today if you are a Hedge Fund that is chasing alpha, you have to actually have a strategy beyond simply having money to pay for information. You need to do the actual research, you need to have a game plan, and your plan needs to better than somebody else's. That is why so many funds are getting requests for withdrawals.  The market is more competitive than ever. Large sums of money, like a large cruise ship, are harder to turn around.  Managers that are used to fighting conventional information warfare are being attacked by non-conventional guerrilla warfare tactics.

One way to resolve the problem is seeing information in a different, layered way.  Using technology to help filter all the different information for an edge is one way that we at Trade Ideas are working to help the Hedge Fund community adjust to this new type of market environment. We help them layer fundamental information with social sentiment and price action together. These layered data points describe the events ideal for a trade.  Trade Ideas allows these events to be tested against execution algorithms to yield alpha probabilities.  As we get closer and closer to the edge of Big Data innovation, it becomes impossible to ignore the need for Real-time Market Intelligence.

To download Trade Ideas and subscribe, or try the Free Trial, visit the Trade-Ideas product application download page.

Those that don't use this type of technology are simply never going to be able to compete with people who are implementing it to help them find the edge.

Follow up on Twitter: @TradeIdeas & @TradeIdeas1