Digital Technologies Eliminated Alpha

Paradoxically, the more we know the less we earn. In the era of data ubiquity and relatively unlimited computational power, hedge funds that manufacture data into money underperform the market, demonstrating negative alpha.* Did anyone expect the digital economy to have that effect on profits? Recent research confirms that none of the major hedge fund strategies were able to outperform the S&P 500 index after the global financial crisis.

• According to Hedge Fund Research, from 1990 to 2000 hedge funds generated massive returns, annualizing at 18.3 percent and beating the S&P 500’s 16.5 percent average gain by almost 200 basis points.
• Enter the Great Recession. Since financial markets began to recover, hedge funds have perennially underperformed the S&P 500 index. Between January 2009 and yearend 2018, hedge funds returned an average annualized 6.09 percent. That’s less than half that of the S&P 500, which rose 15.82 percent annually during the same period.   

In contrast to the erosion of alpha experienced by hedge funds, computing power and the volume of data generated globally (and is in theory available to feed models) increased 60 and 40 times, respectively. Rising data ubiquity has weakened the plausibility of a sustained information edge, which has been critical in achieving long-lasting outperformance. In addition, computer based algorithmic trading lowered the discount for traditional hedge fund strategies. This is in part why now we hear so much about "alternative data" as the financial industry seeks to retain that data edge.

We will leave you with this question: If mass adoption of digital technologies lowered returns in high risk investing, what are the prospects for the rest of the economy?

*Alpha is the excess return of an investment relative to the return of a benchmark index.