The Paradox of Publishing Research

Revealing your sources of alpha can be a good thing

BORIS GNEDENKO and IGOR YELNIK, ADG CAPITAL MANAGEMENT

What is the value of research in today’s financial industry? We will ponder this question focusing on an area of our expertise – quantitative asset management – but we believe our conclusions are applicable to other areas in the industry as well.

Quantitative asset managers retain research departments and spend significant amounts of money to support what is, practically speaking, academic research. The number of publications in the area of quantitative finance has been growing steadily. Many of their authors, even if they are formally university employees, are associated in some way with various financial companies. Assuming that this spending is more than charitable support of university professors, we ask ourselves: how do such investments pay off?

If you are a researcher only working in academia you will naturally publish the results of your research. If you work at a research department of a quantitative asset manager you may still be interested in publication. However, if published, your ideas may potentially be used by other people for building new or improving on existing trading systems. Therefore, your employer will not necessarily be happy about your results being published. Do they have a point? They certainly do.

However, searching www.ssrn.com or studying ideas presented at www.quantpedia.com (a web site systematising publicly available research of trading strategies), one may not only find purely theoretical papers, but also applied works born within financial institutions. Why do they encourage such publications? May it be because the reputational benefits of publishing quality ideas exceed the possible losses of disclosing know-how? If so, why may this be the case?

First, the modern scientific society has turned into a unified organism (thanks in large part to the internet) and new ideas spread with a speed never observed before. Despite its seeming opacity, the world of finance is no exception. Hence, when struck by a great idea, you are unlikely to be alone. Even if you have not found anything similar in the open domain, then, possibly, someone else, sitting next door, is working on the same topic. Asset managers have become participants in the research race: if you do not publish your results today, your competitor will publish something similar tomorrow. They will receive full recognition of their intellectual potential while your exclusivity will be lost anyway.

Second, even if you publish your results, you still have the first mover advantage. Your competition will need time to integrate your ideas in their investment process. By the time they have done so you will have come up with new ideas.

Third, decision-makers allocating capital between asset managers are professional market participants: pension funds, investment consultants, funds of funds, insurance companies, endowments, etc. They employ top-notch people who are well prepared to appreciate quality research. The ability to generate original ideas demonstrates an intellectual superiority and profound understanding of fundamental reasons for your strategy to perform. Such ability becomes a factor in an allocator’s decision-making process. Therefore, paradoxically, research innovations areneeded by asset managers not only to improve the performance of their investment products and outdo their competition, but also to help to raise their profile in the eyes of investors. While good performance rarely hinders asset raising, fundamental research is becoming a differentiating factor.

We have now approached another, perhaps even more interesting, question: how, taking the above into account, have asset managers’ research priorities been changing? Just to build their own investment process, the companies do not need researchers as much as before – they need engineers capable of building and upgrading an investment process based on other people’s research. And such research, as discussed above, can be found more and more often in the public domain.

Information has become far more abundant and easily available. Every new published paper is diluting its value even further. As the value of every single piece of information has depreciated, it has become more difficult to formulate a question that does not already have a publicly available answer. At the same time, information search and processing skills – and this is exactly what an engineer is supposed to be good at – have seen their value appreciate.

New information is increasingly becoming a raw material and researchers as producers of new information have been sliding back down towards the beginning of the production line. Increasingly, value is added at later stages of this line, where information is filtered and comprehended or, in other words, is transformed into knowledge, and synthesised into a finished technology.

Speaking of this phenomenon from an overall industry perspective, it is crucial that research continues on a significant scale. If it is dwarfed by pure engineering, more and more asset managers will exploit the same ideas, just presented differently. The natural conclusion, therefore, would be the exhaustion of the underlying risk premiums leading to lacklustre performance. So far, the right incentives have been in place.