What is "Alternative Data" and how do hedge funds use it?

‘Consensus reality’, quant hedge funds, insider trading and the demand on compliance‘

Every kind of ignorance in the world all results from not realizing that our perceptions are gambles. We believe what we see and then we believe our interpretation of it, we don’t even know we are making an interpretation most of the time. We think this is reality.’ – Robert Anton Wilson

To me, the above quote by Wilson typifies the stock market: a series of gambles predicated on an assumption of value. More and more traditional hedge funds are realizing the rationale behind this concept in a very harsh way, by going out of business.

Leveraging Consensus Reality

There is an interesting philosophical term that captures this concept called ‘consensus reality’ and it speaks to the foundation of our financial systems including the stock market and money. To put it in one sentence: the only reason that the stock market has value is because lots of people (the consensus) believe in its value (the reality); they make long lists, definitions, valuations, categorisations, contracts, rules and laws which solidify its value in the marketplace.

Of course, the stock market is not alone in having its value determined by consensus – we could reduce many tangible things such as laws in general, governments, relationships and so on – but the stock market is peculiarly vulnerable to such a candid realisation.

Consensus Reality and Hedge Funds

As a hedge fund trader, the beauty of stock markets’ reliance on consensus reality is the flip side, that if the trader knows something the market doesn’t, there is more power for the trader to mold said consensus, and therefore reality.

The problem that hedge funds have been facing, other than, until recently, the lack of macro fluctuations in the global economy: is that access to ‘traditional’ information (news, financial statements, public filings etc.) has never been more widespread and instantaneous; so finding out information that the market doesn’t already know has become more and more difficult.

It’s just so much more difficult to get that edge over the competition and outcompete passive indexed funds. The old method of fundamental analysis may not be dead but if everyone is doing the same analysis of the same data, it becomes valueless analysis. Here enters ‘alternative data’.

Alternative Data

Alternative data can be anything from satellite images of oil tankers to video footage of foot traffic in a shopping mall car park, credit card information or massive troves of web scraped data using supercomputers. Basically, anything that the wider market doesn’t have access to or hasn’t analyzed or collected in a meaningful way before.

Alternative data is generally used in conjunction with traditional data sources combining both quantitative and fundamental analysis, colloquially known as ‘quantamental’ investing.

Demand on Compliance

To demonstrate how important alt data for hedge funds is becoming, spending by asset managers in relation to alternative data has gone from $232 million USD in 2016 to an estimated $1.7 billion USD in 2020. This includes the recruitment of huge teams of data scientists and the procurement of corporate espionage services.

The problem with alternative data, as per usual with anything new in financial services, is compliance and ethics. Similar to universal insider trading definitions, the information being used is generally ‘material non-public information’ and the use and procurement of alternative data is largely unregulated.

Understanding how the data is collected, stitched together and can be legally marketed may necessitate a compliance officer who is also a data scientist.

Hedge Fund Alternative Data

This demand for compliance professionals with a data science, or at least a mathematics or computer science background, is becoming more and more keen as quant hedge funds alternative data sources and offerings to clients has increased.

However, the issue that these hedge funds face in attracting the right talent is that a lot of compliance professionals come from law school, and what’s the main reason people give for going to law school? ‘I wasn’t good at maths’.

Like many problems, it can probably be solved with money. In order to attract the right people with the rare set of skills across the board, e.g. law and data science, you need to pay them well.

The other option is to identify talent and then train those people in the extra disciplines, they need to understand the environment they’re working in. This could be a serious investment for some alternative data providers, particularly quant funds, but most likely worth it in the end.

Putting aside the issues that asset managers face, it certainly brings up concerns about the ability for regulators to attract and retain the talent needed to oversee the changes we are seeing in the market. A hedge fund trader I spoke to for comment said:

‘It’s like Real Madrid being pitted against Slough FC…by the time they’ve caught up and understood a new financial instrument, product, package or loophole, the game’s already moved on.’