When you stumble upon the term Alpha Decay, the first information that jumps out a Google search is a scientific definition about a type of radioactive decay in which an atomic nucleus emits an alpha particle and thereby transforms or ‘decays’ into a different atomic nucleus.
This means very little for all of us that work in the financial industry because in our world, the term Alpha Decay has a completely different connotation.
Alpha Decay in Finance occurs when the models created by the group of analysts in investment funds start to decrease their ability to generate returns above the market or benchmarks.
Let’s remember that beta is the return that can be extracted out of investment strategies that mirror or copy the market. Portfolios with this characteristic are also referred to as Indexed products.
Alpha on the other hand, is the excess return above the beta and is usually sought through a wide range of strategies. Alpha is the reason why Hedge and Investment funds support their performance fees in the range of 20%-30% or sometimes even higher while Funds that invest in Indexed products usually only charge a management fee of 0.5% to 2%.
Despite the old arguments between industry figures such as Warren Buffet and Larry Flink from Blackrock, investors are happy to pay high performance fees because they recognize the skills of certain asset managers capable of delivering Alpha returns for them.
As you can see, experiencing Alpha Decay is a serious situation for Investment Funds.
There are three main reasons behind this phenomenon:
1) Information is everyday more available and accessible so strategies that work well tend to become known, popular, and copied by market actors and when that occur, the competition for the Alpha intensifies reducing the profit sharing,
2) The rapid improvement in financial and trading technology, has accelerated the pace of execution and the window of opportunity shrinks in size and,
3) The cost of execution has been reduced to levels where high frequency strategies are not only possible but also profitable.
For years, the Hedge Funds in the crypto space have been immune to this process of Alpha Decay simply because the still obscure nature of the industry and the huge asymmetry of the information allow pretty much every single one of the market participants to enjoy a comfy size sandbox where they can experiment investment strategies and end with Alpha most of the time.
Even though there is a consensus upon which I concur where the industry believes that there is still a horizon of 12 to 18 months where Alpha will still exist abundantly in the crypto space, there is no doubt that with the advent of large institutions joining the space, we are going to see Alpha Decay periods in a short timeframe.
So, what can we do in order to Decrease Reverse the Alpha Decay? We must start thinking outside the square (Crypto square) and start chasing alternative information not monitored before to support our investment hypothesis.
Let me give you an example. Political activity especially in the United States and Europe is becoming one of the driving forces in crypto mass adoption and hence increase of demand. We know what happens with the price of assets where the demand increases.
To illustrate a bit more this impact, I am inviting you to participate in a free Datapalooza event where I will be discussing the topic Using Data to Understand The Biden Executive Order & How Crypto Native Funds are Planning for 2022.
Please use the link below to access the event scheduled for this Wednesday March 23rd at 10:00 am EST.
Yours in Crypto