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May 6, 2013

Defining the Alpha Code

By Mary Schroeder

Also in this article

  • Defining the Alpha Code

Equities traders are becoming increasingly responsible for sifting through huge volumes of information and data to find stocks capable of generating above-average returns. And they are spending more time working with portfolio managers to reach that goal.

"The way a trader is going to add value in the next 10 years is very different from the value proposition in the prior 10," said David Brooks, head of global equity trading at the Boston Company Asset Management. Brooks joined the firm 15 years ago as a senior equity trader.

David Brooks

Now he manages a desk with seven equity traders, including himself. Three are focused on domestic equities, three handle international equities, and one is a junior trader and electronic trading specialist.

Technology is critical to supporting the changing role of the trader, Brooks says.

One key capability is what he calls "alpha profiling," which "allows for a better alignment between the execution strategy and the demonstrated pattern of alpha occurrence in a given investment strategy," Brooks said.

Alpha profiling involves comparing two sets of data for potential above-average returns.

The first set highlights the trading decisions made by a particular portfolio manager over the last one to two years. The data would typically be provided by the firm's supplier of transaction cost-analysis services; they look at execution performance over the time frame from when a trade hits the trading desk until it is completed, Brooks said.

The second set of data is a longer-term alpha profile for the trades executed. The comparison might reveal that alpha for this particular manager typically happens before the traders get the order, for instance, he said.

By understanding a given alpha profile for a given portfolio manager or analyst, the trader can adjust the execution strategy to capture expected alpha, said Brooks.

"A portfolio manager or analyst may think he or she has certain triggers in their process that are the catalyst to a trade," he said. "Alpha profiling allows us to see how you're actually behaving and reconcile that with how you say you behave and how you think you behave, which offers more insight into when and how this alpha really occurs. If there are longer-term consistencies to that profile, you can take advantage of that in a systematic way."

For instance, if a portfolio manager tends to miss alpha opportunities by waiting for confirmation from an earnings release before executing any portion of a given trade, then the portfolio manager should execute a portion of the overall trade ahead of the report. Then, get confirmation of the expected result from the release-and wait to complete the trade until a few days later. That's when the stock price often reverts to an earlier price, after investors' initial reaction to the news, Brooks contends.