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Your Next Challenge Involves Staying Ahead of Academic Research

You have worked hard to come up with an edge and you have employed all sorts of measures to preserve it. You have built your fund business the hard way by delivering absolute return to clients. Next thing you know is that some professor and his graduate students publish your edge in a paper. You probably have to start all over again and your next challenge in addition is staying ahead of academic research.

A couple of days ago I saw this post in The Reformed Broker blog: Can Academic Research Mess With Your Investment Strategy?  The answer is: Of course they can and they have been doing it already. The problem is that in the absence of genuine subjects, a lot of research is directed lately towards uncovering hidden edges in the markets. This is a heaven for researchers as they can work with a lots of data, run statistics and generate all those papers that have probably 100 hidden assumptions they do not even know. From reading some of these papers it becomes clear that some of those researchers do not know the difference between a limit and a market order but that is another story. The issue is that they have all the time they need and all the resources they are required to run models 24 hours a day, 365 days a year until their crude statistical data mining methods uncover some edge you thought nobody would be able to ever figure out. The interesting thing is that most of these researchers do not open a trading account and leave the campus life to start trading the edge but instead they publish it so that everyone learns about it.

An example in the series of such publications is the leverage ETF strategy reported in the blog of Ernie Chan, Quantitative Trading. These researchers went out of their way to demolish that edge for just proving that a good percentage of the volatility at the end of the day is linked to leverage ETF rebalancing. So what? This is not news. But finding and disclosing an edge is news.  Is this a legitimate task of academic research? I don’t know the answers, maybe someone does.

If more academic researchers turn to the markets for quick gratification, then the life of fund managers and traders will become more difficult as they will now have to stay ahead. Especially the life of those who rely on a edge to run a fund business. Staying ahead of academic research requires understanding its weakness and its limitations. One of the limitations is that academic researchers do not have trading experience and cannot deal with edges that depend on analyzing market context. In this new environment that is emerging where there will be constantt massacre of edges, those that have the experience and feel of the market will survive by lengthening their trading horizon enough to deal with volatility and by employing efficient diversification. The rest, those that rely on some specific and fixed edge, will soon see it disappearing with whatever that implies for their future performance.