I work in the investment business and I’ve come to realize that many investment strategies seem to be really information problems in disguise. This essay discusses why the speed of information might be a root-cause of declining investment alpha, and what it might portend more broadly for certain business models and their future profitability.
As The Investing Meta-Game argued, many investment strategies, even medium-duration ones, can be re-framed as information front-running: extraordinary returns almost always derive from knowing some truth before others. The viability of these strategies then is related to how fast information travels.
In the age of carrier pigeons, information traveled slowly, allowing well-informed investors to profit ahead of the news, as Rothschild was rumored on the binary outcome of the Battle of Waterloo. As investors became more sophisticated and financial models widely internalized, information front-running involved more sophisticated financial analysis (adjusted price/earnings) and qualitative insights (good corporate governance, high ROIC, predictable cash flows).
These ‘information opportunities’ persisted proportionate to how difficult the information was to obtain. When information moved slowly, it not only enabled market participants to find and synthesize the information, but also build a meaningful position to take advantage of it.
Today's investment funds broadly seem to have less alpha and this may be due to information moving very quickly: through LinkedIn, blog posts, twitter feeds, investment message boards, sell-side reports, and buy-side instant messages, which quickly identify the 2-3 things that matter most. Many investors don't even need research to benefit from this informational efficiency: active management fees effectively subsidize passive investment products by ensuring information in stock markets is mostly well-priced.
The successful investment strategies in vogue today all seem to be variants of an information-problem. Activist short-sellers create value (or manipulate prices) from formerly private-information released publicly, often in the form of explosive exposés of alleged accounting fraud, many of which are true. Some foreign markets are still information access-constrained by local language requirements, like China A-shares or Japanese small-caps. Multi-manager platforms pursue a nuclear arms race of information-driven leveraged trading strategies which seek to front-run evolving market sentiment, typically around quickly decaying private information of earnings; this need not imply “inside information” as it is defined.
Not all investing resembles the information-bazaar, but most does. If a fund’s turnover exceeds 60% per year some of these conclusions probably apply, as each trade opens the possibility of performance leakage from being front-run by other participants with more accurate short-term information.
Investment strategies, which exist on the leading edge of the information revolution, seem to be the canary in the coal mine for the declining profitability of many information-dependent business models which derive their profitability from hoarding and exploiting the value of private or expensive-to-access information.
Attractive profits often come from constraining information or its availability
I suspect a fair amount of business profit often comes from "hoarding" information (typically cost information) or constraining information availability (scarcity, perceived scarcity, or physical access limitations):
Proprietary trading desks hoard pricing information to profit from client flows;
Retailers hoard product-cost information and access by monopolizing distribution availability;
Brands conveyed expensive to obtain quality / trust information whose scarcity allowed for premium prices of commoditized inputs;
Banks, using trust, curtailed access to payment information-networks to extract transaction fees;
Complex life insurance products with high margins persist because of a scarcity of product-knowledge and the lack of multiple supplier quotes;
Diamond producers hoarded supply information (and actual supply) to enable diamond pricing to rarely decline;
Industrial chemical producers hoarded the costs-of-production information for specialized downstream chemicals to the detriment of their customers.
Conditions today merely reflect the slow technological commoditization of the different ‘building blocks’ of business: capital, logistics, and now information. Capital markets globalized capital flows, ensuring competition for attractive business opportunities. The shipping container brought speed, ultra low-cost transportation, and globalized the availability of many production inputs & outputs, from bulk chemicals, to industrial goods, to consumer products, removing an access constraint of geography. The internet massively accelerated the speed of dissemination and distribution of information, reducing the ability to extract economic rents from hoarded information. Low-cost software options may be the only alternative to preserve some profitability, as the prop-traders at Goldman Sachs become the code-driven Marcus bankers.
Long businesses that facilitate the flow of information, short businesses whose profits depend on hoarding it
Our world is dominated by social animals like ants, monkeys and humans, whose ability to learn, evolve and adapt derive from high-fidelity information transmission mechanisms like language and complex learned behaviors of social memes. Urban cities are another evolved "platform" whose characteristics allowed the free flow of information in the form of ideas allowing societies to innovate, grow and adapt at rates that exceed the characteristics of social organisms alone.
Despite appearances, the modern Corporation is a recent innovation which emerged around the Industrial Revolution. At the time, cottage industries like textile weavers organized into guilds, and then into businesses taking the legal form of a Corporation. This business model solved a few "information" problems like coordinating units of production, group bargaining, marshaling resources, and disseminated learning. This was information "hoarding" at its most efficient and profitable.
Yet problems may arise when business models rely on information "hoarding" to generate profits, and most businesses do. Every investor is familiar with the problem of being a seller on Amazon's marketplace, it’s a commoditizing morass of beggar-thy-neighbor price-competition from some anonymous reseller (capital markets) who probably exists in China (speed of information) and drop-ships products on cheap (containerized) shipping. Amazon itself has pivoted towards marketplace / fulfillment (3P) over first-party (1P) sales.
Other examples abound:
An OEM product manufacturer might instead be imagined as hoarded information about specific manufacturing techniques, with commoditized inputs and comparable shipping costs, competing on a global basis against other OEM's;
Travel agents are nothing more than the amalgamation of different sources of flight and hotel supply availability information, delivered to mostly commoditized demand. And the sources of supply information itself (GDS, OTA, direct connects) are also widely available;
An advertising agency may be nothing more than an corporation with the legacy of an information-rolodex whose suppliers (and costs) are now easily discoverable.
In our modern economy, many platforms play the role of facilitating and coordinating the flow of information over their surfaces from a distributed network of participants, taking a cut in the form of advertising, subscriptions, transaction fees, or bundled product-sales. Their prescience though does not come from hoarded information-resources marshaled internally, but the wisdom of crowds who transact on-top of them. Platforms emergence then might be a mere symptom of instantaneous communication and the diminished value of hoarded information, the same way cities emerged from dispersed small-groups of agrarian humans, when larger networks of organized resources were required to progress.
Academic journals externalize the units-of-production (innovative ideas) and instead tax information-facilitation through subscription fees by providing trust around product quality / relevance (as does AirBnb). It is unclear if the journal business would be profitable if it required employing the legions of researchers necessary to fill its pages. Yet that is the embedded assumption of most Corporations, that internally marshaled information-resources are more cost-efficient and valuable than the insights which are instantly accessible outside them.
Uber uses software to provide information to drivers about demand, and riders about supply, coordinating a transaction; taxi companies internalize it. Craigslist provides information on both buyers and sellers of goods & services; retailers hoard it. Google facilitates the flow of information between searches and web-sites; industry consultants excessively tax it. Spotify intermediates the music-information of abundant artists seeking listeners; like prop desks, record labels excessively capture it.
Alternative asset-manager “platforms” (KKR, BX, APO) seem to have transformed the business of corporate funding into a global phenomenon of increased scale, where the availability of information creates increased access to new funding opportunities (private equity / credit) while dis-intermediating stock, bond markets, and local banks whose (private) information has been commoditized.
These are all information problems in disguise, whose effectiveness and addressable markets seems to depend on the fidelity of the information transmitted: Uber works better with GPS than paper maps and approximate street corners; the business of bank lending works better, when you can more effectively know your borrower from 5,000 miles away. These seem to be the realities of the abstracted world we live in.
Unsolved Information Problems: Hyper-local or Hyper-scale
In our new informationally abundant world, it seems more difficult for any business or person to hoard and exploit the value of proprietary information. An individual being "analytically smarter" is also rarer, especially where intelligence is normally distributed, information generally available, and opportunity (somewhat) democratized. What seems to be left for investors are the information problems that don’t scale (hyper-local) and those that do (hyper-scale).
The hyper-local solutions that don’t scale exploit remaining pockets of private information (like political risk consultants in opaque countries), are access constrained (like local services), or are businesses whose competitive advantages do not derive from information hoarding, but something else, like perceived scarcity (luxury goods), network effects, or regulatory / legal impediments.
The hyper-scale solutions also solve for this new information abundance and its constrained profitability: they are software-driven global platforms which are phenomenally profitable in aggregate but deal in profit margins of pennies not dollars. One might even argue they are the new “hoarders” of information -- on a gigantic scale -- whose profits derive from individuals who click-by-click, turn-by-turn, behavior-by-behavior give up the value of their crowd-sourced information for little recompense.
In the investment industry, business opportunity seems bi-furcated: Blackrock is a hyper-scale software solution whose ETF platform benefits from active managers who efficiently set securities prices; venture capitalists (outside the mega-funds) are a hyper-local solution who find and source opportunities which still possess advantages of constrained information, access and availability.
Investing though is a two-sided pari-mutuel game: a bet on future profitability of business and a game against other investors. Historical financial information that many investors rely on may be less informative about the future, the information of complex intuition may disseminate widely and decay faster, except where participation might be limited by the duration of available investment capital. Sometimes under-performing in the short-term is necessary to outperform in the long-term, and one informationally-deficient financial market participant still seems to exist: the momentum-chasing, volatility-loathing fund investor whose actions no longer distorts the prices of individual securities, but the availability of investment capital itself.