Nerds on Wall Street: Math, Machines, and Wired Markets

Chapter 4. Where Does Alpha Come From?

Life Is Alpha. The Rest Is Details.

—Popular T-shirt at hedge fund events

There was a time not too long ago when, if you posed the question "Where does alpha come from?" to a roomful of academic financial economists, most of them would complain: "It's a trick question! There is no alpha! Markets are strong-form efficient and you are a heathen!" Those complaints are rarer now, even among economists. Two of their own, Sanford Grossman and Joseph Stiglitz, crystallized the contradiction of strongly efficient markets in their eponymous paradox. It is summarized in Stiglitz's 2001 Nobel Prize citation:

If a market were informationally efficient, i.e., all relevant information is reflected in market prices, then no single agent would have sufficient incentive to acquire the information on which prices are based.^[]

If there is no profit to be had from trading on information, traders with information will not trade, so prices will not reflect information and will not be efficient. The joke based on this paradox has an economist and his friend walking down the street, and the economist walks right over a $100 bill on the sidewalk. The friend asks why, and the economist replies, "If it was real, someone would have already picked it up." (See Figure 4.1.)

Figure 4.1. How Alfred E. Neuman might illustrate the Grossman-Stiglitz paradox. If markets are efficient, they reflect all information, and there is no profit to be had from trading on information. ...