Article

Alternative data for investment decisions

Today's innovation could be tomorrow's requirement

Alternative data has become a valuable tool for investment management and asset management firms seeking an information advantage. Download our latest paper to help you evaluate — and mitigate — the risks that come with early adoption. We also assess the technology solutions available to support making investment decisions with alternative data.

Alternative data is likely to bring change

​Alternative data will likely transform active investment management (IM) over the next five years. Hedge fund management, long-only mutual funds, and even private equity managers will be impacted. Firms that don’t update their investment processes to incorporate alternative data could face the strategic risk of being outmaneuvered by competitors that effectively incorporate big data investment into their securities valuation and trading signal process.

Alternative data for investment decisions

The lure of alternative data

The lure of alternative data is largely the potential for an information advantage over the market regarding investment management decisions. True information advantage has occurred at various times in the history of securities markets, and alternative data seem to be just its most recent manifestation. Recall the fortunes made when the carrier pigeon was used effectively to gain an information advantage.

Today's fortunes may rest on the accessibility of vast volumes of big data coupled with advanced analytics that fuel the potential for information advantage, as opposed to the winged messengers of yesteryear. Speed and knowledge are advancing with the use of advanced analytics, and there will be no waiting for laggards, nor turning back.

What is alternative data?

Alternative data consists of unstructured, big data sets drawn from sources such as:

  • News feeds
  • Social media
  • Online communities
  • Communications metadata
  • Satellite imagery
  • Geospatial information

With rewards come risks

An organization's inability to spot, assess, manage, and respond to strategic risks may affect its critical assets, financial performance, or reputation. Estimating the risk and reward equation seems more of a challenge for alternative data than for other types. The risks could be higher; however, the rewards may also be greater.

Information advantage can be hard to come by in current markets — and any edge, even a narrow timing advantage, may yield a more effective trading signal, algorithm, or investment model. Interestingly, alternative data usage is applicable to active strategies, and may provide actively managed portfolios important edge over passively managed portfolios — which currently don't have a way to incorporate alternative data.

Any thoughtful new strategic direction should consider four potential risks — data, model, regulatory and talent — all related to incorporating alternative data in investment selection processes.

A well-known application of alternative data is satellite imagery analysis of parking lots, replacing the old-school approach of physical foot-traffic counts with clickers. In this case, alternative data approaches are faster and more comprehensive than physical counts, leading to an information advantage—even though the data sets were measuring similar consumer activities.

Four potential risks of alternative data

Data risk

Alternative data may carry greater risk than traditional data, given the content of the data fields and the various ways it is sourced and handled. If the risk control processes at alternative data providers are immature, they may increase extended enterprise risk at IM firms through the incorporation of invalid or noncompliant data—thus, ultimately posing a reputational threat.

Model risk

Investment managers should consider model risk in light of the potential for new data sources to impact investment models. There's risk at each point of the model revision—input, implementation, and output—with the biggest impact perhaps at the input phase. Model risk also includes risk that the alternative data may be incorporated in the model incorrectly, that the trading signal generated could be irregular or inconsistent under certain conditions, and that the output of the model could be improperly linked to the trading process. Strong controls around risk overall can serve to mitigate these alternative data-related risks.

Regulatory risk

Since alternative data are relatively new phenomena, fund managers should be aware that regulations and accepted practices governing their use are still in the early stages of maturity. There are still open questions about acceptable practices in the areas of web-gathered information, especially for e-commerce firms. As tempting as it may be to quickly capitalize on this information, leading practices call for a review of the process, looking for copyright, intellectual property, confidentiality, terms of use, and other potential missteps in the generation of that alternative data set. IM firms should consider modifying investor disclosures about investment policy and processes.

Talent risk

In the fast-paced world of analytics and alternative data, competitive edge may reside in finding creative approaches to analyzing or visualizing the data and incorporating them effectively into trading or portfolio construction. A resulting war for talent may then focus on getting to creative insights, through a combination of curiosity, data management, and advanced analytical skills. Loss of intellectual capital through talent turnover is another likely talent risk, given the specialized experience that investment-data scientists and investment analysts using alternative data acquire.

The future of alternative data

​The signals for the future adoption of alternative data seem positive, yet also mixed. Research on the adoption of alternative data finance by investment firm managers indicates that the question to ask may not be whether, but how quickly alternative data usage could become mainstream. While there are certainly risks associated with incorporating alternative data into investment-decision processes, there may also be strategic risks associated with not doing so. With improvements in advanced data analytics and increasing availability of data to analyze, the stage seems set for investment management firms to supplement their decision processes with alternative data. Look for alternative data to likely move quickly through the early adopters' segment and into the early majority segment within the next five years.

More information?

For more information please contact Evert van der Steen via the contact details below.

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