Alternatives Alt-Data Usage

Additional content provided by Michael McClain, AVP, Research.

While not exclusive to alternative investment strategies (the title’s alliteration was too easy and they are significant users), using alternative data sources as part of a firm’s investment process continues to grow across all investment styles.

For background, traditional investment data sources include SEC filings, quarterly earnings calls, and analyst reports. In contrast, common alternative data sources include transactional data such as credit card purchases, web traffic, social media sentiment, and geolocational/satellite images. Even though one of the original use cases of satellite data to measure holiday mall traffic is no longer as useful with shopping done online, tracking the flow and scale of commercial trucking, among other uses, remain beneficial in the industry.

This is by no means an exhaustive list of all sources of alternative data, as firms often keep novel datasets private to prevent more widespread use and a corresponding degradation in value. However, the search for any edge by active managers remains pervasive as investors search for a leg-up on the passive industry. So how should investors view their use and what are the benefits and risks?

Benefits

• Supplement fundamental data analysis: The use of alternative data sources may help investors find additional confirming data points as part of their decision-making process.
• More timely capture of macro data: As there is often at least a monthly or quarterly lag in between macro data releases, the use of alternative data points may help investors develop a better understanding of markets in between release dates.
• Risk management: The use of alternative data points may improve overall risk management as the ability to detect earlier shifts in consumer behavior helps balance out the reliance on stale historical data.

Risks

• Limited track record: Alternative data sources are often a result of ongoing technological developments. Satellite and social network sentiment have limited track records, and in the case of the latter, are subject to manipulation. For example, today, it’s understood that all earnings calls are scrubbed by sophisticated models to measure the use of positive and negative words. Speakers are now often instructed not to use certain words to avoid triggering a negative signal from an alternative data vendor.
• Interpretation: New sources of data, especially those with limited track records, are often used to confirm existing investment bias. This differs from long-term fundamental data where it’s known that earnings growth drives stock market returns.
• Data paralysis: The use of more data does not result in a linear degree of outperformance. Using too many inputs may result in conflicting views and a lack of confidence in the overall investment process.

LPL Research Takeaway

Overall, LPL Research believes market participants can supplement their existing investment process by using novel data sets. However, investors should not solely rely on niche data points to make major investment decisions. In the event that public firms are allowed to report earnings on a less frequent basis, which President Trump has supported, alternative data sets would be expected to become more meaningful; however, over the long term, we still expect earnings to drive the equity market.