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Digital Subscriptions > The Hedge Fund Journal > Issue 108 - October 2015 > On Origins Of Alpha

On Origins Of Alpha

Is the stock market a quasi Ponzi scheme?

Abstract

We argue that an important contributing factor into market inefficiency is the lack of a robust mechanism for the stock price to rise if a company has good earnings, e.g., via buybacks/dividends. Instead, the stock price is prone to volatility due to rather random perception/interpretation of earnings announcements (among other data) by market participants. We present empirical evidence indicating that dividend-paying stocks on average are less volatile, even factoring out market cap. We further ponder possible ways of increasing market efficiency via 1) instituting such a mechanism, 2) a taxation scheme that would depend on holding periods, and 3) a universal crossing engine/exchange for mutual and pension funds (and similar long-holding horizon vehicles) with no dark pools, 100% transparency, and no advantage for timing orders.

Introduction

According to the SEC (U.S. Securities and Exchange Commission) website,1 “A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.” SEC further clarifies: “With little or no legitimate earnings, Ponzi schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.” So, is the stock market a Ponzi scheme? (See Gross [2012].) As we will argue below, the truth appears to have various shades of grey…

Ultimately, our goal here is to ponder the origins of alpha. Why does alpha exist? Where does it come from? The stock market is man-made, with all its complex, artificial and not always rational rules and regulations. Unlike, say, the planetary motion in our solar system, which is governed by the fundamental laws of physics (to wit, gravity), the stock market is messier. It is not directly governed by the fundamental laws of nature.2 This lack of underlying fundamental description makes the origins of alpha murkier. But not all is lost. Let us start by asking:

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About The Hedge Fund Journal

INFORMING THE HEDGE FUND COMMUNITY With access to some of the industry’s biggest names and an astute and talented group of writers and contributors, The Hedge Fund Journal has established itself as a trusted source of information on the hedge fund industry. Highlights of Issue 108: BlueCrest - Equity strategy excels in 2015 Volatility & Uncertainty to Define 2016 - Major challenges facing market participants On Origins of Alpha - Is the stock market a quasi Ponzi scheme? InfraHedge - The largest MAP-infrastructure provider
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