The types of hedge fund edges

If you investigate and conduct due diligence on hedge funds, you will be asking the question, "What is your edge?". In markets that are relatively efficient and certainly competitive, you want to know what makes a manager special. However, when asked the question, most managers cannot help but go into a long monologue about all they do that they think is special. Generally, this is not a concise answer. It is helpful if both parties are able to place their edge within a category. 

There are likely five different edges that a manager can have. They are not limited to one, and it is better if there are multiple edges. Think of the edge like the moat surrounding a company. If there is a strong edge, other firms will have a hard time replicating the behavior of the hedge fund manager. Here are the five edges with quick descriptions: 

Informational Edge - Access to better or faster information. This is the space of alternative data, or data that is expensive and cannot be obtained or processed by many firms. Of course, this edge is dynamic and can change with the usefulness of the data.

Analytical Edge - Superior ability to analyze the same data everyone has —better models. I call this the conversion of public information into private information. A data transformation can be an analytic edge. This is the realm of the quant firm and its army of researchers. Again, this edge is dynamic.

Behavioral Edge - Ability to stay rational when others panic or overreact — exploiting behavioral biases. This could be considered their ability to manage risk through a systematic process.

Structural Edge - Benefits from the setup, like lower transaction costs, access to certain markets, or priority in order execution. If you are a short-term trader, this is critical, but all firms can improve through working on their structural edge.

Technical Edge—Superior tech infrastructure, low-latency systems, or highly optimized software for faster execution than competitors. Most think this is the realm of quants. The technical ability to process data and information is critical for good decision-making and risk management; however, all firms can work on their technical edge.

Note that all firms may have some skill in each of these areas. The problem is having an edge that will translate into a process that will translate into consistent return.