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Sharpening the Saw
Comparing the ROI of Fine-tuning Your Investment Process to Buying External Data
“Give me six hours to chop down a tree and I will spend the first four sharpening the saw.” – Abraham Lincoln
Hedge fund managers invest billions in research for one reason: edge. Managers increasingly buy exotic datasets, call experts in niche fields, fly across the world for conferences and management visits. They spend millions searching for that elusive and fleeting alpha. External sources of alpha are the focus. Yet too often managers ignore the quieter, less glamorous investment. An internal source of alpha: their own investment process.
Alpha Theory has analyzed millions of data points such as price targets across hundreds of portfolios. The data indicates that the ROI of incremental spend on their investment process is much higher than spending more on external research.
In short, data shows that sharpening the saw matters.
The Spend on Research Edge for Hedge Funds and Investment Managers
Hedge funds spend a lot on information or external inputs into their investment process. They are pulling in data from alternative sources like credit card transactions and expert networks. They also invest in risk and attribution tools that help them run simulations and understand factor exposures. However, one part of the process may be overlooked and yet still have a high potential ROI, rivaling the other investments. Let’s start with areas where managers currently invest to hone their skills.
Alternative data: The industry is on track to spend more than $15 billion annually by 2025 on everything from satellite imagery to credit card transactions1. On average, a single hedge fund spends about $1.6 million a year and subscribes to nearly 20 datasets. The large multi-strategy funds spend several million dollars per year on data alone and the retention rates of data vendors are high. Why? Because it works. A J.P. Morgan study found that hedge funds using alternative data generated 2 higher returns than those that didn’t.
Expert networks: GLG, Tegus, Third Bridge—these are now mainstream and represent 2% of the total research budget for hedge funds3. The average expert call costs $1,000–$1,300 per hour! Furthermore, most funds spend from the mid-six figures to more than a million per year on these services. GLG is one of the top-paid research vendors in the world for a reason. Hard to measure in percentage points, but most PMs will tell you the insights are worth the cost. A single call can save a fund millions by steering it away from a bad bet.
Travel: The old-fashioned “kick the tires” approach still matters. Visiting plants, touring stores, attending CES or the JPM Healthcare Conference. This is still where ideas are exchanged, vetted, and debated. A global research travel program can easily cost $1 million a year, and most mid-size funds still spend six figures annually on travel4. Hard ROI? Fuzzy and tough to nail down. But one good trip that helps identify a big opportunity justifies the budget. The question is how often does this happen and measured?
Portfolio analytics tools: This is a growing category. Platforms like SEI Novus, Essentia, and LightKeeper take up 5% of the average research budget. Subscriptions range from $50k to $150k a year for mid-sized funds. These tools analyze your track record, flag behavioral biases, and run portfolio attribution analyses and simulations. Conservative estimates suggest they can boost performance by at least 1% annually by correcting for factor tilts and catching risks early5.
All these investments make a difference. They help managers discover opportunities and understand the markets more clearly. They generate an edge and deliver ROI, though it can be difficult to quantify.
Linking Investment Process Improvements to Incremental Returns
Here’s what many managers miss: external input is necessary, but process discipline inside the firm is an investment too, and one that may yield the highest ROI yet. Of course, we are talking about the ROI of position sizing discipline.
Our team at Alpha Theory have studied more than a decade of hedge fund portfolio data, analyzing the impact of sizing on fundamental manager returns across hundreds of portfolios. We start by asking a simple question: “what if managers had followed a structured sizing process based on their own research inputs?” How would that compare to their actual returns? The results were telling and not surprising.
- The “optimal” portfolios outperformed actual portfolios by an average of 4.3% per year.
- In 11 of 12 years, the structured process beat the actual portfolio. And the 1 year it didn’t, it was almost equal.
- Through 12 years, the cumulative return of the optimal portfolios was 268% vs 130% for the real portfolios.6
This incremental return is generated by sizing the positions managers already own, no new dataset or external insight is required. No extra travel to conferences. Just incremental process improvement, fine-tuning what you already do internally.
Here is another example that seems intuitive but data helps to quantify. Positions with explicit price targets generated 4.9% more on the long side and 7.1% more on the short side compared to positions without targets. And when those targets were kept fresh, meaning they were updated regularly, (at least quarterly) instead of letting them get stale, returns improved even further.
By getting into the habit of doing the basics implementing price targets in their models, updating them regularly, and sizing consistently managers are able to unlock more incremental and sustainable return than most of the other research spends.
Why Process Gets Ignored, Specifically Position Sizing
Why do managers underinvest in their sizing process? There are a number of reasons. Most investors we talk to are trained as security analysts, not portfolio construction experts. They spend their time learning how to forecast business value, not how to build a process to optimally allocate capital across ideas. Some PMs say that they “figure out” sizing on the fly. It’s instinct. It's an art.
To us, that usually means trusting intuition with some gut feel and bias sprinkled in.
There’s also inertia. Buying an exotic new data set is exciting. Calling an expert feels like you’re investigating a story. But revisiting our sizing framework? Updating price targets every quarter? That feels like work. The unsexy kind.
Yet it’s the work that pays.
External Edge vs. Internal Discipline: Position Sizing vs Alternative Data
This isn’t an either/or and we are not arguing that one alpha source is better than another. In today’s hyper-competitive and information overload environment you need both. External investments expand your opportunity set. They improve your hit rate. But internal investments increase your slugging percentage. They ensure you actually capture the value of your hits and monetize them fully.
Throughout the years we’ve seen managers go through different stages of thinking about portfolio construction. We have worked with funds that consistently under-owned their best ideas. Another that held too many “farm” positions that diluted returns. But when they enforced explicit targets and a consistent sizing framework, their performance improved, hands down.
They sharpened their saw and reaped the benefits for the long term.
Sharpen the Saw: Improving your Position Sizing Process Pays Off
Managers will not stop spending on data, experts, or travel. Those investments have meaningful ROI. But their value is not fully tapped without the saw being sharp.
Sharpening the saw means investing in your internal process: your sizing, your target update discipline, your feedback loops. It’s not glamorous work, it can even feel repetitive. But it pays.
Abe Lincoln was right. Spend the time sharpening. Because in investing, just like chopping wood, the sharpness of your saw determines the depth of your cut.
Learn more by downloading the free white paper: Ultimate Position Sizing Guide.
Ready to talk to our team? Reach out to set up a demo.
Footnotes:
1 Source: Neudata via Prnewswire
2 JPMorgan via Daloopa
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