In “Who is on the other side?”, BlueMountain Capital Management analyst and renown author Michael J. Mauboussin provides a brilliantly simple thesis about the different sources of alpha in capital markets.

In his paper, Professor Mauboussin argues that there are four fundamental sources of Alpha:

• Behavioral: A behavioral inefficiency exists when an investor, or more likely a group of investors, behave in a way that causes price and value to diverge.
• Informational: An information inefficiency arises when some market participants have different information than others and can trade profitably on that asymmetry.
• Analytical: An analytical inefficiency arises when all participants have the same, or very similar, information and one investor can analyze it better than the others can.
• Technical: A technical inefficiency arises when some market participants have to buy or sell securities for reasons that are unrelated to fundamental value such as laws, regulations or internal policies that can produce a divergence between price and value.

The four sources of Alpha brilliantly summarize the dynamics of efficient capital markets but do they apply to the emerging technical space? After all, for example, crypto markets are anything but efficient.

To explore this, let’s explore the three principle technologies driving markets in the 4^th Industrial Revolution, and let’s start by understanding what the 4^th Industrial Revolution stands for.

From bespoke conveyor systems that enabled Henry Ford to build the first automobiles to the steam power that powered trains for trade, the first two industrial revolutions sparked a new era of prosperity and economic progress for humankind. More recently, the third revolution ushered in a new era of globalization with instantaneous communication, trade, and commerce over the Internet.

Today, many believe the world is on the brink of yet another industrial revolution. Professor Klaus Schwab, the founder of the World Economic Forum, describes the Fourth Industrial Revolution as the amalgamation of physical, biological, and digital systems through cutting edge technologies such as artificial intelligence, robotics, genetic engineering, and more.

Given that such a major paradigm shift does not happen overnight, Schwab argues we have already entered a transitory phase and are currently witnessing the beginning of the next major milestone. To that end, let’s explore three emerging technologies that are most likely to spearhead the fourth major revolution.

Internet Of Things (IoT)

Between wearables, smart home appliances, commercial security systems, and smart city projects, an increasing number of systems now connect to each other and the internet. These devices collectively come under the umbrella of the Internet of Things (IoT). They are capable of automatically transmitting vital data and metrics to servers on the internet, with little to no human oversight required. According to Oracle, the number of IoT devices is expected to grow to 10 billion by 2020 and 22 billion by 2025.

IoT devices have enabled businesses to collect an unprecedented amount of data about processes such as manufacturing and logistics through connected sensors. Supplementary technologies, such as machine learning, are often used in conjunction to extract actionable insights for better decision-making.

In factories, IoT-enabled sensors have been employed to detect and report faults in machinery, defects in production, and other abnormalities. The logistics industry, on the other hand, has found a myriad of other applications for the technology such as automated delivery alerts, fleet management, and detection of operational failures.

Ultimately, IoT is being used to boost key business metrics such as productivity, efficiency, and revenue. However, its role in consumer space has grown significantly over the past few years, primarily due to the prominence and ubiquity of smart home devices.

Artificial Intelligence (AI)

For the first time in history, modern computers can identify patterns, learn from real-world experiences, and make optimal decisions in challenging environments. With the recent exponential growth of processing power and storage capacity, training a computer to perform these tasks has become significantly easier. As a result, the technology has started to trickle down into everyday interactions such as speech recognition, traffic management, and cybersecurity.

Since the decision-making ability of a computer hinges on there being enough historical data to learn from, artificial intelligence ties together perfectly with IoT. Large swathes of data collected by connected devices or any data source can be quickly analyzed to detect data points that are important and ones that can be safely disregarded.

In 2017, Google made waves in the world of Artificial Intelligence with the unveiling of AlphaZero, a self-taught program that could handily beat world champions at games of chess, Shogi, and Go. For each of those three games, the program would play millions of rounds against itself in a few hours to learn how to make advantageous moves that would improve its chances of winning the game. According to DeepMind’s blog post on the subject,

“The amount of training the network needs depends on the style and complexity of the game, taking approximately nine hours for chess, 12 hours for shogi, and 13 days for Go.”

Given the clear advantages of Artificial Intelligence, it is hardly surprising most industries are keenly looking to integrate the technology into their core workflows. In the retail space, for instance, companies like Amazon are using AI to improve product recommendations, predict consumer spending, and automate customer support with the help of chatbots.

Blockchain & Cryptocurrency

Similar to how AI and IoT are enhanced when combined, blockchain and cryptocurrencies offer unique advantages to this suite of technologies — namely decentralization, immutability, and transparency.

Unlike the current model of the internet, where a few centralized authorities are trusted to safeguard user data and privacy, blockchain allows every user to be an equal stakeholder and part of a larger “network.” By eliminating third parties, the technology opens up a radically new medium of record-keeping and data storage that is far more secure, efficient, and instantaneous than anything previously available.

While most of blockchain’s initial fame attributes to the cryptocurrency market, its potential has since been realized and tested in sectors as diverse as real estate, trade, and government records.

In the supply chain industry, for instance, blockchain can be used to store and replicate data from IoT sensors and also safeguard it from being tampered with or deleted in the future. To that end, IBM and Maersk collaborated to leverage IoT and blockchain technologies and improve traceability in the shipping industry.

According to the press release announcing the platform,

“TradeLens uses IBM Blockchain technology as the foundation for digital supply chains, empowering multiple trading partners to collaborate by establishing a single shared view of a transaction without compromising details, privacy or confidentiality. Shippers, shipping lines, freight forwarders, port and terminal operators, inland transportation, and customs authorities can interact more efficiently through real-time access to shipping data and shipping documents, including IoT and sensor data ranging from temperature control to container weight.”

The finance and banking sectors have already found ways to leverage the strengths of blockchain and digital tokens, effectively lowering fees, improving cross-border trade, and modernizing aging processes.

According to a study conducted by Grand View Research in July 2019,

“The global blockchain technology market size is expected to reach USD 57,641.3 million by 2025, registering a CAGR of 69.4% from 2019 to 2025.”

The Two New Sources Of Alpha

What’s interesting is that all three technologies enable two new sources of Alpha:

The first new product Alpha factor is related to the financial architecture of emerging technology markets and how impact the current launch of new products or assets can have in an inefficient market.

In traditional capital markets, a new IPO or a new bond offering rarely disrupts the behavior of the overall market. There are isolated examples such as Facebook’s failed IPO which triggered months of bearish sentiment about tech stocks but those cases are extremely rare as the efficiencies built into the overall market tend to compensate for any anomalies over long periods of time. The opposite phenomenon happens in the 4^th Industrial Revolution markets. While we transition from inefficient to “less inefficient” markets, the launch of new products like a new derivative or the entrance of an institutional investor can generate incredible Alpha returns.

The second factor is related to the fact that many 4^th Industrial Revolution assets run on decentralized networks whose behavior is governed by different protocols. The behavior of those protocols can generate relevant Alpha returns. For instance, the upcoming halving event in the Bitcoin network has been long anticipated as an event that can influence the price of the cryptocurrency and effectively move the market. While that information is readily available, there is a cost of implementing effective strategies to leverage it. Similar effects take place when a protocol mints or burns a specific portion of tokens impacting the circulating supply.

Conclusion

In the 21st century, computers have become widespread and can be considered an integral part of almost every single industry, including ones that predate the technology itself. It is not too hard to imagine a future where existing processes are completely replaced or enhanced by some combination of IoT, AI, and blockchain technologies.

By enabling new means of data collection, automating the process of decision-making, and introducing a more robust and secure medium of data storage, the 4th Industrial Revolution is poised to drive automation and digitization to every last industry, and provide new ways to seek Alpha.