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Understanding Market Participants

Max Darnell

Managing Partner | Chief Investment Officer | First Quadrant


Executive Summary

  • Different perspective, different result
  • Fundamental characteristics matter only when they matter to investors
  • Market participants have different needs and preferences
  • Market participants will pursue trades that are not motivated by profit
  • Understanding market participants’ objectives and motivations provides a rich opportunity to add value

The financial market is an incredibly rich and complex space, and academics and practitioners alike have dedicated enormous effort into understanding its forces. It is perhaps surprising, then, that few have focused on the forces that drive the individuals who come together to create the market. Many treat market participants as a homogenous group, all motivated by a singular desire to maximize profit. But of course, different market participants have different needs and preferences – some may vary based on the dimensions of the market environment. Others may vary within the same trading period! Almost all market participants will at times pursue trades that are not purely motivated by profits, with another segment of participants that will always trade without profit as their main objective, and this provides a rich opportunity for profit-seeking investors to engage in mutually beneficial trades. This incredible diversity among market participants, and their motivations, provides fascinating insight into how asset prices are formed.

What – and Where – to Hunt

Whether you are beta-grazing or alpha-hunting, it makes sense to graze where the herd is light and hunt where the competition is scarce. Some investors, such as trend-followers, conduct high-altitude flyovers of this territory, but few have bothered to invest significant time and resources into parsing the rich, detailed complexity of investor behavior. And as a result, we believe that most miss the opportunities to participate in the profitable alpha transactions that this landscape offers.

Over the past decade, First Quadrant has seen a broad collection of managers spend enormous time and money trying to access fundamental data sooner, or at a more granular level, than their competitors – think cars in parking lots, lengths of crop shadows, shadows on oil barrels. But fundamental characteristics matter only when they matter to investors; they do not have intrinsic value. 

Cars in parking lots, for example, might indicate strong consumer demand for a particular company. However, if we are in a market environment where investors place a high value on ESG (environmental social governance) characteristics, then an early indicator of future profitability like consumer demand might not be as influential for that stock’s returns as the company’s corporate governance.

So instead of trying to win the rat race of acquiring fundamental data just slightly before other managers, we have chosen to focus our efforts on understanding how market participants will evaluate fundamentals.

The Reality

Market participants have different and changing needs and preferences, and these are strongly influenced by the economic and financial environment. Many academic papers have elected to treat market participants as a homogenous group, with the singular objective of profit-maximization. Practitioners have adopted this simplifying assumption as fact rather than necessity, and thus the conveniences of academic theory have become ingrained as truth. But in the daily movements of markets, we see tremendous variety in investors’ time horizons, liquidity needs, risk tolerance, regulatory requirements, tax-driven liabilities, desire for capital protection, and spending objectives (note the entirely rational nature of these motivations).

This dismissal of the full range of factors that drive investment decisions is surprising. The incredible diversity among broad cohorts of investors is not only fascinating from an intellectual perspective, but also an important reason for the very existence of many profitable alpha opportunities. The First Quadrant investment team has spent 30 years exploring these differences across investors, seeking to understand and anticipate how divergence in their needs and preferences can impact market prices, and how investment objectives can (rationally!) vary across different market environments. And though we believe we have only scratched the surface, we are seeing very different, and encouraging, results.

Through our research, we can often infer when market participants are trading with objectives other than profit-maximization in order to participate in a potential win-win exchange. Sometimes, for instance, we can provide liquidity to those who need it during times of stress, or bear the risk to provide a hedge when others are unwilling. 

In essence, when we don’t need to face off against alpha seekers, alpha need not be a zero-sum game.


Past performance is no guarantee of future results. Potential for profit is accompanied by possibility of loss. The views expressed are the views of First Quadrant, L.P. only through this period and are subject to change based on market and other conditions. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. 

WRITTEN BY

Max Darnell

Managing Partner | Chief Investment Officer | First Quadrant

PUBLISHED: March 20, 2019

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