Dr. Richard Peterson, a psychiatrist by training, knows first-hand that emotions often rule investors. After the financial crash of 2008, he invested in stocks such as Citigroup (C), when others were selling. His now-closed MarketPsy Long-Short Fund went on to outperform the Standard & Poor's 500-stock index from September 2008 through the end of last year.
"In the end, 75 percent of the overall strategy was based on sentiment," says Peterson, managing partner of the fund's parent MarketPsych Capital. The fund, which began with $1 million, had a 28 percent return from Sept. 2, 2008, through Dec. 31, 2010. The S&P 500 lost 1.6 percent over the same period.
Peterson was able to do this by using software that his company developed over seven years that looks at online financial news, financial social media, and corporate interviews. It quantifies 400 types of sentiments and topics from optimism and anger and management changes or product releases for 6,000 U.S. stocks and exchange-traded funds. He now sells that software to hedge funds and other financial firms.
In recent years, more investors have begun scouring the Web for subjective information about stocks. For Peterson's hedge fund, it meant analyzing prevailing sentiment and buying some stocks that investors were generally pessimistic about. For example, the World Health Organization declared a public health emergency over H1N1 swine flu on Apr. 25, 2009. Investors on American Airlines' (AMR) online stock message boards signaled their concern about possible reductions in airline travel. Two days later, the stock slumped 13 percent. On Apr. 30, 2009, the MarketPsy hedge fund bought AMR at $4.81 a share. It sold the position six days later for $5.95 a share, a 24 percent gain.
MarketPsych, like other quantitative investment firms, uses algorithms and computerized models to trade stocks. Typically, those models have included income statements, market-related data, prices, volume and earnings forecasts, which computers then crunch to help inform trading decisions. Over the years, as quantitative investing became more popular, the returns associated with those conventional data points have slowly eroded, says Rochester Cahan, quantitative equity strategist at Deutsche Bank (DBK).
"In the past two to three years, it has led a big drive among quants to find data that's less scrutinized," Cahan says. It spurred some hedge fund managers to look at more subjective data such as sentiment in news stories and to figure out a way to put that information into their trading models, he says.
MarketPsych faces competition from other companies that sell software and services to monitor sentiment about stocks on the Web, including Ravenpack, Thomson Reuters (TRI), and Bloomberg Businessweek's parent company, Bloomberg LP. RavenPack's business has quadrupled in the past year, and includes some of the world's top hedge funds, says Chief Executive Officer Armando Gonzalez, who declines to name any customers. "The institutional clients are starting to understand the value of news and having it faster than anybody else to detect the things you don't expect," he says. Gonzalez predicts the market will grow "significantly" in the next five years.
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