It all Depends on Maths

My last post questioned the true meaning of the increasingly popular phrase “evidence-based investing”. All investing should be evidence based. Anything else is just punting (speculation). That said, it looks to me like the term is beginning to be used by some as a marketing label.

Why is this a problem? Because it creates the possibility that people will simply choose “evidence-based investing”without necessarily considering how the evidence might apply to their circumstances or goals. Somewhat ironic, investing in “evidence-based investing” without first considering the evidence, wouldn’t you agree?

This would be a bad thing to do.  No investment strategy works all of the time. Wes Gray made this clear in one of my all-time favourite Alpha Architect posts: Even God would Get Fired as an Active Investor. Its a must-read for anyone that invested in an active (fundamental or quantitative) investment strategy.

Success in investing depends on investing in a strategy that we can stick with. We can’t do that without forming reasonable expectations around the possible risks and rewards involved.  Obviously requires evidence. But it also requires an understanding of the key factors that determine whether the evidence applies to a particular set of circumstances. 

An example might help to illustrate the idea. Are rising interest rates good or bad for equity market performance? On the one hand, a higher discount rate results in lower valuations, which is usually bad for performance.  But on the other hand, higher interest rates may be due to improving economic conditions. In this case the negative valuation impact form higher rates may be positively offset by higher corporate earnings. In other words, the proper interpretation and application of the evidence all depends on the circumstances. 

Let’s apply this idea to making an evidence-based decision on whether or not to invest passively, use a factor-based approach or hire a fundamental active manager. How can we decide which way to invest? A friend and mentor once explained the challenge to me this way:

Friend: What’s the typical institutional fee for a fundamental global equity fund manager?

Me: between 0.5% and 0.75% basis points depending on the strategy.

Friend: OK, lets assume the fee is 0.5%. Let’s also assume they’re skillful, that is they have an information ratio of 0.5 over the long-term and they take a reasonable amount of active risk, for example a tracking error of 5%. How much would you expect them to beat the market by?

Me: With a tracking error of 5% and an information ratio of 0.5, I’d expect them to beat the market by 2.5% over the long-term.

Friend: OK, that sounds fair. What percentage of active global equity fund managers under-perform the market over any one-year, three-year or ten-year period?

Me: It varies, but it’s usually between 60-90%.

Friend: Lets assume it’s 75%. The expected value of your alpha from selecting that manager is expected alpha multiplied by the probability of selecting a manager that out-performs or (5% × 0.5) × (1-0.75) = 0.5%.

In other words, the fund manager has just captured the ENTIRE expected  value of alpha!

What’s the point of this story? The clues are in the maths (Americans say “math”, Australians say “maths”). There are 4 variables:

  1. level of active risk
  2. fee paid
  3. manager skill
  4. your skill in selecting the manager

The decision to invest actively depends on how your circumstances relate to these four variables. It’s as simple as that. Figuring your circumstances out requires some honest self-examination. A good place to start would be to answer questions such as:

  1. How much active risk am I comfortable taking? Can I patiently invest through ups and downs in the market? Will I stick with my chosen strategy even if it under-performs the market for several years?
  2. How much will it cost me to invest? Do I have any negotiating leverage (e.g. a large institutional investor offering seed funding) that can swing the equation in my favour?
  3. Is the manager skilled? Or, is the manager investing in an opportunity set where the competition is weak?
  4. Do I have an edge that shifts the odds of finding a market-beating manager in my favour?

Of the four variables, the fee paid is definitely the most powerful. Its a tautology, the lower the fee paid, the more that’s left for you. It’s also the most reliable. In other, words there’s a one-for-one relationship between what you save and what you get to keep.

One of the best ways I’ve found to lower fees is to avoid paying for risk management (see my earlier post). Admittedly, this is much easier said than done. It can be tough to create the right kind of culture and relationships for this to work.

You’ll have more success with active management if you spend your fee budget on areas where the competition is weaker. For example, would you rather hire an active US investment-grade credit manager or an active emerging markets debt manager? .

This chart from Michael Mauboussin’s must-read paper, Looking for Easy Games,  might help you make up your mind:

active-dispersion

Finally, its important to have an edge that helps you improve the odds of finding skilled managers. This is probably the least reliable and most difficult variable to solve in the expected net-of-fee alpha equation.

Unfortunately, there are no easy answers. Here are some ideas I’ve found helpful:

In many cases answering these questions will point towards indexing or investing in a systematic, rules-based strategy designed to target a specific factor such as value or momentum. In some cases, it may point towards selecting a fundamental manager. In either case, you’ll truly be practising evidence based investing.

 

 

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Evidence-Based Investing? It all Depends

Would you be surprised if I told you that 60% of packaged foods in America contain added sugar?

My guess is no, you wouldn’t be. You probably know that sugar is highly addictive. What better way to get customers hooked on your products. So its no surprise that companies load products with sugar. After all, isn’t that what you’d expect from a food producer trying to maximize their profits?

But would you conclude that its impossible to produce packaged foods without added sugar? Somehow I don’t think that you would.

In a similar way, should we be surprised that the vast majority of active fund managers under-perform the market? Just like the packaged food manufacturers, they are simply doing what it takes (or at least what it took historically*)  to attract investors and to maximize their profits.

This blog post is not a defense of active management. Far from it. Active management deserves to be criticized. The continuing loss of market share to indexing and factor-based strategies has been largely self-inflicted. Nor am I criticizing every active fund manager.  I have had the privilege of investing with a handful that are genuinely skillful.

This is a post about reasoning and logic. Under-performance is not necessarily evidence that the market can’t be beaten as a lot of commentators argue. Instead, its more likely to be evidence that many fund managers put profits before the financial health of their investors.

Why am I bringing this up? Because it’s an example of why I’m frustrated by much of the blogging and tweeting about “evidence-based investing”. There seems to be a consensus view  making its way around the internet that all of the evidence points towards indexing or factor-based investing as being the only sensible way to invest.

I don’t disagree that indexing or factor-based strategies are the sensible way to go. Nor am I arguing that the majority of individuals and institutions should attempt to pick fund managers or stocks. Frankly, most won’t succeed.

So what am I arguing? That all the “evidence” really says is that it all depends. Both academic research and empirical results show that the choice between active and passive depends on a lot of factors. In other words, the conclusion that the “evidence” points to is far more nuanced than many people would have you believe.

I may be frustrated, but I’m not surprised because nuance doesn’t sell. If you’re a fund manager or adviser (and many of the commentators are) your clients want to know what your philosophy and process is.  So you have to take a confident stand. After all, how many clients are going to hire someone whose answer to one of the fundamental investment questions about your investment approach is “it all depends”?

The name of this blog – Market Fox – was inspired by the idea that investing is all about the future and that the future is both uncertain and unknowable, which means that “it all depends” is more often than not the right answer.

If you, the reader, take anything from this post it should be this: That analysis without synthesis is of little help when it comes to investing. The evidence only gets its meaning after you have struggled to reconcile all of the opposing facts and have come up with an explanation that reconciles them.

OK enough of the sermon. Lets come back to the evidence that the significant majority of active fund managers under-perform the market. What other evidence is there that we should consider?

In 2015 Joseph Mezrich at Nomura  published a paper entitled Your Fund Managers Really Can Pick Stocks. A copy of a presentation outlining the key findings of the paper can be found here.

Nomura created a market cap-weighted index of US large cap equity managers holdings from 2004 – 2014. In other words, they made no attempt to select fund managers, they simply aggregated up all of the holdings of all of the active mutual funds to create a market cap-weighted index of mutual funds. They used the CRSP mutual fund database, which is survivorship-bias free.

Mezich and the team at Nomura then ran the results through a Fama-French-Carhart factor model. Here’s what they found:

nomura-1

Statistically significant (t=3.79) alpha of 2.15% per year versus the Russell 1000 after accounting for exposures to the market, size, value and momentum factors.  This is shown in the chart below, where the mutual fund holdings (dark blue) out-perform the Russell 1000 (purple) and the mutual funds themselves (light blue).

nomura-2

How do we synthesize this evidence with the evidence that most mutual funds under-perform the market? Remember, no attempt was made to select the “best” funds. These results reflect the performance of US large cap equity managers as a group. They are the smartest and brightest, the best-of-the-best. Supposedly they are good, and the competition is now so tough, that they’ve turned investing into the “losers game” (please see my earlier post).

The 2% out-performance happens to be more or less equivalent to the average all-in investment fee and transaction costs of the mutual fund industry.

For those interested in an academic reference, I recommend reading Five Myths of Active Portfolio Management by Professor Jonathan Berk of Stanford Graduate School of Business.

In light of this additional evidence, which conclusion do you think is more likely:

  • Most mutual funds under-perform the index because the market can’t be beaten?
  • Most mutual funds under-perform because they extract the entire value created by their collective skill in fees and costs?

Where does the evidence lead you? I hope that you’ll answer “it all depends”.

 

 

  • Most investors want to have their cake and eat it too – long-term market beating returns without short-to-medium-term under-performance.
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GREATEST STOCK PICKER OF ALL TIME: BUFFETT OR LYNCH? – My Guest Post on Alpha Architect

Who is the greatest stock picker of all time?

Many investors knee-jerk reaction is Warren Buffett.

Understandable response, but is that the answer? Maybe not…

So who is the greatest investor of all time?

A few years ago, I asked this question of a mentor and friend. His answer surprised me. Without a moment’s hesitation, he replied that it was Peter Lynch. Our conversation went something like this…

Me: Lynch, what about Buffett? Surely his results over such a long period of time speak for themselves?

Friend: Buffett  isn’t a stock picker, his success is largely due to factor bets such as value and quality. Lynch, on the other hand, was a genuine stock picker.

Me: What makes you say that?

Friend:  He performed well, even when experiencing outflows. Buffett never had to manage outflows.(1) Also, the magnitude of his out-performance was so large that it’s statistically unlikely that his performance was due to luck.

You can read the rest of my post on the Alpha Architect Blog.

P.S. A big thank you to Wes Gray, Jack Vogel and the team at Alpha Architect for inviting me to blog with them!

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Managing the Disposition Effect

I’ve written about why the disposition effect matters in an earlier post. Now it’s now time to consider what we can do to manage it. We can learn to manage the disposition effect if we:

  • Develop a personal investment philosophy
  • Improve our self awareness by keeping a diary
  • Promote discipline of sticking to our investment process by using checklists
  • Establish a sell discipline
  • Shift our focus away from losses
  • Focus on the key factors supporting our investment thesis instead of the stock price

What do you stand for?

If you don’t stand for something, you’ll fall for anything – Gordon A. Eadie

How can you select an investment strategy that’s right for you? The first step is to decide on a set of personal investment beliefs. They must be personal. We are far more likely to stick to conclusions that we arrive at through our own logical reasoning and research. In other words, we need to take the time to convince ourselves that we are comfortable following our chosen strategy.

Having conviction in our beliefs requires finding the answers to questions such as:

  1. What are my risk and return objectives? *
  2. What is my investment horizon? *
  3. Which investment risks am I rewarded for?
  4. Is it possible for me to beat the market?
  5. How and when should I diversify?
  6. How much should I be willing to pay in fees and costs?
  7. How should I define, measure and manage risk?
* Questions 1 and 2 relate to investment objectives and not investment beliefs.

The term “belief” accepts that there are few objective truths in economics and finance. Investors choose to interpret the way in which markets function and the reasons why other investors behave the way they do.

Beliefs are statements that articulate how we will try to achieve our investment objectives. They are based on observations of how markets function and how investors behave. Investment beliefs accept the reality that economics and finance cannot be captured in hard, predictive models. Instead, they encompass a view on how (other) market participants learn or fail to learn or on how financial markets will function in the future.

Failure to define a clear investment philosophy results in poor investment outcomes as Professor Aswath Damodaran of NYU Stern School of Business explains:

The absence of a core philosophy has two predictable consequences: (a) a lack of consistency, where active investors veer from one strategy to another, often drawn to whatever strategy worked best during the last time period (emphasis added) and (b) me-tooism, as they chase momentum stocks to keep up with the rest.

It’s important to identify and stick to a strategy that you: a) have chosen based on reasonable expectations of risk and return identified through research and experience and b) suits your personality.

Self-Awareness is Crucial

Answering the seven questions above requires self-awareness. It requires thinking deeply about our personality and how we react to different situations. For example, it means answering questions such as:

  • Am I impatient or anxious?
  • Do I seek the approval of others before making decisions?
  • Do I always need to be right?
  • How do I cope with uncertainty?
  • How do I react to losses?
  • Do I get a thrill out of trading?

Experience has taught me that finding the “right” investment strategy is similar to finding the right diet – its pointless if you can’t stick to it. Your diet’s never going to work if it requires you to cook each day but you work long hours and find it hard to make the time to prepare meals.

For example, a value investing strategy looks for companies that appear to be cheap relative to the intrinsic value of their assets or earnings. Sounds good, after all who doesn’t like the idea of finding a bargain?

But  value investing often requires patience. It can take several years for the stock price to eventually reflect the underlying value of a company. It may require a willingness to take a contrarian view. Stocks are rarely cheap without reason or a problem that creates uncertainty.

Consequently, value investing is not suitable for someone that is impatient, has a short-term investment horizon, or is reluctant to go against the crowd by owning out of favor companies.

Using a strategy that doesn’t fit your personality, objectives and ability to tolerate risk significantly increases the risk that you will fall prey to the disposition effect.

Keep a Diary

Elite athletes improve by creating feedback and learning from it. Whether it’s watching a tape of the game, or checking the output of wearable body sensors post match, athletes always take the time to look for feedback. Think about it, how else can an athlete identify the areas that they need to work on to improve their performance?

In a similar way, we need to create feedback that we can study to improve our performance as investors. And there is no better tool than keeping a diary.

Unfortunately all of us have selective memories. We naturally fall into the trap of exaggerating our successes and minimizing our failures. We attribute winners to our brilliance and losers to bad luck.

This is where a diary comes into its own. It allows us to confront our decisions as they were, not how we remember them later.  Writing things down creates the feedback that we can use to improve.

What should we include in our investment diary? The short answer is any information that will help us to identify patterns in our behavior and decision making. This might include:

  • Investment thesis – the reasoning behind the investment decision.
  • Portfolio allocation and fit – how much are we willing to invest? How does this investment improve our overall portfolio?
  • Risk limit – how much are we prepared to lose?
  • Success factors – how will we know if we’re right?
  • Failure factors – how will we know if we’re wrong?
  • Our emotional and physical state

Your dairy notes can also be used to create a “story” for each stock , a technique that the legendary fund manager Peter Lynch used to beat the market by a huge margin. We’ll pick up the idea of how creating a story can help manage the disposition effect again later in this post.

Use a Checklist

Checklists are also an important tool for managing behavioral biases. Checklists promote consistency. They help us to avoid two behavioral traps:

  • Inconsistent weighting of relevant factors due to emotion or circumstances.
  • Skipping important steps in our investment process.

How might we fall into the trap of inconsistency? Suppose that our investment philosophy is to invest in quality companies at reasonable prices. We consider two companies for investment, company ABC and XYZ. The fundamentals of company ABC are:

  • P/E ratio = 15x
  • RoE = 12%
  • Forecast sales growth = 7.5%
  • Debt-to-total capital = 10%

And the fundamentals of XYZ are:

  • P/E ratio = 25x
  • RoE = 24%
  • Forecast sales growth = 12.5%
  • Debt-to-total capital = 30%

ABC is cheaper, but XYZ is twice as profitable. ABC has a more conservative balance sheet (lower debt) while XYZ has faster forecast earnings growth. Which company should we chose?

Unfortunately, what ends up happening is that we assign different levels of importance to each of the factors over time. For example, we may place more emphasis on cheaper valuation during periods where the valuation of most companies are expensive. We may pay more attention to sales growth during periods where economic growth is slow. Or we may focus more on debt levels during periods of rising interest rates.

In other words, on any given day we might make a different choice, not because the companies have changed, but because we have. An inconsistent process will result in inconsistent performance. 

Two resources that ca help you to create your investment checklist are:

Follow the Rules

Selling at a loss is always hard. That’s why most professional investors develop a sell disciple or a set of rules that must be followed. An example might be a rule that states that a stock must be sold when a loss reaches a predetermined percentage of the purchase price or of the value of the overall portfolio.

Such rules are designed to help the investor make decisions that are right on average and over time. In other words, no rule will work 100% of the time. But that’s OK. The purpose of a sell disciple is not to win on every trade. Rather, it is to prevent a large and permanent loss of capital.

The famous “boy plunger” Jesse Livermore wrote in his book How to Trade in Stocks:

Profits always take care of themselves, but losses never do. The speculator has to insure himself against considerable losses by taking the first small loss. In so doing, he keeps his account in order so that at a future time, when he has a constructive idea, he will be in a position to go into another deal, taking on the same amount of stock as he had when he was wrong.

Once again, there is no one-size-fits-all sell discipline. We each have to develop a set of rules that are consistent with our objectives, investment strategy and risk tolerance. In their paper on the disposition effect, professors Hersh Shefrin and Meir Statman provide an example of one trader’s rule and the reasoning behind his rule:

I have a hard and fast rule that I never let my losses on a trade exceed ten percent… Some guys have a five percent rule. Some may have fifteen. I’m a ten man. The thing is, when you’re right you’re making eighths an quarters. So you can’t take a loss of a point. The traders who get wiped out hope against hope… They’re stubborn. They refuse to take losses… When you’re breaking in a new trader, the hardest thing to learn is to admit that you’re wrong. It’s a hard pill to swallow. You have to be man enough to admit to your peers that you’re wrong and get out. Then you’re alive and playing the game the next day.

There are 3 key points to note in this quote:

  1. Your wins have to be bigger than your losses, otherwise you won’t make a profit. And the easiest way to create a positive asymmetry between winners and losers is to keep your losses under control.
  2. Hope is not an investment strategy.
  3. The emphasis is risk management. Survival is always the first priority.

Sidestepping Mental Accounting

Changing the way we think about losing stocks can make them easier to cut. In other words, we can side-step the mental accounting and narrow framing by redefining the sale of a losing stock.

What are mental accounting and narrow framing? Here’s a description from my earlier post on the disposition effect:

We open a new mental “account” each time we purchase an investment. We then focus on the performance of each account, rather that the performance of our portfolio as a whole. This is known as narrow framing. Shefrin and Statman suggest that selling a losing stock is hard to do because we perceive this as closing our mental account at a loss.

We can bypass mental accounting by reclassifying the reason for the sale. Shefrin and Statman cite the example of transferring (selling a loser and simultaneously investing the proceeds in an other opportunity) between investments:

Gross’ suggestion to “transfer your assets” seeks to overcome the major obstacle standing in the way of loss realization, namely the need to close a mental account at a loss. A client who transfers his assets does not close his original mental account, and therefore does not have to come to terms with his loss.

Essentially, we are tricking ourselves into not paying too much attention to the loss. In this case, the trick has the positive effect of helping us to get over the inertia that makes it hard to realize a loss.

Other ways to do this include setting deadlines (e.g. selling a stock if it hasn’t performed as expected after 2 years) or looking for opportunities to execute a tax swap.

Check the Story, not Performance

In his book One Up on Wall Street, Peter Lynch recommends creating a story for each company that we invest in. Lynch explains:

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand its path… Once you’re able to tell the story of a stock to your family, your friends… and so that even a child could understand it, then you have a proper grasp of the situation.

Why create a story? For three important reasons.  Firstly, to understand what you’re invested in and why. Secondly, to identify the key drivers of success and failure so that you can keep track of them.

The decision to hold a stock should be based not on the desire to realize a profit. We shouldn’t be too hasty to sell a stock if the company continues to deliver on its story.

Its surprising just how few companies actually create value for their shareholders. For example,  Alpha Architect (one of my favorite blogs for keeping up-to-date with academic research) recently cited a study by Hendrik Bessembinder at Arizona State University showing that from 1926 -2015 “the entire gain of the US stock market since 1926 is attributable to best performing four percent of listed stocks.

So if we’re lucky enough to find a company that can compound its earnings, selling it simply to “lock in” a profit is a dumb idea.  There’s a very high probability that the next stock we buy won’t be as good.

Thirdly, focusing on a story, i.e. company fundamentals and the factors that influence them, also helps not to focus too  much on the current share price or historical performance (our mental account).

How can I create an investment story? Professor Aswath Damodaran lists the steps involved in creating an investment narrative in the diagram below taken from his blog post Narrative and Numbers: How a number cruncher learned to tell stories!

narrative-to-number-steps

In summary, the tools that can help us to better manage our behavior and improve the quality of our decision-making are:

  • Investment beliefs.
  • Keeping a diary
  • Using a checklist
  • Following a strict sell discipline
  • Avoid focusing on losses
  • Follow the story instead of the stock price

Other posts on Behavioural Finance:

 

Feature Image courtesy of the Online Trading Academy

Too Many Smart People in the Market – a Problem?

Larry Swedroe – who’s writing I frequently enjoy –  recently published a post on ETF.com  entitled Scale’s Effect on Active Performance. The post is an excellent summary of the academic research into the relationship between fund size and performance which finds that active managers find it tougher to beat the market as they get bigger.

Towards the end of the article, Swedroe lists several possible explanations why this is the case, one of which caught my attention…

Third, the competition is much more highly skilled today. As Charles Ellis explained in a recent issue of Financial Analysts Journal, “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. … They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”

Ellis has been a proponent of this view for many years, most notably in his excellent book Winning the Loser’s Game, 5th Edition: Timeless Strategies for Successful Investing. Here are some quotes…

Unhappily, the basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management … 85 percent of investment managers have and will continue over the long term to underperform the overall market.

The problem is not that investment research is not done well. The problem is that research is done very well by many… As a result, no single group of investors is likely to gain and sustain a repetitive useful advantage over all other investors on stock selection. Because they are so large, so well-informed, and so active, institutional investors set the prices. That’s why the only way to beat the market is to beat the professionals who, as a group, are the market.

Just how good and tough to beat are the hundred largest institutions? Here are some realities: The very largest institutions each pay Wall Street $1 billion annually and pay their leading stockbrokers as much as $100 million apiece, and the stockbrokers earn it by making the best markets and providing the best research services they can deliver. The institutions have Bloomberg and all the other sophisticated information devices. Their professionals meet with corporate management frequently. They all have teams of in-house analysts and senior portfolio managers with an average of 20 years of investing experience – all working their contacts and networks to get the best information all the time. You get the picture: Compared to any individual investor, the institution has all of the advantages.

Sounds convincing, almost incontrovertible, doesn’t it? I must admit, that I have some sympathy for this line of reasoning. I recommend that every active investor read  Ellis’ book while trying to keep an open mind. This may be hard to do, as many active investors believe in active management with an almost religious fervor.

If you do read it with an open mind, you’ll probably come to the same conclusion as I did: the majority of individual investors and institutions would be better off indexing. But don’t just take my word for it, check the research.

My opinion is based predominantly on the observation that most individuals and institutions can’t help but get themselves into trouble because they make errors in judgement and have difficulty controlling their emotions and their behavior. In other words, we’re human  (myself included!) and we find it difficult to patiently stick with an active strategy, with the uncertainty and discomfort that may bring, long enough to reap the rewards (see my earlier post on how long it can take for active management to work).

This also results in active fund managers running”closet index” investment strategies – active enough to hopefully attract investors, while close enough to the benchmark to reduce the risk of getting sacked (you can read more about this in an earlier post: Beating the Market Part 3: Sheep Get Slaughtered). You could argue that this is, in some way, a rational response to the impatience of their clients.

That said, I’m not sure that it necessarily follows that its impossible to beat the market because the market is made up of too many smart people. In fact, the counter-argument could also be made: that too many smart people make the stock  market even more inefficient.

For example, here’s a quote from Scott Fearon’s book: Dead Companies Walking, which I highly recommend. Fearon is a long-short equity manager with a long-term track record of out-performance. On page 206, he profiles the personality of the typical institutional investor under the sub-title: The Most Dangerous People in the World… 

The financial world suffers from an inherent flaw: the people who work in it, by and large, are terrible investors.

Number one: They’ve spent their whole lives going along to get along. They’re climbers, strivers, joiners, cheerleaders. (That’s how they got those good degrees and those prestigious jobs in the first place!) This makes them naturally prone to groupthink and all to susceptible to manias and bubbles.

Number two: They are hypercompetitive, which keeps them from admitting failure and adjusting their strategies when things inevitably go wrong. This makes them all too susceptible to disastrous behaviors like averaging down and clinging to bad ideas.

Number three: They worship rich and powerful people, so they automatically defer to authority instead of questioning popular assumptions. Again, this makes them susceptible to manias and asset bubbles. It also creates an even more destructive mind-set –once they themselves rise to positions of power, they see themselves as infallible and worthy of worship.

Add it all up and there’s only one conclusion you can reach: these are the last people you want safeguarding your money.

Let’s suppose that Fearon’s profile of the typical institutional investor is accurate. In that case, isn’t it possible that filling the market with more materialistic, hyper-competitive people with a herd mentality is likely to make the market even more inefficient?

Of course you may be thinking that Fearon is overly harsh in his assessment of the average institutional investor. Fair enough. What then? Here’s a quote by the legendary hedge fund manager Seth Klarman in a paper entitled  A Response to Lowenstein’s Searching for Rational Investors In a Perfect Storm

Let me offer a simple thought experiment. Imagine that every adult in America became a securities analyst, full time for many, part-time for the rest. (With close to half the adults in this country already investing in stocks or mutual funds, this may not be. Every citizen would scour the news for fast-breaking corporate developments. The numerate ones would run spreadsheets and crunch numbers. The less numerate would analyze competitive factors for various businesses, assess managerial competence, and strive to identify the next new thing. Now, for sure, the financial markets would have become efficient. Right? Actually, no. To my way of thinking, the reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital. The Internet will not make the market efficient, even though it makes far more information available at everyone’s fingertips, faster than ever before. Markets are inefficient because of human nature—innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions—they simply cannot help it (emphasis added).

As many smart people as there may be in a market they will still be people; influenced by the same emotions and subject to the same foibles as the rest of us.

One more viewpoint to consider. Institutional investors, whether smart or otherwise, are generally links in a long chain of principal and agent relationships, each with its own potential for conflicts of interest.

Believers in market efficiency (i.e. too many smart people in the market mean that the it’s impossible to beat) largely ignore effects of the principal and agent problem as Professor Paul Woolley from the London School of Economics explains in  “Why are financial markets so inefficient and exploitative – and a suggested remedy”:

The crucial flaw has been to assume that prices are set by an army of private investors, or the “representative household” as the jargon has it. Households are assumed to invest directly in equities and bonds across the spectrum of the derivatives markets. Theory has ignored the real world complication that investors delegate virtually all their involvement in financial matters to professional intermediaries… who therefore dominate the pricing process.

Delegation creates an agency problem. Agents have access to more and better information than the investors who appoint them, and the interests and objectives of agents frequently differ from those of their principals. For their part, principals cannot be certain of the competence or diligence of the agents. Introducing agents brings greater realism to asset-pricing models and, more importantly, gives a far better understanding  of how capital markets function.

Clearly most investors rely on agents to invest and most agents have conflicted interests. Do we have any reason to believe that having more smart people in the market reduces these conflicts? I’m not sure that it does.

Yes, the market is really tough to beat and most people are probably better off not trying to beat it. But I think it’s debatable that this is due to the problem of too many smart people operating in the market for 3 reasons:

  1. Markets may attract the wrong kind of people as investors (Fearon)
  2. Even smart people are still people (Klarman)
  3. Smart people may be looking out for their own interests (Woolley)

Bad News for Active Management: Correlations High & Dispersion Low

 

sandp-correlation-and-dispersion-dashboard

According to the excellent S&P Indexology Blog, dispersion and correlation – two key measures of the potential for active management to add value – were flashing warning signs for active management at the end of Sept 2016.

Dispersion across most equity market is very low, meanwhile correlations have risen – generally, a bad combination for active returns.

In addition to the Indexology Blog, Michael Mauboussin’s paper Minding the Opportunity is an excellent resource for those wishing to learn more about how dispersion and correlation can be used to measure the potential for active management.

It will be interesting to see what effect the Trump rally has had when the December-end numbers are released.