“Evaluating Trading Strategies”

The Buttonwood column in the February 21st issue of The Economist talks about a recent article published in the Journal of Portfolio Management, titled “Evaluating Trading Strategies,” authored by Profs. Campbell Harvey of Duke and Yan Liu of Texas A&M.

Long ago, I’d come to think of the difference between academic financial theorists and portfolio managers as somewhat like that between teachers of academic literary theory and actual authors.  That is to say, the two sets of people live in very different worlds, with little in common    …and without that much relevance for each other.

Three exceptions with finance:

–academics are often used as front men for various investment schemes, such as in the case of the ill-fated Long-Term Capital Management, which raised a huge amount of money to implement a strategy of buying illiquid bonds and collapsed shortly thereafter–destabilizing the world financial system in the process

–they often sit as window dressing on the boards of directors of financial companies, and

–their theories inform much of the methodology of the investment consultants on whose advice pension fund managers rely heavily.

its conclusion

The article has an emperor’s new clothes aspect to it.

Simply put, it says that academic finance researchers routinely use a standard for testing for the statistical significance of their findings that is much too weak and alrady discredited in mainstream scienticif research.  Because of this failing, in statistical work in finance large numbers of false.  This is through ignorance, not malice.

As the authors put it:

“So where does this leave us? …Most of the empirical research in finance, whether published in academic journals or put into production as an active trading strategy by an investment manager, is likely false.  …half the financial products (promising outperformance) that companies are selling to clients are false”

Who knows whether this article will have any long-term effects?

In the real world, very few people take academic finance theories seriously–except for pension funds, which rely heavily on consultants who use it to legitimize their advice.  The conclusion that the “advice” is little more than picking numbers out of a hat (arguably even less reliable than that method) has the potential to really shake up this chronically poor-performing sector.