Category Archives: Academic Theories

science and math vs. academic finance (pension consultants, too)

February 26, 2015 By in Academic Theories, Capital Asset Pricing Model (CAPM) Tags: , , Leave a comment

“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.

information asymmetry

August 25, 2014 By in Academic Theories, Capital Asset Pricing Model (CAPM), Portfolio management Tags: , , , , , , Leave a comment

That’s the fancy name for the situation where either you know more than the other guy or vice versa.  Think:  buying a used car, or competing in a game/sport with someone who has only half your experience and skill.

In investing, cases like the first are ones that everyone not an auto mechanics wants to avoid.  We should, however,be spending a lot of our research time seeking out the second type.

practice vs. academic theory

One of the odder things about financial theory taught in MBA programs is the professors’ insistence–despite overwhelming evidence to the contrary–that such situations don’t exist in investing.  Officially at least, they maintain that everyone possesses the same information.

There are several odd aspects to this state of affairs:

–professional investors are happy not to rock the boat, since, to the degree that students actually believe this stuff, business schools churn out large amounts of “dumb money” to be taken advantage of,

–if all market participants have precisely the same information, how is it an ethical enterprise to charge thousands of dollars a credit to inform students that they already know everything?

–in some deep sense, professors know they live in a Copernican world despite the fact they teach Ptolemy to get a paycheck.

When I was a student at NYU, the finance faculty had a number of eminent tenured theoreticians, as well as one semi-retired portfolio manager who was an adjunct teaching for fun.  One professor proposed a contest:  faculty members would each provide $10,000 of their own money into either a portfolio managed by the theoreticians or one managed by the adjunct “practitioner.”  Over, say, a year or two that would provide a practical illustration of the superiority of theory over vulgar practice.  Unfortunately, the test never got off the ground.  No one was willing to give real money to the professors; everyone wanted to back the working portfolio manager.

More tomorrow, on making information asymmetry work for you and me.

why I don’t like stock buybacks

August 18, 2014 By in Dividends, stock buybacks, Tobin's q Tags: , , , , , , Leave a comment

buyback theory

James Tobin won the Nobel Prize for, among other things, commenting that company managements–who know the true value of their firms better than anyone else–should buy back shares when their stock is trading at less than intrinsic value.  They should also sell new shares when the stock is trading at higher than intrinsic value.  Both actions benefit shareholders and add to the firm’s worth.

True, but not, in my view, a motivator for most actual stock buybacks.

Managements sometimes say, or imply, that share buybacks are a tax-efficient way of “returning” cash to shareholders, since they would have to pay income tax on any dividends received.  I don’t think this has much to do with buybacks, either.  It also doesn’t make a lot of sense, since a majority of shares are held in tax-free or tax-deferred accounts like pension funds and IRAs/401ks.

the real reason

Why buybacks, then?

Years ago I met with the CEO of a small cellphone semiconductor manufacturer.  We had a surprisingly frank discussion of his business plan (the stock went up 20x  before I sold it,  which was an added plus).  He said that his engineers were the heart and soul of his company and that portfolio investors like me were just along for the ride.  He intended to compensate key employees in part by transferring ownership of the company through stock options from outsiders to engineers at the rate of 8% per year!!

Yes, the 8% is pretty extreme. In no time, there would be nothing left for the you and mes.

Still, whether the number is 4% or 1%, the managements of growth companies generally have something like this in mind.  They believe, probably correctly, that they won’t be able to attract/keep the best talent otherwise.

The practical stock option question has two sides:

–how to keep the portfolio investors from becoming outraged at the extent of the ownership transfer and

–how to keep the share count from blowing out as stock options are exercised.  A steadily rising number of shares outstanding will dilute eps growth; more important, it will alert portfolio investors to the fact of their shrinking ownership share.

The solution?   …stock buybacks, in precisely the amount needed to offset stock option exercise.

is there a better way?

What I don’t like is the deception that this involves.

However, would I really prefer to have companies allow share count bloat and have high dividend yields?  What would that do to PE multiples?   …nothing good, and probably something pretty bad.

So, odi et amo, as Ovid said (in a different context).

 

 

the FT, Vanguard and Morningstar: active vs. passive investing

July 14, 2014 By in Academic Theories, index funds, indexing Tags: , , , Leave a comment

Saturday’s edition of the Financial Times opens with a screaming front-page headline, ” $3.5 billion pulled out of Fidelity funds.”  

 …must have been a slow news day.  

The article goes on to explain that net inflows of individual investor cash into the stock market–both in the EU and the US–over the first half of 2014 have been going to index products, not to active managers. 

I can see several good reasons why this is so:

1.  Indexing is like cruise control.  You know you’re going to get more or less the return on the index against which a given index fund/ETF is benchmarked.  So you only have two variables to consider:  how closely the fund/ETF is able to track the benchmark, and what its expense ratio is.  There’s no fretting about an active manager’s style and strategy, or whether he/she is still running the portfolio whose historical record you’re examining

2. Fidelity doesn’t necessarily want mutual fund customers.  I’ve had a Fidelity brokerage account for decades.  Fidelity has never approached me, ever, to buy a mutual fund product of any type.  I presume it’s because the company makes more money from having me trade individual stocks.

3.  Picking active managers takes some effort.  It requires having some understanding of the stock market and an ability to deduce strategy from the lists of holdings that managers report each quarter to the SEC.  

True, there is Morningstar, a service which has been providing its famous “star” rankings of mutual funds for about a quarter century.  Although Morningstar, disingenuously, warns buyers of its star information not to use it as the reason for picking a given mutual fund, people do pay for the rankings.  So they must have a reason.  Investment management companies take out full-page adds to tout their high star-ness.  Inflows seek high-star funds and shun low-star ones.

Over at least the past several years, however, Vanguard points out that following Morningstar rankings hasn’t been a good idea.  The index fund giant is publicizing a study it did of Morningstar fund rankings from 2011 – 2013.  Over the three years, Vanguard says there was a strong correlation between Morningstar star ranking and fund performance, but it was the opposite of what the rankings suggested.  One-star funds performed the best vs. their peers, two-star funds the next best   …and so on, in order, with five-star funds performing the worst.  Whoops!

Personally, I’ve never been a fan of Morningstar’s use of short-term volatility as a measure of the riskiness of a portfolio.  My guess is that the relative stability of a fund’s NAV ends up being the most important factor in getting a high star rating.  So that rating has little to do with future return potential.  But I have no real idea how Morningstar could have gone as badly astray as Vanguard says.

Anyway, to sum up, if there’s any news in the FT article, it’s the (understandable) extent to which individual investors are embracing psssive investing, not the fact that they’re doing so.

 

 

 

what is “smart beta”? (l): alpha and beta

May 7, 2014 By in Academic Theories, Alpha and Beta, Portfolio management, smart beta Tags: , , Leave a comment

I’m going to write about this in two posts.

Today’s will give some basic background. Tomorrow’s will look at smart beta itself.

alpha and beta

Right after WW II many professional investors, and academics as well, were eager to apply newly emerging computer technology to analyzing the stock market.  Harry Moskowitz, an IBM scientist, was the first.  He suggested using computers to record and analyze the interrelations in price action among all the stocks in the market.  But measuring the reciprocal influences on even relatively small numbers of stocks proved too daunting for the computing machines of the day.

That led to the idea that the task be simplified by not relating each stock in a universe like the S&P 500 to each of the other 499.  Study, instead, how they each behave in relation to some common standard–in fact, relate each to the index itself.  un a regression analysis that correlates the daily price change in each stock with the price change in the index.

An equation showing the results for a stock “y” would be in the form:

y = α + βx + an error term that can be ignored

So the price change “y” for any stock can be broken down into two elements:

—systematic,return, or beta, the portion due to market fluctuations.  For academics, this is a constant “β” derived from the regression, multiplied by “x,” the price change in the market  and,

—a non-systematic term or alpha,, an “extra” return, that can be either positive or negative.

By definition, the β of the market = 1.0 (the sum of all the returns of the market components = the return on the market).

In the strange world of academic financial orthodoxy, it’s impossible to achieve a positive α. The only was investors can achieve a higher return than the market is by arbitrage–by borrowing money and buying what amounts to an index fund.

The popularity of this view–whose only virtue as I see it is its simplicity–shows itself in industry jargon.  Active managers are said to be “seeking alpha.”  Pension plan sponsors routinely separate their equity assets into active and passive, the latter being moneh invested in “safe” index products.

“Smart beta” is a marketing approach by active managers to e a portion of their “safe” index assets to the “seeking alpha” pool.  Apparently they’re successful, although the essence of their pitch is semantic—-they label their active managing activity as being “beta,” not alpha.  It’s the equivalent of the old junk bond pitch, “all the safety of bonds, all the high returns of stocks.”  We all know how that ended.

More tomorrow.