Consider this figure:

Correlations among global securities

The first 14 securities are indexes and ETFs of various segments of the USA equity market. These are followed by a European and a Chinese equity ETF. The last  five are currency, fixed income or anti-inflation securities.

Note how the equity indexes are very highly correlated with each other (with most correlations over 0.8 and thus green in the matrix), but very uncorelated with the non-equity securities. GLD, the gold ETF, is truly uncorrelated with both equity and the 30 year T-Bond ^TYX.  Interestingly, GLD  and TIP (the anti-inflation US treasury security) are moderately correlated at 0.4. We would expect this since they both are used to protect against inflation, but are not equivalent in their structure.

The two rows above the matrix show the returns and volatility of each security. Note that the highest volatility is for VGK (41%/yr) and the lowest is for TIP at 5%/YR. On the other hand, only 7 of 21 securities measured have positive returns for the last 45 days. The highest return was China (FXI at 50%/YR) and the lowest was Dow Jones US Industrials (IYJ at -38%/YR).

We say this matrix, derived from the last 45 days of price action, indicates securities can best be picked based upon estimates of returns, assuming most securities will continue their very high correlations. Only asset classes, broadly categorized as equity/fixed income/anti-inflation, have negative or zero correlations for diversification.

Thus, we see yet again how the asset allocation task requires the asset class be picked before individual securities.

We set forth a somewhat formal answer in our post on the three main economic scenarios, deflation, neutral and inflation. We want to present a more intuitive answer below.

First, we need to set the stage.

As we have discussed, the Efficient Markets Hypothesis (EMH) is an idea fiercely defended by a variety of senior finance professors, in spite of massive evidence to the contrary. Our post here gives a good summary of what the EMH is, why it is wrong and how it leads to mistakes.

The issue revolves around the implication of EMH that active management is a waste of time and money, since no amount of work can produce more insight than everyone else in market has or can get, and so an investor can get only the market ROI overall over the long run. Thus, according to the EMH, one should just invest in index funds.

OK, let’s stipulate EMH is useless. Now what? How should we invest? Before answering this question, let’s also stipulate, for obvious reasons, we cannot avoid this question.

One answer could be, just give our money to an advisor and let him invest for us. But of course, that raises the question as to how one chooses an advisor who if not sufficiently skilled, is sufficiently lucky. So we need to define an investment strategy.

In spite of all the confusion and uncertainties, one can still make some rational investments, while staying emotionally calm. Let’s define assumptions for a strategy:

The goal is to maximize our ROI, subject to a level of risk we can tolerate. Clearly, the ROI and the risk level are both subjective. We are willing to take more risk to get larger ROI. But the relationship between those two large factors is not known in advance.

We believe the current economic condition is mainly deflationary (prices are dropping and being a creditor is good).

We want to hold securities in such a way that when we discern inflation signs, we can switch easily from the current deflationary position to an inflation stance.

In our case, we want to preserve capital, but have growth reasonably better than that of money market rates (which are now ~0%/YR). This is the risk avoidance component of the strategy. Additionally, we want exposure to some upside to growth. The allocation between our risk avoidance securities and the upside-capture securities is where emotion enters the framework.

Our specific recommendation: account for deflation buy owning a variety of bonds and bond funds. Position the portfolio for upside by owning equities in companies in sectors which we believe are especially promising in the current political-economic environment. This idea, of course, is a standard approach, but modified by a strong emphasis on a small amount of very high risk/high payoff equities. The portion devoted to capturing future innovations or even disasters through equities can of course be enhanced by using various combinations of long dated puts and calls.

Using this broad approach, we can manage risk simply through the allocation between fixed income and equities, and focus on higher risk equities to be exposed to upsides from innovation.

This is not what is called well-diversified….rather, it’s a bet on specific beliefs. Remember, if you diversify enough, you effectively index everything.

Finally, some examples: First, the online, medical records sector, which will be quite actively converting old medical records to electronic format, as well as creating new records electronically, and the semiconductor industry, which continues to grow and also acts as a leading indicator of economic revival.

Here’s the answer, in beautiful brevity:

Professor Bolster stated his overall conclusion: “He has an alpha of 0; he could do worse. He’s harmless.”

This means you would have gained nothing and lost nothing for the risk level of Cramer’s recommendations over the time horizon analyzed (July 2005 to the end of 2007). For details, see the full results described here:

Paul J. Bolster and Emery A. Trahan, “Investing in Mad Money: Price and Style Effects,” Financial Services Review, Vol.18 (2009), pp. 69–86.

You also can read a summary here.

“There is the strong possibility that policy makers in the US and UK will not time the transition from the current quantitative easing to a more tightened monetary policy. That is not because they are no competent. It is because the task is very tricky and there is no play book outlining the steps. This is not Tom Landry (former Dallas Cowboy coach) pacing the field with a play for every situation already planned and practiced well in advance.

The odds favor they will either be too late or too early. Getting it “just right.” The Goldilocks play, would be more than fortunate. In fact, there may be no right play to call. They may be forced to choose between a slower economy and/or inflation/deflation. And as this week’s Outside the Box authors note, there is also the possibility of yet another asset bubble, making the choices even more risky.”

See full text here

Of course, we have written about this looming disaster, and proposed some specific ways investors can prepare for it. See, for example:

http://www.rocketcap.com/portfolios-for-deflation-inflation-and-good-luck/

We want to bring together two recent pieces with our commentary that we hope will convince you it is rational to try to beat the market-with the proper understanding.

This week, two independent and credible sources chose to publish strong articles concerning the EMH. These are quite interesting and even entertaining. The Economist magazine published a column by a famous professor who defends macro economists generally and EMH in particular, and John Mauldin’s newsletter published a long article by another economist making the case against EMH. We believe active investing is strongly supported by contemplating what follows.

To begin, consider the column by Nobel Prize Winner in Economics Robert Lucas, which was published in the Economist, 8-8-09; Lucas says, in defense of the EMH:

But Mr Fama tested the predictions of the EMH on the behaviour of actual prices. These tests could have come out either way, but they came out very favourably. His empirical work was novel and carefully executed. It has been thoroughly challenged by a flood of criticism which has served mainly to confirm the accuracy of the hypothesis.

The only problem with this claim is what it doesn’t say: the EMH has also been shown in painful detail to be false, through a variety of empirical observations. See for example an entire book by Andrei Shleifer “Inefficient Markets”.

This next article, which is substantial, gives a very powerful explanation and analysis of EMH and directly points out the dangers this belief causes. This is well worth reading. But, for those of you who simply want the juicy stuff, this should encapsulate it:

The Efficient Market Hypothesis, according to Shiller, is one of the most remarkable errors in the history of economic thought. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brainwashing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed it. Only two hands stayed up!

And we wonder why funds and banks, full of the best and brightest, have made such a mess of things. Part of the reason is that we have taught economic nonsense to two generations of students. They have come to rely upon models based on assumptions that are absurd on their face. And then they are shocked when the markets deliver them a “hundred-year flood” every 4 years. The models say this should not happen. But do they abandon their models? No, they use them to convince regulators that things should not be changed all that much. And who can argue with a model that was the basis for a Nobel Prize?

Here is the full text:

Six impossible things before breakfast, or how EMH has damaged our industry

What follows is the text of a speech to be delivered at the CFA UK conference on “What ever happened to EMH”. Dedicated to Peter Bernstein – Peter will be fondly remembered and sadly missed by all who work in investment. Although he and I often ended up on opposite sides of the debates, he was true gentleman and always a pleasure to discuss ideas with. I am sure Peter would have disagreed with some, much and perhaps all of my speech today, but I’m equally sure he would have enjoyed the discussion.

The Dead Parrot of Finance

Given that this is the UK division of the CFA I am sure that The Monty Python Dead Parrot Sketch will be familiar to all of you. The EMH is the financial equivalent of the Dead Parrot. I feel like the John Cleese character (an exceedingly annoyed customer who recently purchased a parrot) returning to the petshop to berate the owner:

“He’s passed away, This parrot is no more, He has ceased to be! He’s expired and gone to meet his maker. He’s a stiff! Bereft of Life, he rests in peace! If you hadn’t nailed him to the perch he’d be pushing up daisies! His metabolic processes are now history! He’s off the twig! He kicked the bucket. He’s shuffled off his mortal coil, run down the curtain and joined the bleedin’ choir invisible! This is an ex-parrot!!!”

The shopkeeper (picture Gene Fama if you will) keeps insisting the parrot is simply resting. Incidentally, the Dead Parrot Sketch takes on even more meaning when you recall Stephen Ross’s words that “All it takes to turn a parrot into a learned financial economist is just one word – arbitrage”.

The EMH supporters have strong similarities with the Jesuit astronomers of the 17th Century who desperately wanted to maintain the assumption that the Sun revolved around the Earth. The reason for this desire to protect the maintained hypothesis was simple. If the Sun didn’t revolve around the Earth, then the Bible’s tale of Joshua asking God to make the Sun stand still in the sky was a lie. A bible that lies even once can’t be the inerrant foundation for faith!

The efficient market hypothesis (EMH) has done massive amounts of damage to our industry. But before I explore some errors embedded within the approach and the havoc that they have wreaked, I would like to say a few words on why the EMH exists at all.

Academic theories are notoriously subject to path dependence (or hysteresis, if you prefer). Once a theory has been adopted it takes an enormous amount of effort to dislocate it. As Max Planck said “Science advances one funeral at a time”.

The EMH has been around in one form or another since the Middle Ages (the earliest debate I can find is between St. Thomas Aquinas and other monks on the ‘just’ price to charge for corn, with St. Thomas arguing that the ‘just’ price was the market price). Just imagine we had all grown up in a parallel universe. David Hirschleifer did exactly that: welcome to his world of the Deficient Markets Hypothesis.

“A school of sociologists at the University of Chicago proposing the Deficient Markets Hypothesis – that prices inaccurately reflect all information. A brilliant Stanford psychologist, call him Bill Blunte, invents the Deranged Anticipation and Perception Model (DAPM), in which proxies for market misevaluation are used to predict security returns. Imagine the euphoria when researchers discovered that these mispricing proxies (such as book/market, earnings/price and past returns), and that mood indicators such as amount of sunlight, turned out to be strong predictors of future returns. At this point, it would seem that the Deficient Markets Hypothesis was the best-confirmed theory in social science.

To be sure, dissatisfied practitioners would have complained that it is harder to actually make money than the ivory tower theorists claim. One can even imagine some academic heretics documenting rapid short-term stock market responses to news arrival in event studies, and arguing that security return predictability results from rational premia for bearing risk. Would the old guard surrender easily? Not when they could appeal to intertemporal versions of the DAPM, in which mispricing is only corrected slowly. In such a setting, short window event studies cannot uncover the market’s inefficient response to new information. More generally, given the strong theoretical underpinnings of market inefficiency, the rebels would have an uphill fight.”

In finance we seem to have a chronic love affair with elegant theories. Our faculties for critical thinking seem to have been overcome by the seductive power of mathematical beauty. A long, long time ago, when I was a young and impressionable lad starting out in my study of economics I too was enthralled by the bewitching beauty and power of the EMH/rational expectations approach (akin to the Dark Side in Star Wars). However, in practice we should always remember that there are no points for elegance!

My own disillusionment with EMH and the ultra rational Homo Economius that it rests upon came in my third year of university. I sat on the oversight committee for my degree course as a student representative. Now at the university I attended it was possible to elect to graduate with a specialism in Business Economics, if you took a prescribed set of courses. The courses necessary to attain this degree were spread over two years. It wasn’t possible to do all the courses in one year, so students needed to stagger their electives. Yet at the beginning of the third year I was horrified to find students coming to me to complain that they hadn’t realised this! These young economists had failed to solve the simplest two-period optimisation problem I can imagine! What hope for the rest of the world. Perhaps I am living evidence that finance is like smoking. Ex-smokers always seem to provide the most ardent opposition to anyone lighting up. Perhaps the same thing is true in finance!

The Queen of Hearts and impossible beliefs

I’m pretty sure that the Queen of Hearts would have made an excellent EMH economist.

“Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”"

Lewis Carroll, Alice in Wonderland.

Earlier I alluded to a startling lack of critical thinking in finance. This lack of ‘logic’ isn’t specific to finance, in general we, as a species, suffer belief bias. This a tendency to evaluate the validity of an argument on the basis of whether or not one agrees with the conclusion, rather than on whether or not it follows logically from the premise.

Consider these four syllogisms:

1. No police dogs are vicious.
   Some highly trained dogs are vicious.
   Therefore some highly trained dogs are not police dogs.
2. No nutritional things are inexpensive.
   Some vitamin pills are inexpensive.
   Therefore, some vitamin pills are not nutritional.
3. No addictive things are inexpensive.
   Some cigarettes are inexpensive.
   Therefore, some addictive things are not cigarettes.
4. No millionaires are hard workers.
   Some rich people are hard workers.
   Therefore, some millionaires are not rich people.

These four syllogisms provide us with a mixture of validity and believability. The table below separates out the problems along these two dimensions. This enables us to assess which criteria people use in reaching their decisions.

As the chart reveals, it is the believability not the validity of the concept that seems to drive behaviour. When validity and believability coincide, then 90% of subjects reach the correct conclusion. However, when the puzzle is invalid but believable, some 66% still accepted the conclusion as true. When the puzzle is valid but unbelievable only around 60% of subjects accepted the conclusion as true. Thus we have a tendency to judge things by their believability rather than their validity – clear evidence that logic goes out of the window when beliefs are strong.

All this talk about beliefs makes EMH sound like a religion. Indeed, it has some overlap with religion in that belief appears to be based on faith rather than proof. Debating the subject can also give rise to the equivalent of religious fanaticism. In his book ‘The New Finance: The Case Against Efficient Markets’, Robert Haugen (long regarded as a heretic by many in finance) recalls a conference he was speaking at where he listed various inefficiencies. Gene Fama was in the audience and at one point yelled “You’re a criminal….God knows markets are efficient”.

Slaves of some defunct economist

To be honest I wouldn’t really care if EMH was just some academic artefact. The real damage unleashed by the EMH stems from the fact that as Keynes long ago noted “practical men… are usually the slaves of some defunct economist”.

So let’s turn to the investment legacy that the EMH has burdened us with: first off is the Capital Asset Pricing Model (CAPM). I’ve criticised the CAPM elsewhere (see Chapter 35 of Behavioural Investing), so I won’t dwell on the flaws here, but suffice it to say that my view remains that CAPM is CRAP (Completely Redundant Asset Pricing).

The aspects of CAPM that we do need to address here briefly are the ones that hinder the investment process. One of the most pronounced of which is the obsession with performance measurement. The separation of alpha and beta is at best an irrelevance and at worst a serious distraction from the true nature of investment. Sir John Templeton said it best when he observed that “the aim of investment is maximum real returns after tax”. Yet instead of focusing on this target, we have spawned one industry that does nothing other than pigeonhole investors into categories.

As the late, great Bob Kirby opined “Performance measurement is one of those basically good ideas that somehow got totally out of control. In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to serve.”

The obsession with benchmarking also gives rise to one of the biggest sources of bias in our industry – career risk. For a benchmarked investor, risk is measured as tracking error. This gives rise to Homo Ovinus – a species who are concerned purely with where they stand relative to the rest of the crowd. (For those who aren’t up in time to listen to Farming Today, Ovine is the proper name for sheep). This species is the living embodiment of Keynes’ edict that “it is better for reputation to fail conventionally than to succeed unconventionally”. More on this poor creature a little later.

Whilst on the subject of benchmarking, we can’t leave without observing that EMH and CAPM also give rise to market indexing. Only in an efficient market is a market cap-weighted index the ‘best’ index. If markets aren’t efficient then cap weighting leads us to overweight the most expensive stocks and underweight the cheapest stocks!

Before we leave risk behind, we should also note the way in which fans of EMH protect themselves against evidence that anomalies such as value and momentum exist. In a wonderfully tautological move, they argue that only risk factors can generate returns in an efficient market, so these factors must clearly be risk factors!

Those of us working in the behavioural camp argue that behavioural and institutional biases are the root causes of the outperformance of the various anomalies. I have even written papers showing that value isn’t riskier than growth on any definition that the EMH fans might choose to use (see Mind Matters, 21 April 2008 for details).

For instance, if we take the simplest definition of risk used by the EMH fans (the standard deviation of returns), then the chart below shows an immediate issue for EMH. The return on value stocks is higher than the return on growth stocks, but the so-called ‘risk’ of value stocks is lower than the risk of growth stocks – in complete contradiction to the EMH viewpoint.

This overt focus on risk has again given rise to what is in my view yet another largely redundant industry – risk management. The tools and techniques are deeply flawed. The use of measures such as VaR gives rise to the illusion of safety. All too often they use trailing inputs calculated over short periods of time, and forget that their model inputs are effectively endogenous. The ‘risk’ inputs such as correlation and volatility are a function of a market which functions more like poker than roulette (i.e. the behaviour of the other players matters).

Risk shouldn’t be defined as standard deviation (or volatility). I have never met a long-only investor who gives a damn about upside volatility. Risk is an altogether more complex topic – I have argued that a trinity of risk sums up the aspects that investors should be looking at. Valuation risk, business or earnings risk, and balance sheet risk.

Of course, under CAPM the proper measure of risk is beta. However, as Ben Graham pointed out beta measures price variability, not risk. Beta is probably most often used by analysts in their calculations of the cost of capital, and indeed by CFOs in similar calculations. However, even here beta is unhelpful. Far from the theoretical upward sloping relationship between risk and return, the evidence (including that collected by Fama and French) shows no relationship, and even arguably an inverse one from the model prediction.

This, of course, ignores the difficulties and vagaries of actually calculating beta. Do you use, daily, weekly or monthly data, over what time period? The answers to these questions are non-trivial in their impact upon the analysts calculations. In a very recent paper, Fernandez and Bermejo showed that the best approach might simply to assume that beta equals 1.0 for all stocks. (Another reminder that there are no points for elegance in this world!)

The EMH has also given us the Modigliani and Miller propositions on dividend irrelevance, and capital structure irrelevance. These concepts have both been used by unscrupulous practitioners to further their own causes. For instance, those in favour of repurchases over dividends, or even those in favour of retained earnings over distributed earnings, have effectively relied upon the M&M propositions to argue that shareholders should be indifferent to the way in which they receive their return (ignoring the inconvenient evidence that firms tend to piss away their retained earnings, and that repurchases are far more transitory in nature than dividends).

Similarly, the M&M capital structure irrelevance proposition has encouraged corporate financiers and corporates themselves to gear up on debt. After all, according to this theory investors shouldn’t care whether ‘investment’ is financed by retained earnings, equity issuance or debt issuance.

The EMH also gave rise to another fallacious distraction of our world – shareholder value. Ironically this started out as a movement to stop the focus on short-term earnings. Under EMH, the price of a company is, of course, just the net present value of all future cash flows. So focusing on maximizing the share price was exactly the same thing as maximizing future profitability. Unfortunately in a myopic world this all breaks down, and we end up with a quest to maximize short-term earnings!

But perhaps the most insidious aspect of the EMH is the way in which it has influenced the behaviour of active managers in their pursuit of adding value. This might sound odd, but bear with me while I try to explain what might upon cursory inspection sound like an oxymoron.

All but the most diehard of EMH fans admit that there is a role for active management. After all, who else would keep the market efficient – a point first made by Grossman and Stigliz in their classic paper, ‘The impossibility of the informational efficient market’. The extreme diehards probably wouldn’t even tolerate this, but their arguments don’t withstand the reductio ad absurdum that if the market were efficient, prices would of course be correct, and thus volumes should be equal to zero.

The EMH is pretty clear that active managers can add value via one of two routes. First there is inside information – which we will ignore today because it is generally illegal in most markets. Second, they could outperform if they could see the future more accurately than everyone else.

The EMH also teaches us that opportunities will be fleeting as someone will surely try to arbitrage them away. This, of course, is akin to the age old joke about the economist and his friend walking along the street. The friend points out a $100 bill lying on the pavement. The economist says, “It isn’t really there because if it were someone would have already picked it up”.

Sadly these simple edicts are no joking matter as they are probably the most damaging aspects of the EMH legacy. Thus the EMH urges investors to try and forecast the future. In my opinion this is one of the biggest wastes of time, yet one that is nearly universal in our industry. Pretty much 80-90% of the investment processes that I come across revolve around forecasting. Yet there isn’t a scrap of evidence to suggest that we can actually see the future at all.

The EMH’s insistence on the fleeting nature of opportunities combined with the career risk that bedevils Homo Ovinus has led to an overt focus on the short-term. This is typified by the chart below which shows the average holding period for a stock on the New York Stock Exchange. It is now just six months!

The undue focus upon benchmark and relative performance also leads Homo Ovinus to engage in Keynes’ beauty contest. As Keynes wrote:

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the price being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees”

This game can be easily replicated by asking people to pick a number between 0 and 100, and telling them the winner will be the person who picks the number closest to two-thirds the average number picked. The chart below shows the results from the largest incidence of the game that I have played – in fact the third largest game ever played, and the only one played purely among professional investors.

The highest possible correct answer is 67. To go for 67 you have to believe that every other muppet in the known universe has just gone for 100. The fact we got a whole raft of responses above 67 is more than slightly alarming.

You can see spikes which represent various levels of thinking. The spike at fifty reflects what we (somewhat rudely) call level zero thinkers. They are the investment equivalent of Homer Simpson, 0, 100, duh 50! Not a vast amount of cognitive effort expended here!

There is a spike at 33 – of those who expect everyone else in the world to be Homer. There’s a spike at 22, again those who obviously think everyone else is at 33. As you can see there is also a spike at zero. Here we find all the economists, game theorists and mathematicians of the world. They are the only people trained to solve these problems backwards. And indeed the only stable Nash equilibrium is zero (two-thirds of zero is still zero). However, it is only the ‘correct’ answer when everyone chooses zero.

The final noticeable spike is at one. These are economists who have (mistakenly…) been invited to one dinner party (economists only ever get invited to one dinner party). They have gone out into the world and realised the rest of the world doesn’t think like them. So they try to estimate the scale of irrationality. However, they end up suffering the curse of knowledge (once you know the true answer, you tend to anchor to it). In this game, which is fairly typical, the average number picked was 26, giving a two-thirds average of 17. Just three people out of more than 1000 picked the number 17.

I play this game to try to illustrate just how hard it is to be just one step ahead of everyone else – to get in before everyone else, and get out before everyone else. Yet despite this fact, it seems to be that this is exactly what a large number of investors spend their time doing.

Prima facie case against EMH — Forever blowing bubbles

Let me now turn to the prima facie case against the EMH. Oddly enough it is one that doesn’t attract much attention in academia. As Larry Summers pointed out in his wonderful parody of financial economics “Traditional finance is more concerned with checking that two 8oz bottles of ketchup is close to the price of one 16oz bottle, than in understanding the price of the 16oz bottle”.

The first stock exchange was founded in 1602. The first equity bubble occurred just 118 years later – the South Sea bubble. Since then we have encountered bubbles with an alarming regularity. My friends at GMO define a bubble as a (real) price movement that is at least two standard deviations from trend. Now a two standard deviation event should occur roughly every 44 years. Yet since 1925, GMO have found a staggering 30 plus bubbles. That is equivalent to slightly more than one every three years!

In my own work I’ve examined the patterns that bubbles tend to follow. By looking at some of the major bubbles in history (including the South Sea Bubble, the railroad bubble of the 1840s, the Japanese bubble of the late 1980s, and the NASDAQ bubble¹), I have been able to extract the following underlying pattern. Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate. This bursting is generally slightly more rapidly than the inflation, taking around two years.

Whilst the details and technicalities of each episode are different, the underlying dynamics follow a very similar pattern. As Mark Twain put it “History doesn’t repeat but it does rhyme”. Indeed, the first well documented analysis of the underlying patterns of bubbles that I can find is a paper by J.S. Mills in 1867. He lays out a framework that is very close to the Minsky/Kindleberger model that I have used for years to understand the inflation and deflation of bubbles. This makes it hard to understand why so many amongst the learned classes seem to believe that you can’t identify a bubble before it bursts. To my mind the clear existence and ex ante diagnosis of bubbles represent by far and away the most compelling evidence of the gross inefficiency of markets.

The EMH ‘Nuclear Bomb’

Now as a behaviouralist I am constantly telling people to beware of confirmatory bias – the habit of looking for information that agrees you. So in an effort to avert the accusation that I am guilty of failing to allow for my own biases (something I’ve done before), I will now turn to the evidence that the EMH fans argue is the strongest defence of their belief – the simple fact that active management doesn’t outperform. Mark Rubinstein describes this as the nuclear bomb of the EMH, and says we behaviouralists have nothing in our arsenal to match it, our evidence of inefficiencies and irrationalities amounts to puny rifles.

However, I will argue that this viewpoint is flawed both theoretically and empirically. The logical error is a simple one. It is to confuse the absence of evidence with evidence of the absence. That is to say, if the EMH leads active investors to focus on the wrong sources of performance (i.e. forecasting), then it isn’t any wonder that active management won’t be able to outperform.

Empirically, the ‘nuclear bomb’ is also suspect. Today I want to present two pieces of evidence that highlight the suspect nature of the EMH claim. The first is work by Jonathan Lewellen of Dartmouth College.

In a recent paper, Lewellen looked at the aggregate holdings of US institutional investors over the period 1980-2007. He finds that essentially they hold the market portfolio. To some extent this isn’t a surprise, as the share of institutional ownership has risen steadily over time from around 30% in 1980 to almost 70% at the end of 2007. This confirms the zero sum game aspect of active management (or negative sum, after costs) and also the validity of Keynes’ observation that it [the market] is professional investors trying to outsmart each other.

However, Lewellen also shows that, in aggregate, institutions don’t try to outperform! He sorts stocks into quintiles based on a variety of characteristics and then compares the fraction of the institutional portfolio invested in each (relative to institutions’ investment in all five quintiles) with the quintile’s weight in the market portfolio (the quintile’s market cap relative to the market cap of all five quintiles) – i.e. he measures the weight institutional investors place on a characteristic relative to the weight the market places on each trait.

The chart below shows the results for a sample of the characteristics that Lewellen used. With the exception of size, the aggregate institutional portfolio barely deviates from the market weights. So institutions aren’t even really trying to tilt their portfolios towards the factors we know generate outperformance over the long term.

Lewellen concludes:

“Quite simply, institutions overall seem to do little more than hold the market portfolio, at least from the standpoint of their pre-cost and pre-fee returns. Their aggregate portfolio almost perfectly mimics the value-weighted index, with a market beta of 1.01 and an economically small, precisely estimated CAPM alpha of 0.08% quarterly. Institutions overall take essentially no bet on any of the most important stock characteristics known to predict returns, like book-to market, momentum, or accruals. The implication is that to the extent that institutions deviate from the market portfolio, they seem to bet primarily on idiosyncratic returns – bets that aren’t particularly successful. Another implication is that institutions, in aggregate, don’t exploit anomalies in the way they should if they rationally tried to maximize the (pre-cost) mean variance trade-off of their portfolios, either relative or absolute.”

Put into our terms, institutions are more worried about career risk (losing your job) or business risk (losing funds under management) than they are about doing the right thing!

The second piece of evidence I’d like to bring to your addition is a paper by Randy Cohen, Christopher Polk and Bernhard Silli. They examined the ‘best ideas’ of US fund managers over the period 1991-2005. ‘Best ideas’ are measured as the biggest difference between the managers’ holdings and the weights in the index.

The performance of these best ideas is impressive. Focusing on the top 25% of best ideas across the universe of active managers, Cohen et al find that the average return is over 19% p.a. against a market return of 12% p.a. That is to say, the stocks in which the managers display most confidence did outperform the market by a significant degree.

The corollary to this is that the other stocks they hold are dragging down their performance. Hence it appears that the focus on relative performance -and the fear of underperformance against an arbitrary benchmark – is a key source of underperformance.

At an anecdotal level I have never quite recovered from discovering that a value manager at a large fund was made to operate with a ‘completion portfolio’. This was a euphemism for an add-on to the manager’s selected holdings that essentially made his fund behave much more like the index!

As Cohen et al conclude “The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over-diversify”. Thus as Sir John Templeton said, “It is impossible to produce a superior performance unless you do something different from the majority”.

The bottom line is that the EMH nuclear bomb is more of a party popper than a weapon of mass destruction. The EMH would have driven Sherlock Holmes to despair. As Holmes opined “It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts”.

The EMH, as Shiller puts it, is “one of the most remarkable errors in the history of economic thought”. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brain washing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed in it….only two hands remained up!

A similar sentiment seems to have been expressed by the recent CFA UK survey which revealed that 67% of respondents thought that the market failed to behave rationally. When a journalist asked me what I thought of this, I simply said “About bloody time”. However, 76% said that behavioural finance wasn’t yet sufficiently robust to replace modern portfolio theory (MPT) as the basis of investment thought. This is, of course, utter nonsense. Successful investors existed long before EMH and MPT. Indeed, the vast majority of successful long-term investors are value investors who reject pretty much all the precepts of EMH and MPT.

Will we ever be successful at finally killing off the EMH? I am a pessimist. As Jeremy Grantham said when asked what investors would learn from this crisis: “In the short term, a lot. In the medium term, a little. In the long term, nothing at all. That is the historical precedent”. Or as JK Galbraith put it, markets are characterised by “Extreme brevity of financial memory… There can be few fields of human endeavour in which history counts for so little as in the world of finance”.

Footnote:
¹ - Two economists have written a paper arguing that the NASDAQ bubble might not have been a bubble after all – only an academic with no experience of the real world could ever posit such a thing.

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John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore

]]> http://www.rocketcap.com/macro-economics-learned-from-the-queen-of-hearts/feed/ 0 http://www.rocketcap.com/be-your-own-hedge-fund-manager-use-structured-notes/ http://www.rocketcap.com/be-your-own-hedge-fund-manager-use-structured-notes/#comments Fri, 31 Jul 2009 23:01:29 +0000 admin http://www.rocketcap.com/?p=1385 The Joys of Structured Notes

We draw your attention to very useful and well established type of security, the Structured Note (SN). (We emphasize SNs are not the Structured Investment Vehicle of recent ill repute.)  Their fundamental purpose is to provide an investment that focuses on a specific set of investment goals, market beliefs and risk preferences of the investor. These notes can provide diversification for all kinds of portfolios. They can deliver a chosen combination of bond, equity and options behavior, and they are customized and offered by financial institutions. Even better, you can design and implement many of the characteristics of these notes for yourself…or your RIA can do so.

The main characteristics of structured notes are:

1. A defined maturity date, upon which the note expires and the positions are closed.
2. Specified amounts of principal can be placed at risk, from 0% (“Principal Protected”) to over 100% (“Principal at Risk”)

These SNs are effectively a hedge fund style investment, without the fund. They are unlike ETFs and mutual funds for the two reasons above.

Simple Example of a Structured Note Designed at Home

Here’s a very simple example to get you started conceptually: A Principal Protected Note. (The numbers are intended to illustrate the concepts. Scales and other details are readily accounted for in practice).

Suppose you believe the S&P500 will appreciate in a year, but you are worried about Black Swans flying into your portfolio. You want to invest, but you are a bit anxious. How can you gain some upside and not risk much downside?

The idea is to build the note based on existing securities with required properties to get the desired behavior. Suppose you buy a zero coupon bond (ZCB) from the US Treasury and the ZCB has 1 year maturity and $10000 par value. Let’s say you pay $9800 now and the UST will pay you $10000 one year from from now for a 2% ZCB.  In 1 year, you will get your principal paid back with a $200 profit. What if you invested that $200 due to you in one year, now? In effect, you will spend your future guaranteed profit on the possibility you can make more money in a year through investing.

For example, do this: put the $200 in a money market account. Then buy an out-of-the-money call option on the S&P500 Index. In one year, there are two possibilities:  the option will be worth nothing, in which case you have only the money market remainder if any, or the option will have some profit in addition to any money market remainder.

Worst case, you lose the full $200. But you get the $10000 payoff, $200 of which matches what you risked on the option initially. So your $9800 principal is repaid.

Extensions of the Basic C0ncept to More Complex Structured Notes

You can extend the maturity of the ZCB and the type of option or stock position (purchases, spreads and straddles,…). You can choose other types of very high quality bonds. For example, if the ZCB above had a maturity of 20 years and paid 4%, then the initial purchase would be $4564 and you would get back $10000 at 20 years. So you would have $5436 to invest in some other position. Again, you could lose the entire $5436 and still regain your initial capital in 20 years.

Of course, this form of principal protection is simplistic since the time value of the money is lost. But the main idea holds.

These basic concepts can be developed by your investment advisor to target your specific investment beliefs, and they offer good diversification possibilities.

Live it up, be a hedge fund manager!

Fraction of Actively Managed Fixed Income Funds Beaten by the Benchmark

According to this result, you should buy only passively managed bond funds if you like their underlying index benchmark. The only exception to this interpretation is for the high yield, or junk, bond funds (Barclay’s High Yield Index in the Table). These funds seem to require deep knowledge of the issuers, since they are all by definition high risk, and so active management works better than benchmark to extract risk. (Note: the original research from IndexUniverse won’t be available directly online until early August 09. We got this table from the “webinar” by Index Universe called “Advanced Fixed Income: Not Your Grandfather’s Bonds” today, 30 JUL 09.)

(Please keep in mind all information and ideas presented on this web site are subject to our Terms of Use. We also remind you that nothing written here can be a recommendation for any particular person to invest. Please consult your own financial or investment advisor before you make any investments.)

Can the Fed Control the Money Supply?

The problem is this: Given the enormous amount of money Bernanke’s Fed has “printed” to restart the credit markets, there now is a substantial danger the Fed will not successfully retrieve that money. Bernanke needs to use all the Fed’s tools to raise interest rates sufficiently for banks to place money on deposit with the Fed, and out of the economy. The Fed must start, at a crucial time we’ll label TIME, a control policy of raising rates fast enough and high enough to attract money. This is a tricky balancing act. When the Fed pays interest, the amount and timing must not be so high or fast as to slow the economy into recession again and deflation, or be so low and slow as to enable inflationary expectations to squirt loose. There are thus three huge unknowns in this problem and all of them are beyond investor influence: TIME, interest rate level, and speed of change in interest rates. Perfection happens when Ben gets it exactly right, and the economy washes the excess money supply back with minimal impact on prices. But being wrong will launch deflation or inflation.

Under these conditions, how best to invest? We take a scenario approach. There are three main future economic conditions (Deflation, Perfection, Inflation) and four main investable asset classes to choose from. We need to pick the amount to invest from each class, depending on our beliefs about the future.

Main Investable Asset Classes

The main asset classes are roughly described this way, considering the variations within each class. First, cash. This ranges from cash in mattress, to money market funds and extremely short term T-Bills. Second, Fixed Income comprises all forms of bonds and ETFs/Mutual Funds based on bonds, both corporate and municipal, and various Treasury offerings, most particularly Treasury Inflation Protected Securities (TIPS). Third are corporate equities and ETFs/Mutual Funds based on them. Finally, we have hard assets. These consist of commodities (metals, precious metals, food products, animal products,…) and real estate (land, buildings, and Real Estate Investment Trusts (REITs)). REITs enable liquidity in real estate purchases, since one trades shares of corporations whose assets are interests in real property. Note that more esoteric asset classes, such as hedge funds and derivatives all can be fit into these categories, if you are willing to sit on top of the bag to close the zipper.

Model Portfolios

Let’s look at a straightforward way to invest for each scenario. Consider this table, which shows the amount of your investable assets to invest in each class, given the scenario.

These amounts were intuitively chosen. By applying the Markowitz portfolio optimation algorithm, one can create an optimal portfolio for all three cases based on one’s own specific ROI and risk assumptions.

Perfection

Under the Perfection scenario, the economy percolates along without undue influence of the money supply, and is what we call “normal”. Our nominal portfolio for Perfection consists of equal amounts of equity and fixed income, with lesser equal amounts of cash and real assets. Again, we note the specific assets in each class are chosen by the individual investor.

Inflation

With inflation, one wants to hold hard assets and inflation protected securities. The two most often named are gold and TIPS. Commodities generally gain in price with overall inflation. Stocks vary with inflation. Empirically, the equities evidence is mixed. Some firms win due to having price increases masked by inflation, while others lose since their purhases also rise with inflation. Surprisingly, cash tends to track inflation. So, compared to Perfection, the model portfolio has more cash and fixed income, with an increased dose of TIPS, less equities, and much more Real Assets.

Deflation

Under deflation, cash is king, and the model portfolio shows this bias compared to the Perfection condition.

Combination

Of course, these scenarios are mutually exclusive, and we can build only one portfolio of all our assets. To build the final portfolio, we have to assign a probability to each scenario, and then combine the asset classes according to the scenario weights.

Bernanke Article in WSJ, 7-21-09

He concludes by saying:

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

The only problem with all this is what he failed to address: how to get the timing right. All his tools are good ones, but the entire challenge is to start using them at best time. He can err by starting too soon, and slow growth, or too late, and enable inflation to squirt loose.

How can he get it right?

No answer. So in self-defense, take anti-inflation positions, while their prices are relatively low.

On 30 June 2009 NYSE Euronext (NYX) announced that its wholly-owned subsidiary, NYSE Arca, began trading MacroShares Major Metro Housing Down Trust (Ticker Symbol “DMM”) and MacroShares Major Metro Housing Up Trust (Ticker Symbol “UMM”), both exchange traded products. These new securities are sponsored by MacroMarkets LLC, which was co-founded by Prof. Shiller.

The MacroShares Metro Housing products are based on the S&P/Case-Shiller Composite-10 Home Price Index, an established indicator of U.S. home prices in the 10 largest cities.  MacroMarkets states that MacroShares Major Metro Housing trusts provide investors with access to the housing asset class, allowing for leveraged investment in either the upward or downward movement of home prices with no issuer or counterparty credit risk.

As described by MacroMarkets, UMM and DMM are paired trusts that work as follows. When UMM are created, an equal number of DMM are also created. UMM funds are invested in the “Major Metro Housing Up Trust.” DMM investor funds are invested in a separate “Major Metro Housing Down Trust”. These trusts enter into a settlement contract: a binding agreement to pledge assets to one another over time, according to a predetermined formula that is driven by changes in the Reference Index. The trusts feature a 3x leverage factor, such that the underlying value of each is intended to track three times the cumulative percentage change, upward or downward, in U.S. single family home prices, as measured by the S&P/Case-Shiller Composite-10 Home Price Index.

UMM and DMM track three times the percentage change of single-family homes, as measured by the Case-Shiller Composite Home Price Index. Essentially, this is a way to Short or Buy the value of residential real estate with one transaction. If you are bullish on housing, buy UMM. If you are bearish on housing, or want to hedge the value of your own home, buy DMM. Details are given in the fund’s detailed prospectus.