(In)efficient markets, indices and investors - Martellini explains - brilliant!

Highly recommended: Lionel Martellini's Inefficient Benchmarks in Efficient Markets at the EDHEC Research Institute. Martellini is precise and brief in his explanation of a couple of the slipperiest and most important ideas in finance and investing. Quotes: 

• " ... cap-weighted indices are inefficient benchmarks, regardless of whether or not markets are efficient (keeping in mind that they probably are efficient, at least to a first-order approximation)... " i.e. the implication is that indices like the S&P 500 and the S&P/TSX 60 aren't very good
• " ... When the word “efficient” is used in reference to a market, as in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, it suggests that at any given time, prices in the market fully reflect all available information on all stocks in the market. ... " and "... there is a consensus regarding the fact that markets can still be regarded as somewhat efficient ... " i.e. it's not impossible but it's hard to outperform the market, considering fees and costs
• " ... even if markets are efficient, at least up to a first order approximation, investors can still be holding highly inefficient portfolios. The word “efficient”, now applied to a portfolio as opposed to a market, means that the portfolio performance can be improved without any increase in risk through an improvement in the portfolio diversification ..." i.e. it isn't a great idea to invest only in Royal Bank shares even if the price is correct
• " ... empirical evidence also suggests that the average investor holds a severely inefficient portfolio. In other words, the finding here is that the portfolio held by the average investor, which by definition is a cap-weighted index, tends to be poorly diversified. This result is hardly a new finding, ..." i.e. buying SPY (S&P 500 tracker ETF) or even VTI (Vanguard Total US Market ETF) or XIC (S&P/TSX Total Market ETF) is NOT the ideal thing to do.
• "... various alternative weighting schemes have been proposed to improve upon cap-weighting (see Amenc et al. (2011), Arnott, Hsu and Moore (2005), Choueifaty and Coignard (2008), Maillard, Roncalli and Teiletche (2008) to name but a few), and it is now commonly accepted that moving away from cap-weighting tends to enhance diversification and increase risk-adjusted performance over long horizons. ..." i.e. consider dumping SPY and XIC. I think the best practical answer is an empirical matter - if another non-cap-weighted (like equal-weighted, or fundamental weighted) index ETF exists for the asset class with reasonable costs that do not eat up the performance gain (e.g. perhaps PRF, EWI, RSP, PXC, CRQ;

Luck or skill? Ray Dalio of Bridgewater

Do investors like Warren Buffett succeed through luck or skill? The statistical argument is that such success cannot be distinguished from luck so therefore we cannot believe in skill. Yet ... when we encounter successful people in more tangible pursuits like sports or music, we don't say they are just lucky.

The other day I came across Principles, the exposition of what uber-rich investor Ray Dalio believes and lives by. Dalio is the founder of Bridgewater Associates, the world's biggest hedge fund according to Wikipedia. (Interestingly, Bridgewater manages some of our pension money as one of the Canada Pension Plan Investment Board's private investment partners). Principles isn't flowery imaginative writing - just plain, matter-of-fact, direct statement - but what it says rings true. It also isn't about investing principles he follows - that may come later he says. Though meant primarily as a management bible and indoctrination tool for new employees at Bridgewater, there is much value for self-reflection on what it takes to be successful e.g. "everyone has weaknesses. The main difference between unsuccessful and
successful people is that unsuccessful people don’t find and address them, and successful people do".

Dalio evidently (e.g. see John Cassidy's Mastering the Machine in the New Yorker of last July) lives by his principles with a ruthless and implacable discipline. It's the same as in any other human endeavour. To become highly successful, let alone the best, requires enormous unstinting effort.

Interesting is his take on ability since most people including me believe that talent must be there too. His reply is "... if you are motivated, you can succeed even if you don’t have the abilities (i.e., talents and skills) because you can get the help from others". In investing terms, that could mean using an advisor but then Dalio's principle 187 kicks in - "Have good controls so that you are not exposed to the dishonesty of others and trust is never an issue. A higher percentage of the population than you might imagine will cheat if given an opportunity, and most people who are given the choice of being “fair” with you and taking more for themselves will choose taking more for themselves." Or it could mean a person should take the passive index ETF route where talent and ability aren't required at all.

Dalio unintentionally provides support for the argument that there really is investing ability. First, as he says in principle 31,"People who have repeatedly and successfully accomplished the thing in question and have great explanations when probed are most believable. Those with one of those two qualities are somewhat believable; people with neither are least believable". The phenomenal success of Bridgewater is a hefty track record and this book is a pretty good explanation.

Second, in footnote 38 on page 21 he says "Luck—both good and bad—is a reality. But it is not a reason for an excuse. In life, we have a large number of choices, and luck can play a dominant role in the outcomes of our choices. But if you have a large enough sample size—if you have large number of decisions (if you are playing a lot of poker hands, for example)—over time, luck will cancel out and skill will have a dominant role in determining outcomes. A superior decision-maker will produce superior outcomes". Investing is very much an activity where there really is luck or true uncertainty at play so one cannot expect always to be correct, no matter how much data one collects and analyzes. Now, it is true that the world's biggest hedge fund may have got there merely by gathering assets and snowing all those giant pension funds about actual investment performance but there is some direct performance evidence cited in Wikipedia.

As the ancient Greek Aeschylus said "Call no man happy till he is dead". Dalio's investing prowess is only as far away as the next market shift that he has not anticipated which runs contrary to his investments. He does claim not to be too concentrated and is aware of the danger per principle 197 "make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil ... knowing what you don’t know is at least as valuable as knowing" and principle 195 "Constantly worry about what you are missing. Even if you acknowledge you are a “dumb shit” and are following the principles and are designing around your weaknesses, understand that you still might be missing things". The New Yorker article also says he deliberately does not make any concentrated bets to avoid the possibility of being wiped out.

A blowup by Bridgewater / Dalio would no doubt make the skeptics happy, strangely including blogger Pension Pulse. I prefer to think investing is like sports - champions do exist because they are better than everyone else at the time but they all have their day.

Index Investing Becoming a Victim of Its Own Success

Too much of a good thing can end up being bad. That includes using a benchmark index as the basis for an investing apparently.

In the July 2010 paper (download here from SSRN; acknowledgement to Stingy Investor where I found the link) On the Economic Costs of Index-Linked Investing, NYU prof and NBER research associate Jeffrey Wurgler reviews some research results that are disquieting for investors who follow a passive index strategy based on popular indices such as the S&P 500.

Wurgler says: "... the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits ..." The problems:

• the inclusion of stocks in the index pushes up prices, by around 9% around the time of the event, a factor that has been getting worse as indexing has gained popularity; this effect is observed for other indices besides the S&P 500, like the TSX 300 (now the delicately named TSX Composite, which hides the fact the fact that it has been shrinking steadily in number of stocks over the years to 235 today)
  
• active managers who are benchmarked against the index have an incentive to overweight index members, even if they think a non-index stock will appreciate the same percentage, due to lesser tracking error
• stocks that join a leading index such as the S&P 500 suddenly begin to move much in tandem and keep doing so, which Wurgler vividly likens to the movements of a school of fish; he calls this effect "detachment"
• the S&P 500 school of fish members moves on their own and less like the overall market, a net loss of diversification for the investor
• S&P 500 membership has in the past over the long period of 1980 to 2005 conferred an increasing price premium; he cites one study that found the S&P 500 stocks got an 82 basis point annual alpha return premium; while it might seem like a good thing to get a hefty excess return, he says it might be a sign of an "indexing bubble" that will sooner or later deflate
  
• as a consequence, bubbles and crashes are more likely; he discusses the mechanism that may explain both the 1987 crash and the May 2010 flash crash
• the risk and return relationship actually does not hold - low beta(risk) stocks have been found to generate better returns, by a lot, than high beta stocks, a phenomenon he rightly calls a spectacular anomaly; he explains how fund managers benchmarked to an index will favour high beta stocks
• he raises the possibility that the S&P cap-weighted index amounts to a strategy of large-cap growth and momentum ... "Clearly, the line between passive and active investment is blurrier than usually presented."
  

Here's another juicy quote: "the popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average, to beat the index—it may actually be contributing to their underperformance."

What does he suggest one do about it?

• instead of the S&P 500, pick a broader index like the Wilshire 5000 - "The S&P 500 Index's detachment means, however, that it is reflecting less and less the performance of the full stock market. Index funds based on the more comprehensive Wilshire 5000 (which has included as many as 7,200 stocks) are now providing more robust diversification and stock market exposure."
• exploit the observed "spectacular anomaly" through strategies that focus on low-beta stocks, e.g. employ maximum Sharpe ratio, minimum volatility and absolute returns, though I'd guess that is probably beyond most individual investors' capability

It's the inverse of the dictum that the market only moves towards efficiency if people exploit and thereby remove the inefficiencies - if too many people assume the market is efficient and therefore invest in passive index funds, then the market becomes more inefficient. A delightful irony indeed!

Institutional Investors Lose Money Just Like Individual Investors

Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors by Scott D. Stewart, John J. Neumann, Christopher R. Knittel and Jeffrey Heisler in the Nov/Dec 2009 issue of the Financial Analysts Journal tells us that pension plans, endowments, foundations and other large pools of assets ($10 trillion in 2006) make exactly the same mistakes and get the same poor results as individual investors. "Much like individual investors, who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions." In fact, the study shows they lost money and lots of it.

This is despite the fact that "Pension plans, endowments and foundations are typically staffed with professionals with years of experience and advanced degrees."

Index investing with a fixed asset allocation seems more sensible every time a new study comes out.

I am left with this question - if individual investors lose money on average over extended periods and the pros do too, who the heck IS making money?

PS - acknowledgement to Index Funds Advisors whose excellent newsletter included the link to the study.

PPS just realized that I've been doing this blog for three complete years now. It is a sort of full circle in that my second post on Feb.1, 2007 was about a paper on the same subject as today's. The 7 Deadly Sins of Investors seems to apply as much to institutional investors as individuals.

The Index Finger Moves on - Shrinking TSX and Declining Index Effect

The Shrinking TSX
Another ones bites the dust. As I noted last year, the TSX Composite Index has been shrinking for years. That seems to be continuing, though at a slower pace. When Enerflex Systems Income Fund (EFX.UN) leaves the index next week as the result of a buyout (see Standard & Poors press release) the TSX Composite will be down to 210 companies, a third fewer than a mere nine years ago. One would have thought equity markets should expand over time, not shrink.

When one considers that the largest US all-company index the Wilshire 5000 Total Market Index contains about 5000 companies, it is apparent how small and thin the Canadian market is. All the more reason to diversify outside Canada in my opinion.

The Shrinking Index Effect
The index effect is the excess returns or profits from trading on a stock that is being added to a major index, such as the TSX 60, the S&P 500 or the UK's FTSE 100. The addition of a stock to an index causes its price to rise unduly as indexers (and closet indexers) rush to buy it. A neat little 2008 paper by Aye Soe and Srikant Dash from Standard and Poors called The Shrinking Index Effect showed how the opportunity to make such profits has declined considerably to the point they think "... its days as a profitable trading strategy may be numbered". They looked at five different major indices, the above three plus Japan's Nikkei 225 and Germany's DAX 30.

The paper is a good brief primer on the various indices and how they are changed. It's interesting that the FTSE 100 and DAX 30 changes are quite mechanical and predictable while those of the TSX 60 and the S&P 500 are not.

Buyers of passive index funds, which automatically buy into index changes and have to pay the higher price that follows the announcement price pop, may take heart that they are being less taken advantage of. To quote the authors: "... hedge funds and proprietary trading desks have increased their market participation in index trades to exploit this opportunity. As with any arbitrage opportunity, increase in arbitrageur activity has diminished profits." Arbitragers are not the only factor at work but the net effect is the market becoming more efficient! The chart image below taken from the study shows the big decline - the upper vs the lower line at time ED (ED means the day the entry of a stock into the index takes effect) - in available trading profits from TSX 60 changes between 1998-2003 and 2003-2008.


Of course, the efficiency process is never finished. Srikant Dash and Berlinda Liu suggest in another paper at SSRN called Capturing the Index Effect via Options, that arbitragers can continue to make large excess profits (31% on average on the S&P 500) by trading options instead of the stock itself.

Example of Kaupthing: Market Efficiency at Work

One of the reasons I enjoyed Johnsson's book Why Iceland? so much is the insider view into what drove the failure of Icelandic banks in 2008. The machinations of savvy players show us how market efficiency works, how the search for excess profits or so-called alpha, and the attainment thereof, is actually the source of market efficiency.

Jonsson's story on page 63: The weak position of the Kaupthing bank relative to other banks was noticed first in 2005 by a trader named Herleif Havik at the Petroleum Fund of Norway. He began doing what he perceived to be a kind of low- or no-risk pair of trades, by selling Credit Default Swap (CDS) protection on Barclays bank while buying the same protection on Kaupthing. The reason was apparently that Barclays and Kauthing debt traded at the same premium. Havik figured that Iceland could not, in the event of a crisis, offer the same back-up to Kauthing as Britain could to Barclays. To do the buying and selling of CDS, it was not necessary to actually hold any of the debt and in fact, Jonsson says the PFN did not own any Kaupthing bonds. Havik's trades attracted attention and drove up CDS premiums on Kaupthing. Other financial players began to focus on Iceland. The weakness of the business model of the Icelandic banks had been noticed.

It was by detecting the mis-priced bonds of Kaupthing (aka market inefficiency) and exploiting it that the market forced an eventual and brutal return towards efficiency.

The incident leaves questions to ponder:

• Was PFN, a state-controlled fund no less, and Havik somehow morally to blame for doing so, since the dénoument has left Icelanders suffering?
• Is naked CDS trading bad or merely the equivalent of buying a put or a call? e.g. Bad - SEC chairman Maison Fleury; OK - Derivatives Dribble)
• Was the pendulum swing the other way, all the way to bankruptcy of all the Icelandic banks, the only way back to efficiency, or was it too far?

Market inefficiency and mis-pricing after the event is much easier to tell than beforehand. One of my favorite quotes is "Half the money I spend on advertising is wasted; the trouble is I don't know which half." (attributed on Wikipedia to John Wanamaker) It is not necessary to assume that every security is correctly priced at every moment to believe in market efficiency, nor does one need to deny that significant chunks of securities like whole stock indexes are correctly priced at any one time. Market efficiency means fair pricing, neither systematically biased too high or too low. Only after fact do we find out which it was - high or low - and there may be a good lag before that happens.