Weekend Reads

A late set of weekend links for your reading enjoyment!

Stuff doesn’t make people happier. Control over their time does. So to the extent that the goal of personal finance is to make you happier, I encourage people to view it as a way to gain control over their time, rather than a way to accumulate more possessions. -Morgan Housel

Morgan Housel on What You Need to Know to Be a Successful Investor (Chris Reining)

The Seduction of Pessimism (Collaborative Fund) and What Is Your Belief System (Enterprising Investor)

A Kansas Investment Firm Spurring Change on Wall Street (New York Times)

In the New Bond Market, Bigger Is Better (Wall Street Journal) versus Treasury’s Regulation Unwind Already Having An Effect on Markets (Bloomberg)

Solar Power Will Kill Coal Faster Than You Think (Bloomberg)

American Chipmakers Had a Toxic Problem. Then They Outsourced It (Bloomberg Businessweek)

 

Definitions: Beta & Alpha

Before delving deeper into the topic of market efficiency and active vs passive, it may be helpful to briefly review the definitions of beta and alpha.

Beta

At it’s simplest, beta can be defined as the volatility of an asset relative to a benchmark. The benchmark is often an index of a specific sector or an entire asset class. For example, a US large-cap stock that is 20% more volatile than the S&P 500 index has a beta of 1.2. Or if the volatility is 20% less than the index , it’s beta is .8. Beta is a measure of relative volatility.

Alpha

Within the Capital Asset Pricing Model (CAPM), this same beta is used to forecast returns. Under CAPM, higher beta leads to higher returns and lower beta results in lower returns. In other words, a fund with more volatility should have higher returns and a fund with lower volatility should have lower returns. Reality rarely unfolds as modeled, so an ex-post CAPM equation was created. It adds a variable called alpha to account for the difference between an asset’s actual return and it’s expected return (which CAPM predicts to be the benchmark return, adjusted for volatility). Below are a couple of examples on calculating alpha:

  • An investor invests in large-cap domestic stocks and reports a 10% return, while the Russell 1000 returns 7%. The investor has produced 3% alpha.
  • An investor invests in global equities and reports a 9% return, while the MSCI All Country World Index returns 13%. The investor has (negative) alpha of -4%.
Beta, Colloquially

The term beta is often used to refer to the risk and return characteristics of a benchmark. Some examples: US large-cap beta may refer to the Dow Jones Industrial Average or the S&P 500, investment grade bond beta is often synonymous with the Barclays Agg index, or tech beta may simply refer to a tech-sector ETF. I often refer to index ETFs as cheap, liquid beta. Some may compare large-cap beta to small-cap beta or consumer staple beta to consumer discretionary beta, when discussing risk and returns. Below are some examples of how someone might refer to beta:

  • Utility sector beta is sensitive to interest rates.
  • An index fund may be called beta exposure.
  • An investor holds investment grade bonds and reports a -1% return while the Barclays Agg is down 3%. Some might say that the beta return was -1% (and alpha was positive 2%).
To recap:
  • Beta is an asset’s volatility, relative to a benchmark.
  • Alpha is an asset’s return above it’s benchmark, after controlling for differences in volatility.
  • Technical definitions notwithstanding, the term beta is often shorthand for a benchmark or may refer to the benchmark’s risk and return characteristics.

Weekend Reads

Hanging out in the Rocky Mountains, so just a trio of related articles this weekend:

Stop Pretending You’re Not Rich (New York Times)

Conspicuous Consumption Is Over. It’s All About Intangibles Now (aeon)

The Happiness Spending Threshold And What It Really Means To Live Within Your Means (Nerds Eye View)

Does It Matter Whether Markets Are Efficient or Not?

Does it matter whether markets are efficient or not?

Not really and here’s why:

  • As I mentioned last week, nobody knows how efficient or inefficient markets are (due to the joint hypothesis problem, eloquently summarized here)
  • Asking whether a market is efficient is often a proxy for asking whether one can outperform. However, the questions are different, as we’ll see below.

Last week’s post mentioned Eugene Fama, who won a Nobel prize for developing the Efficient Markets Hypothesis (EMH). However, Jack Bogle (who founded Vanguard) also has a hypothesis called the Costs Matter Hypothesis (CMH), which he introduced here in 2003. Consider the following, which both Fama and Bogle agree on:

  • In any market, aggregate investor performance will equal the overall market performance minus costs. This statement holds whether a market is efficient or inefficient. Regardless of a market’s efficiency, investors as a whole will underperform because they bear costs. To outperform the market, you must beat the market by more than your costs.
  • Since total investor performance is limited to market performance minus costs, any investor’s outperformance comes from another investor’s underperformance. So to beat the market, you must also beat other participants.

Thus, the important question for investors is not whether markets are efficient or not, but whether they can reliably and consistently beat both the market and other investors net-of-fees. If the answer is yes, investors might benefit from using active management. If the answer is no, it is likely better to use a lower-cost vehicle, such as an index fund.

Of course, there is more than one market. There are many asset classes and markets, so the question of whether you can beat the market or not must be asked over and over. Each market is unique and changes throughout different environments, so the question needs to be continually asked: is it possible for me to beat this market net-of-costs?

Weekend Reads

The usual eclectic mix of topics for your weekend reading. Enjoy!

Other Times Unemployment Has Been This Low, It Hasn’t Ended Well (Wall Street Journal)

The Doctor Is In. Co-Pay? $40,000. (New York Times), part of a series The View From Behind The Velvet Rope

Personality Plays a Bigger Part Than IQ in Financial Success (iris)

Alex Honnold First Person to free solo El Capitan (National Geographic)

How The Most Interesting Man In The World (Dos Equis guy) Met The Most Powerful Man In The World (Obama) (Politico)

New Map Reveals Ships Buried Below San Francisco (National Geographic)

An Introduction to Cryptocurrencies and Blockchains, by yours truly 😉 (Morling Financial Advisors)

Earlier This Week: Are Markets Efficient?

Interactive Map: Unemployment Rate by County (GeoFRED)

Mid-Week Reads: Paris Accord Edition

Despite Trump’s recent withdrawal from the Paris Accord, market forces are driving the world away from fossil fuels and towards renewables. Some mid-week Paris Accord reads:

Why Paris Matters Less Than It Seems (Wall Street Journal)

Coal Isn’t Coming Back, Even With Trump Leaving the Paris Accord (Bloomberg)

India Cancels Mega Plans to Build Coal Power Stations Due to Falling Solar Energy Prices (India Times)

Are Markets Efficient?

Are markets efficient?

A finance professor and his student were walking across campus when they spotted a $20 bill on the ground. The professor advised, “Don’t bother picking that up. If it was real, someone would’ve picked it up already.” The student picks it up anyways and buys himself to a beer.

There are not a lot of $20 bills laying on the ground, but they are found from time to time. That’s the short answer. The long answer is as follows:

The term efficiency is used to connote several different ideas, but the most common one is a concept formalized into the Efficient Markets Hypothesis (EMH) by Eugene Fama, who won a Nobel prize for his work on the subject. The theory basically says that markets allocate capital best and thus value assets best (or “efficiently”). There are 3 forms of the theory:

  • Weak Form: all historical information is priced into an asset’s price.
  • Semi-Strong Form: all historical and public information is incorporated into an asset’s price.
  • Strong Form: all historical, public, and non-public information is Incorporated into an asset’s price.

However, below are some instances when when each of the forms does not hold up.

Strong Form

  • Prices often have material and sustained moves when private information is publicized.
    • Prices often move on earnings announcements or press releases.
    • The uncovering of scandals or fraud impacts prices.
  • I do not know anyone that subscribes to the strong form of the EMH.

Semi-Strong Form

  • Arbitrage opportunities exist fairly frequently. Although not all are actionable due to constraints and costs, enough are:
    • Closed-end funds can trade at extreme premiums and discounts to their underlying NAV.
    • We have seen public companies trading for less than the value of their stakes in other public companies.

Weak Form:

  • Momentum as a risk factor has been shown to offer a return premium.
  • Flash crashes and flash rallies have extreme mean reverting tendencies.

Beyond poking holes in the idea of market efficiency, the above examples represent opportunities for active managers to outperform. Yet, it is difficult for investors to outperform on a consistent basis, which implies (but does not prove) that markets are at least somewhat efficient.

So what can we conclude? That markets are not always efficient, but are probably efficient at least some of the time. This is a very unsatisfying answer, but that is okay because it is unclear whether market efficiency even matters to investors. I’ll explain why in an upcoming post.

P.S. My own view is that markets are generally efficient, although this cannot be proven. I could’ve listed more examples of market inefficiency, but they would not have been robust enough to categorically prove markets are inefficient and stand up to every possible logical critique. On the other hand, data showing that markets are difficult to beat does not prove markets are efficient, but it seems like investors would beat the markets more easily, frequently, and consistently if markets were generally inefficient.

Thus, I believe markets are generally efficient. However, efficiency seems non-existent during certain times (ie. when rationality gets thrown out the window during bubbles and panics) and in specific asset classes (where there are constraints to arbitrage, complexity, due diligence costs, transaction costs, or anything else that makes it difficult to invest easily). So my usual answer to the original question is that markets are generally efficient, but there are episodes and pockets of inefficiency.

Weekend Reads

My best reads of the week:

Active Management Find Favor in Fixed-Income (Institutional Investor)

The Happiness Spending Threshold And What It Really Means To Live Within Your Means (Nerds Eye View)

Some Lessons I Learned from the Dotcom Bubble for the Coming Crypto Bubble (Continuations)

Behind the Scenes at Orchard Platform, a Struggle to Innovate (New York Times)

Mary Meeker’s 2017 internet trends report: All the slides, plus analysis (recode)

Why “Gig Health” Matters (Financial Times)

The Advantage Of Being A Little Underemployed (Collaborative Fund)

Taking to task an industry that bets on children’s lives for an easy profit (Washington Post)

The Work You Do, the Person You Are (New Yorker)

The Curious Case of the Disappearing Nuts (Outside) and Trouble at the top of the world: Bodies recovered at Everest and complaints of stolen oxygen (Washington Post)

Infographic: The Properties of Money

Courtesy of: The Money Project

Market Efficiency, Indexing, and Low Cost Investing vs Active Management

Part of the reason I write is to articulate various frameworks and positions that are in my head. Many people ask me similar questions too, so hopefully I can just refer them to the blog in the future. That being said, I’m going to kick-off a multi-post series on the oft-misunderstood concepts of market efficiency, low-cost investing, index investing and passive management.

Despite the growing popularity of index investing (which I highlighted last week):

  • Active managers still manage the majority of assets under management (AUM).
  • Many investors’ think that they or someone they hire can beat the market.

On the flip side:

  • Many investors’ conflate market efficiency, indexing, low-cost investing, and a host of other concepts.
  • Many passive investors overstate the case for market efficiency and/or index funds.
  • Some investors have a blind faith in market efficiency and/or passive management.

Adding to (or abetting) the confusion is a financial services industry that markets and promotes a wide range of approaches. It can be difficult to find unbiased answers and construct a framework without researching these topics yourself. My goal for the next few posts is to provide some answers in a concise way.

Weekend Reads

A diverse set of reads for the long weekend:

Cutting Off Your Nose to Spite Your Face (Abnormal Returns)

The Psychopath in the Corner Office (Institutional Investor)

Only Robots Can Tally What the Largest US Pension Fund Pays in Fees (Wall Street Journal)

Alone on the Open Road: Truckers Feel Like ‘Throwaway People’ (New York Times)

Veteran big game hunter dies after elephant, felled by gunfire, collapses on him (Washington Post)

Twitter has ‘kicked around’ the idea of offering a premium subscription service (ReCode)

Earlier this week:

Watching the Migration to Index Funds (Thoughtful Finance)