Sunday, May 11, 2014

Adding Value to Investment Management

I've clumsily touched on this before.

I believe active investment management (e.g., being a stock picker who is aiming to outperform the market) is actually just a proxy for risk exposure--dialing up or down one's exposure to market risk. Consider the market price discovery process as a game whereby success is rewarded, poor performance is punished, and market knowledge increases even if average participant knowledge and skill does not.

For example, consider people betting on football games. The bets placed are on which team will win and by how many points in a given matchup. As people make their guesses over the course of many games and over time, the good guessers are rewarded with more resources while the bad guessers are punished encouraging or forcing them to exit the market. The average guess is the market price, the best estimate of future results. The market's knowledge increases along two dimensions: as more people make guesses, more information is incorporated into the price; additionally, as results come in, the better guessers dominate the guessing. This is a simple illustration of the wisdom of crowds. Yet as a new participant starts making guesses, there is no way to know what his guesses will look like or if they will be more accurate than the average guess. Paradoxically, these new guesses will very likely be less accurate than the market's estimates but their addition to the market will add to the market's accuracy. How does this paradox hold?

Imagine the market estimate is for OU to beat Texas by 10 points. A new bettor comes into the market betting that OU will beat Texas by 17 points. Let's assume that subsequently the market estimate adjusts to OU will beat Texas by 11 points. OU then does beat Texas by 12 points. The market was more accurate than the new guesser, but the new guesser improved the market's accuracy. I contend the specifics of this example are a good representation of new information incorporated into the market. It didn't have to be that the new guesser was less accurate and still accretive to the market estimate. To be clear that is my argument.

Thus, the market price is a random walk (we can't predict the direction or magnitude of the next change in price) with a drift--a drift towards greater accuracy. Active managers are attempting to be smarter than the market. However, the market is pretty darn smart, like +99% smart--meaning that is how close the market generally gets to accuracy (being as accurate as one could be at a given point in time). How confident are we these managers can add to that and why would we think they could, over time, across hundreds of securities at any one point in time? Even if there is a persistent flow of "dumb money" flowing in to the system, why should these managers be in any position to consistently pluck it off? It is very doubtful they would be, and if they were, why is the dumb money so willing to put itself in such a position? We can tell stories here to hypothesize about why, but inherently there is a tension between those stories and the underlying market process that makes those stories necessary--if the market is getting smarter, then the new money must be getting dumber to allow for smart money to be smart (i.e., smarter than the market). But then how can the market be getting smarter???

Active management is risky arbitrage at best. Here is what I mean: imagine I see that the price of rice in Japan is $550 per ton while the price in the U.S. is only $450 per ton and total shipping costs average about $50 per ton. A riskless arbitrage would be if I could instantly buy rice in the U.S. market and sell rice in the Japanese market at the prevailing prices less the shipping cost. Let's say I explore that option but find it is not available. The next best thing is to physically buy rice in the U.S., rent a ship, steam over to Japan, sell the rice . . . then . . . profit. Turns out when I get there they won't let me sell it. Or they will let me sell it but only with a hefty $100 per ton tariff charge. Oh, and the ship might sink before I get there. What I have engaged in is a risky arbitrage. My ignorance of Japanese tariffs or my bad fortune on the high seas means my attempts to beat the market on pricing rice were in vain.

I was operating somewhat in the dark in my rice arbitrage, and more knowledge would have been helpful. Alas, overwhelmingly most knowledge is hidden. Market participants, even the brilliant ones, can never be certain they even have the sign on the price discrepancy right. To wit from our analogy, the price of rice in Japan might be LOWER than the world price once all opportunity costs including risk are considered.

This puts active management in a new light. It isn't an attempt to deliver above-market returns. It is an attempt to deliver more risky or less risky market performance--it could be either case depending on the manager. Modern portfolio theory simplifies the world and says investors achieve this by borrowing or lending at the risk-free rate and then increasing or decreasing respectively their exposure to THE market portfolio. Perhaps active management is a real-world facilitator to achieve these ends.

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