Showing posts with label EMH. Show all posts
Showing posts with label EMH. Show all posts

Sunday, May 29, 2022

Desperately Seeking Alpha

Great investing is generally about taking on the right risks and being compensated properly for risks taken. It is primarily NOT about out trading other investors.  
This is a sister post to Does Active Investing Work in Theory? exploring the two types of active management: alpha seeking and risk-adjusted return matching. The former is the sexy one; for almost all of us the latter is the realistic one. 

Let's make sure when we say "alpha" we all agree on what we are talking about. The term alpha generally means some version of outperformance. Imagine two runners in a 400m race where one finishes half a second ahead of the other. The faster finisher could be said to have .5 seconds of alpha over the opponent. But that is a bit too simplistic. In investing we usually want to know if any apparent outperformance is actually truly outperformance once we consider any inherent differences between competitors including adjusting for risk taken. 

In a fair race there shouldn't be inherent differences in the playing field so to speak. The runners are on the same track travelling at the same time. For investors we don't get such clean, simple comparisons. Even for our runners on an elliptical track the runner on the inside ring will have to start a bit behind the other runner so as to compensate for the less distance of the inner track lane and so the finish line can be a straight line across the track. 

What about risk taken? Pushing the analogy consider if one of the runners was using performance-enhancing drugs. This could be in one of two varieties. In one case they could be banned substances that if caught he would be disqualified. An outside gambler betting on him was taking a greater risk than perhaps he intended. In the other case they could be allowed substances but that have dangerous potential side effects. His risk now is that he runs the race (maybe winning and maybe not) and then suffers a bad health outcome. 

Back to investing, we ideally want to compare the performance of two investors isolating just the set of factors inherent in their investment "skill". I put skill in quotes because we never can be quite sure we are seeing skill or luck or that we have forgotten about an important difference we would have intended to adjust away. 

Most of the time in investing it is risk in its many forms that we want to adjust for. As an example, if I tell you I am a great investor because I have substantially outperformed my S&P 500 benchmark for the past 5 years, you might not be so impressed if I then reveal that it is because my only investment has been the single stock Apple, Inc. Sure, I outperformed in total return, but I took WAY more risk to do so. If that risk adjustment isn't made, we can't say much about this so-called outperformance.

There are other adjustments to consider like if an investor has been using inside information to facilitate his outperformance. The fact that this unethical practice might not be repeatable should make us doubt that this outperformance is replicable. At some point we would have to consider if the inside information advantage was just a different version of luck. 

Alpha seeking in active management is an attempt to outperform the competition, be it other investors or a benchmark index, adjusted for risk. How is this such a daunting task? Don't we hear about great investors all the time doing exactly this? Actually we do not. We hear about some investors' performances when they happen to be outperforming and often that is not true outperformance because they are not risk adjusted. But there is more to say about how difficult this is.

The capital markets (stocks, bonds, etc.) are very efficient markets primarily because they are very thick markets (i.e., there are lots of people participating in them). This is helped by the fact that they are very lucrative to those who perform well in them. The idea that some investors will outperform is a near certainty. The idea that that investor is you or someone you pick to follow is highly unlikely. 

Public capital markets are a ruthless machine viciously and constantly seeking to eliminate any advantage an investor may possess. The more brilliant your new method of discovering and unlocking outperformance, the more quickly and decisively the market will absorb it away from you. And in those cases where apparent persistence in outperformance exists, the more likely a hidden risk difference has yet to be understood.

For active management the sooner one gives up on alpha the happier and more financially successful one will likely be. Instead of trying to outperform adjusted for risk, try to just keep up by taking the right risks. 

A human investor's benchmark isn't a stock index or a bond index or some combination of the two. It is the realistic financial goals they are trying to achieve. These are some combination of consuming well today and being able to consume well tomorrow and for the rest of one's life. For most of us this includes more than ourselves--primarily our family and somewhat our friends and our charitable desires.

Our investment portfolios must be constructed initially and revised regularly to be appropriate for achieving these goals successfully. This is intentionally vague since it isn't something we easily know even for ourselves much less specifically for others. What we can say is that broadly diversified, low-fee investment into marketable securities should help our cause in most cases. 

Hence, the active management of financial assets that I believe desirable for most all investors is simply risk-adjusted return matching. Try to get the market's return adjusted for the risk you want and need to take. Notice two important nuances in that last sentence: the market is more than the stock market and I am framing risk not as something to avoid but rather as something to embrace appropriately. Risk negation isn't a thing. Risk tradeoff is. You are taking and will take risk. PERIOD. 

What risks to take more of and what risks to take less of is the essence of good investing. Being well diversified into low-fee index funds takes care of some of the typical risk factors like concentration risk, market risk, and credit risk, but others persist beyond that first step. In most cases one needs to also consider liquidity risk (being able to use one's financial assets when one needs to), inflation risk (maintaining purchasing power), wipe-out risk (losing so much one is permanently set back to a lower standard of living or truly financially wiped out), bad-discipline risk (letting emotion drive decisions that thwart the long-term plan; this could be the more obvious bailing out at the worst possible moment but also the less obvious overexposure due to complacency or exuberance), and mismatch risk (having an investment portfolio poorly constructed to fit with an investor's specific investment horizon and objectives). These risks push in different directions at different times and with different magnitudes. Active management is a fluid process of balancing and rebalancing risk tradeoffs.

Successful active management is difficult enough before attempting to then add alpha to the objective set. Notice also that attempts at alpha generation might certainly interfere both intentionally and unintentionally with risk management since taking on different risk profiles is both a means and an effect of reaching for alpha.

Leave it up to the professionals to try to generate alpha. You are too smart to lose money they way they do. 

Friday, December 18, 2020

Does Active Investing Work in Theory?

We know active investing almost always doesn't work in practiceThe vast majority of professional money managers underperform their respective index over meaningful periods of time. Let that sink in. Compared to what we could easily do on our own through indexing, most of the people we pay very large sums to invest our money give us back less after they do their job and take their fee. For those few that do, we say they earn alpha--return in excess of the market for the same level of risk taken. 

As a side note realize something. Your Uncle Fred with all the great stock picks or your friend who just quit his job to start day trading and who has actually has been making money trading stocks, bonds, options, or whatever HAS NOT been taking the same level of risk as any index. Those two happen to be winners in a likely random pool of many people taking on tremendously more risk than they realize. If 10,000 people all flip coins ten times in a row, some of them almost certainly will get ten heads in a row (singularly by itself a 1 in 1,024 chance). 

However, I am focused on professionals here. Guys and gals who dress sharp, use all the right jargon, are actually highly intelligent and reasonable, and who most of the time lose money for their clients. Perhaps their clients are buying something else than returns [paging Robin Hanson--investing professionally isn't about making money]. Highly likely in many cases. It feels good to deal with these pros. Plus they can in fact help investors stay disciplined--better to make 5% versus the benchmark's 6% over 10 years than to bail out when the market declines and earn only 1% over that same 10 years. Fortunately for EMH and unfortunately for this theory, this affect has been shrinking to recently be nearly nothing.

So, while active management doesn't work in practice, does it work in theory? Start with the assumption of a manager that can consistently and reliably earn 1% alpha. When her benchmark is up 6%, she is up 7% on average. Why does she need your money? 

I can think of two likely reasons:
  1. She could want to use it to reduce her own risk. 
  2. She could have more opportunity than she can herself realize.
Notice that these are not altruistic motivations. The first is fairly unfavorable for the client--you are giving her money not for your benefit but for hers. She uses the additional funds to smooth out the volatility in her own income. When you pay a management fee to her, you are directly subsidizing her income. And just the use of the funds themselves is an indirect subsidy allowing her to invest more broadly. All of this might be justified if the second reason holds.

In the second she only would invest your money once she has invested all of her own money including all the money she can borrow at less than the total return of the investment, which is the market return plus alpha (6% plus the 1% in this case). Theoretically and in practice she will charge you a small fee to cover transaction cost plus a little profit to her to let you participate in her investing endeavors. Yet as we saw in the first reason she should probably be paying you as you are giving her a benefit of lower risk in the form of a smoother income stream.

Essentially this is an arbitrage which we know is going to have a limited capacity. Even if she is in that elite company of professionals who can outperform the market, her last idea (say the last stock her analysis says to buy) will be her worst idea and only be at best just as good as the market itself. It seems very likely by the time she gets to your money, we are firmly in reason-one (personal risk reduction) territory. 

This is quite damning for professional money management--in theory. What might save it and asset managers like myself who do in fact invest client money with money managers? 

First, we must admit just how challenging it is to find professionals who can outperform the market. Second, we must consider that the first reason above, income-smoothing risk reduction, might actually have a win-win aspect to it. Yes, she does enjoy less risk by using your money, but she doesn't get this for free. In fact she is probably risk averse enough that the second reason doesn't hold firmly.

Rather than fully lever all of her available resources--put her risk at ludicrous speed--she would likely prefer giving you most all of the risk of her performance and collect a steady fee for doing so. She is giving up the potential for return upside so that she has only very little downside risk. This flips the concern from being a pure doesn't-work-in-theory problem to being a pure principal-agent problem. sigh We can't catch a break. Now we have to worry that she isn't incentivized properly to continue to do what we hope she can do--outperform the market at the same level of risk. But at least we partially rescued active management in theory.

As bad as this is (in theory), this is in public market active management. The same forces are at play plaguing private markets like private equity and private debt. At least public markets are not opaque, very hard to benchmark, illiquid, et al.

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.

Sunday, January 20, 2013

The alpha dog don't hunt (maybe)

As a strong proponent of the semi-strong version of the Efficient Market Hypothesis (EMH), I have a bone to pick with the idea of alpha generation. First some terms explained.

Money managers such as mutual fund managers and hedge fund managers operate under the following premise: The attempt to grow investors' money over time. Some managers attempt to outperform the market (active managers) while others just attempt to replicate or stay with the market (passive managers). For this discussion we are only concerned with the investments of active managers. Whether successful or not (and success is a complicated determination as we will see), the investments will have some kind of results. There are two components of those results, alpha and beta.

Answering the last part first, beta is the component of a money manager's results (performance) that is attributable to or describable by the underlying market's results. That is to say someone who simply invests in the stock market will have results just from being invested in the stock market--regardless of the individual decisions that investor makes. A manager or investor who exactly mimicked the results* of the stock market would have a stock market beta equal to 1. One who exactly doubled the stock market's results* would have a beta equal to 2. Keep in mind that these figures apply up and down such that a portfolio with a beta of 2 would expect to have twice the up or down results of the underlying market. Comparing a manager with a beta of 1 to a manager with a beta of 2, we could say that the manger with beta equals 2 is expected to be twice as risky relative to the other manager considering the same underlying market for both.

Alpha on the other hand is the component of a money manager's results (performance) that is in excess or deficiency of the underlying market's results given the risk the manager took on. That is to say someone who simply invests in the stock market will have results just from the individual decisions that investor makes--regardless of the results from just being invested in the stock market. A manager or investor who exactly mimicked the results of the stock market would have a stock market alpha equal to 0% at any given level of beta.

The problems of moving from these theoretical constructs to the real world begin with the fact that if the market is really, really good at identifying, processing, and applying information (that is to say the market is highly efficient), then alpha shouldn't be possible (market participants shouldn't be able to out think the market). Our problems continue once we realize that it is very difficult to look at a money manager's results and separate out alpha and beta. The two get quite confoundedly interwoven for a number of reasons.

For one, when do we stop defining down the proper market comparison (benchmark) for a manager? Suppose he purchased 499 of the 500 stocks in the S&P 500 index in proportion to their weight in that index less the left out stock. Seems reasonable that the S&P 500 would be the proper benchmark. But the stock that gets excluded will make a big difference in how representative the S&P 500 is for his performance. Excluding Apple (currently ~4% of the index) versus excluding AutoNation (currently ~.01% of the index or 1/400 the value of Apple in the index) would have a significantly different effect. Suppose another manager purchased the same 499 stocks as the first but in quite different proportions. Suppose another only purchased 10 of the stocks. Describing all of these managers or any of them as compared to the  S&P 500 might not be a very meaningful description.

Another reason alpha and beta are difficult to separate is that manager process and performance is not always very transparent. This makes finding suitable benchmarks more difficult. We could go on, but the foundation of the problem is already well established. A manager's alpha might just be the beta of a better defined benchmark.

So what to make of the elusive search for alpha? My thought is that the only true alpha is good beta management--perhaps "meta beta"would be the clever term for it. The goal then for a money manager is to achieve a beta appropriate for the investor and opportunistic when and if possible. A beta of .5 would be great in relative down markets but would have an obvious cost of underperformance generally. A beta of 2.5 would be great most of the time but would have the extreme risk of permanently impairing capital some of the time. Opportunistic beta management is dangerously close to market timing, which almost certainly is a fools errand. Yet there may be some ability to capture gains once we consider the position of the individual investor we are attempting to match up with an appropriate beta (e.g., relatively high beta for an investor with no withdrawal needs, a high capital base, a long time horizon, and otherwise high willingness and ability to take on risk).

I look at this, my understanding of and belief (or disbelief) in alpha, as a work in process. I have to reconcile any degree of belief in alpha with any degree of belief in efficient markets. Starting with my assumptions and belief in efficient markets does have a flavor of receiving the answers in advance of asking the questions, but I'll try to keep an open mind. I'll keep thinking . . .

*Mimicking results, doubling results, etc. with regard to beta means both the end result (return) and the path to get there (volatility).