Evidence Based Finance

01/05/2023

Stick with value.
Wait for mean reversion.

This post updates our value spread with data through the end of 2022. The fourth quarter of 2022 saw value recover from the bout of temporary insanity that gripped some portion of the market over the summer, but the spread ends 2022 very much still in rarified territory – at the 94th percentile, t...

01/02/2023

Initial thoughts for 2023:
The US market ended the year about -20%, pretty bad.
Looking historically though, how many negative back to back years has it had since 1928? Only 4.
Great news for us right? Maybe not:

The conditions in those years except for 1939-1941 were all pretty similar. In 1928, 1973, and 2000 the Fed hiked rates into a recession.
While not guaranteed, a recession is widely expected for 2023.

What to do? Stay the course, don’t change what you’re doing. Don’t try to predict the market. Don’t listen to experts because they don’t know either.

09/13/2022

The Evidence Based Investor details 20 years of active management failure:

    By LARRY SWEDROE   Nobel Prize winner Eugene Fama is considered the father of the efficient market hypothesis (EMH), which asserts that financial markets are “informationally efficient” — the result of financial markets processing millions of trades, reflecting the viewpoint of investor...

08/17/2022

The spread between growth and value is back at an all time high and Cliff Asness asks if everyone out there is "Cray Cray".
Any mean reversion between growth and value will continue to be favourable for the evidence based value investor.

This adds another three months of data to the May entry in our series of value spread updates. Over the past two months, some portion of the market went temporarily (I hope) insane, punishing value, as we measure it, to the point where the value spread has retraced most of its modest gains since the...

08/17/2022

Had an opportunity to discuss my philosophy on financial advice, fees, and evidence based investing with Dr Yatin Chadha on his BeyondMD podcast:

‎Show beyond MD with Dr. Yatin Chadha, Ep Evidence Based Investing - Jan 27, 2022

08/16/2022

Part 5: Diversification

Indexes do not always make for optimal portfolios, as they can have heavy weightings in certain sectors. More than half of the market capitalization of the S&P/TSX Composite Index, for example, is in just two sectors, energy and financial services. An actively managed portfolio can diversify away from such concentrations, and can include attractive sectors and securities that are not well represented in the index.

The first point is true, Canada’s market has large weightings in Energy and Financial Services. But do actively managed funds create increased value by diversifying into “attractive sectors and securities that are not well represented in the index”?

This assertion would be easy enough to prove, just provide long term fund returns in Canada.

Unfortunately, Canadian managers have underperformed their benchmarks 84-91% after fees, over the last 10 years. It seems they aren’t finding more attractive sectors and securities than the benchmark.

However, for the first time in their argument for active investing: Recent studies have shown that truly actively managed portfolios tend to outperform. A 2009 paper by Yale finance professors Martijn Cremers and Antti Petajisto concluded that the best-performing funds focus heavily on stock selection, and have high “active share,” a measure that identifies the portion of a portfolio that is different from the benchmark index.

The implication here is that most active managers are trying to just look like the benchmark, when you isolate for “active share” you find that they do tend be a predictor of outperformance.

Although the paper and its methods have been widely panned, Cliff Asness of AQR Capital effectively recreated the study in his own paper “Deactivating Active Share” and found that “for a given benchmark, we did not find reliable evidence that high-active-share funds earn higher returns than low-active-share fund”. While funds with more active share looked and behaved less like the benchmark, there was no ability to predict whether that performance was good or bad. He went on to conclude “that active share does not reliably predict performance and that investors who rely on it to identify skilled managers may reach erroneous conclusions.”

The authors investigate Active Share, a measure meant to determine the level of active management in investment portfolios, and find it wanting.

08/16/2022

Part 4: Asset Allocation market timing

CI claims that “Active managers will respond to changes in the markets and the economic cycle by adjusting the allocation of their portfolios to reduce volatility and improve results. Investors with passive investments are more likely to be missing out on this crucial aspect of investing.“

We know from SPIVA reports that most active funds do not have “improved results” – particularly relative to their benchmark. However, do active funds have reduced volatility? While active management underperformance of returns becomes common knowledge, this claim that active funds provide a smoother, less volatile return has taken hold.

On its face, the claim seems absurd. They are claiming to own fewer stocks, taking on more risk to try to achieve outsized gains, but that, even with more risk, investors should expect less volatility/smoother returns.

S&P researched this claim in their research paper “The Volatility of Active Management” and found that “Over the full sample period, an average of 80% of U.S. funds and 65% of European funds demonstrated greater volatility than their category benchmarks” Their sample period was from 2007-2015, so it included the 2007 &2008 market correction.

08/16/2022

Part 3: Positioned for Opportunity

“Active portfolios can be structured to invest in securities and sectors that offer greater potential growth than the market as a whole. Active managers can add value by identifying and buying companies that are undervalued or out of favour, or those that offer above-average growth prospects.“ - CI asset management

This implies that active managers have sufficient skill to consistently outperform their counterparts and the benchmark. Although the idea makes sense, smart people should be able to find good deals consistently in the stock market… does this work in reality?

In 2010, Eugene Fama (2013 Nobel prize winner for economic sciences) and his colleague Ken French published “Luck vs Skill in the Cross Section of Mutual Fund Returns” which concluded that on average US equity fund managers do not demonstrate evidence of skill. If there were uncommon skill involved in stock picking, you would expect that skill to be demonstrated over a period of time, or it could be perceived as just luck.

S&P do a Persistence Scorecard, that reviews how fund managers perform relative to their peers over time and their ability to stay in the top quartile consistently. Were they able to consistently outperform, it would be a clear sign of skill.

In their 2020 scorecard, S&P research “reinforce the notion that choosing between active funds on the basis of previous outperformance is a misguided strategy. After all, there remains a 98.5% chance that a top-quartile fund will not stay in the top quartile for the next four years.”

S&P Indices

08/16/2022

Part 3: Downside protection

CI states that “during periods of market weakness, active managers can take steps to protect assets within a portfolio by switching to safer more stable investments. Meanwhile, a passive mandate offers no flexibility and is designed to be always fully invested.”

Again this is true, passive funds are designed to be fully invested and you will take the brunt of market downturns. However, active managers CAN take steps to protect and switch to more stable investments. But can they do this reliably and get back in to capture the upside?

Ben Felix of PWL capital summarized the downside protection question like this “while active fund performance is generally very poor on average, it appears to be slightly less poor during bear markets”. He found that in the 11 down markets in the US and Europe from 1973 – 2003, there were only 5 instances where more than 50% of active managers outperformed.

Do they capture the upside after a market downturn though? This must be viewed in a long-term lens and we will review in the next post.

When you watch a magic act, it’s fun to be fooled. Even though we know it’s just a sleight of hand, it’s still entertaining when that torn-up card reappears out of nowhere.

08/16/2022

Part 2: The potential to outperform

CI notes although both have fees “that active management offers the potential to outperform the market benchmark, while a passive portfolio will under-perform the index due to fees and expenses.”

This is true, active management has the potential to outperform. But how often do they outperform a benchmark and can they do it consistently? No.

There are mountains of evidence across all markets that show roughly 20% of funds tend to outperform the benchmark over 10 years, the evidence can be reviewed in my article “The case for passive low cost investing”. Importantly though, this idea is made moot with William Sharpe’s rationale that because fees are so much higher for actively managed funds “the average actively managed dollar must underperform the average passively managed dollar, net of costs.”

Simple math proves the value of low cost index investing over expensive mutual funds.

08/16/2022

Defeating the arguments of active firms
Part 1: Active vs Passive management

I’ve chosen to use the CI Global Asset Management article “How active management makes a difference” for the strong man case for active management. www.ci.com
CI has been managing clients money in Canada since 1965, over 1.3m Canadians invest through them with over $280B in assets under management.
What is passive management?

According to CI.com “With a passive approach, also known as indexing, one invests in a portfolio that seeks to hold all the securities, in the same proportion, as the index, or a representative sample of the securities in the index. The goal is to track the performance of the index, so an investor’s returns will rise and fall with that benchmark. A passive portfolio will own the companies represented in an index regardless of their quality or performance.”

It is passive because there is no manager choosing what to invest in, you invest in everything. It is cheap because there is no need to pay analysts to research companies, pay for transactions to buy and sell stocks, or have corporate investment strategy infrastructure. And it is easy to buy, there are scores of index funds across Canada for every kind of investment need.
What is active management?

This is likely what people think of when they are considering how to manage investments.

Paraphrasing investment management firm CI Investments – with an active approach, portfolio managers follow a process in which they research, analyze, buy and sell securities based on the investment mandate of the portfolio. They will seek to investing in securities that offer the potential for attractive returns and manage the makeup of the overall portfolio through diversification.

There are fees and expenses associated with both passive and active investment. Although passive management is generally 10x cheaper.

CI Global Asset Management partners with financial advisors to offer investors a diverse and comprehensive lineup of Canadian, global and industry funds.

08/16/2022

The theoretical framework for evidence-based investing

The first economic model that seemed to realistically capture what was going on in financial markets was the Capital Asset Pricing Model (CAPM). Proposed by Nobel laureate William Sharpe in 1962, CAPM gave a baseline for how investors could expect to be compensated for taking risk with stocks.

What the CAPM model captured is called “beta” – it is a measure of risk / volatility of a single stock or portfolio compared to the market as a whole. If something is more risky or volatile, it has a beta greater than the market (=1), you would expect a higher return than the market for the risk you take to own it. The other side of that is a portfolio or stock with a beta less than 1, it is considered less risky and you’d expect to get less return than the market for owning it.

It is also helpful in identifying systemic risk and unsystematic risk. Systematic risk is the risk of the entire market moving in one direction together, an example might be 2008, when regardless of the portfolio of stocks you owned and where, you realized a significant correction.

Unsystematic risk is risk or volatility that you can diversify away by owning many different stocks. Unlike systemic risk, which one cannot control, Investors can control how much diversity they take on, so they can take actions to mitigate unsystematic risk.

This model is particularly useful to index investors, who take on maximum diversification to control their market risk.
Efficient market hypothesis (EMH) – The reason you index

In 1970, Eugene Fama, who would be awarded the Nobel Prize in Economic Sciences in 2013, published “Efficient Capital Markets” in the Journal of Finance. It created the basis for the efficient market hypothesis, which in its simplest form, theorizes that asset (stock market) prices reflect all available information, so it is impossible to consistently beat the market.

So with these two facts, the evidence based investor would likely remove all unsystematic risk through maximum diversification and own the entire market.

As the efficient market hypothesis (EMH) was tested, anomalies began to show issues in CAPM’s pricing model for stocks – the model was only explaining about 70% of diversified portfolio returns. In 1993, Fama and his colleague Ken French published, “Common risk factors in the returns on stocks and bonds” – which created the Fama-French 3 factor model for explaining stock returns that was potentially able to be a better explanation of market returns.
Fama-French Factor model – the reason to look beyond market indexes

Using EMH as a basis, Fama and French found that there were stocks with similar characteristics that were showing excess return over time – these are identified as “factors”. This is interesting because if EMH is correct and prices reflect all information, additional returns above the market cannot reliably be achieved by finding mispriced stocks. So how were these groups gaining additional return in their data?

What it posits is that these similar characteristics create groups of more risky assets and for taking additional risk, investors should expect outsized returns. The factors are:

Market Risk – “beta” as explained by CAPM
Size factor – they found that small sized companies tended to perform as a group better than larger companies.
Value – using price-to-book ratio, they found that lower price-to-book ratios tended to perform better as a group than higher price-to-book. Simplified, this means that lower priced companies are considered riskier than higher priced ones, so you should expect greater return long term for owning them.

When you include these factors together, they can explain closer to 90% of diversified portfolio returns, from 70% of just CAPM. They have since gone on to identify two more factors, profitability and investment, that can provide additional explanatory power to the model.
Why does this matter to investors?

It is important to know why you invest the way you do. You invest in broadly geographically diverse low-cost index funds because:

You believe that stock pickers cannot outperform the market, as all information is already incorporated into the price (efficient market hypothesis)
You are looking to capture market returns through broad diversification and are willing to take the risk (beta) to do so. (Capital asset pricing model)

This single factor is relatively easy to capture at a low cost, it is easy for investors to understand -allowing them to do it themselves and maintain the investment strategy over long periods.

The underlying basis for this thesis is very easy for us to understand and we experience it daily, you are betting long term that capitalist companies whose primary goal is to increase shareholder value, will do that overall.

This is where most evidence-based investing stops. The best portfolio tends to be the low-cost one, the one you can understand, and the one you can stick with through good times and bad – and the simplicity of index-based investing will do this for most.

However, the same people that created the framework for us to understand why index investing can provide returns in excess of active managers also identified evidence-based ways for investors to gain additional return above the market – by capturing other independent risk factors.