The risk story behind expected profitability

Investors demand higher returns for taking on more risk.  Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market.  The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return.  The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk?  If a company is profitable, wouldn't the market include that information in the price?  To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns.  When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.

All else equal, the market will place a higher relative price on a company with higher expected profitability.  If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A.  Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets.  So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.

The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class.  This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model.  It has now been found that the poor performance of small cap growth companies can be explained by low profitability.  This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.

Original post at pwlcapital.com

High Frequency Trading

The promotion of Michael Lewis' new book has caused a significant amount of discussion in the media around whether or not High Frequency Trading (HFT) causes harm to the integrity of financial markets.  The debate is very interesting.  One argument says that HFT makes markets more efficient and expedites the arbitrage of the occasional inefficiency, while the other says that it is a big scam causing investors to lose out on profits.

With the right investment philosophy, there is no need to be overly concerned by either side of this debate.  The ability of High Frequency Traders to rapidly create small profits using superior technology is not a new phenomena; it is an issue that is generally present when dealing with market orders and order routing.  As an example, an active manager who wants to trade specific securities within a short period time would be affected by these issues.

A market based approach to investing does not require large market orders, and it does not require rapid trade execution. Investing in asset classes rather than the latest hot issue means that individual stocks with the right characteristics become interchangeable parts in a much broader strategy.  The flexibility in this approach eliminates the need for the immediate liquidity that HFT is able to profit from.

Original post at pwlcapital.com

How Hard is it to Beat the Market?

How hard can it really be to beat the market?  If I say that all available information is included in the price of a security, it follows that someone had to act on the available information in order for it to be included in the price.  Someone had to get the information, make a decision to buy or sell the security, and then execute a trade for that information to be included in the price.  So every time someone can be the first to act on new information they must make a profit, right?

In 1945, F.A. Hayek pointed out that there are two types of information:

1. general information that is widely available to all market participants, and
    

2. specific information about particular circumstances of time and place, including the preferences and needs of each unique investor. 

As a pricing mechanism, the market is able to aggregate all information into a single metric.  That metric is the price, and it is constantly influenced by participants competing with each other to be the first to bring information to the market in order to make a profit.  As hard as they try, no single market participant can have the full set of information because new information is being randomly generated constantly.  If someone overhears a conversation between two Apple employees, they are in possession of information that nobody else has; if someone sees an oil tanker sink in the middle of the ocean, they have unique information; if a pension fund manager goes on a site visit to a mine and hears something before everyone else, they have specific information particular to their circumstances – there is an infinite amount of information like this being constantly generated, and due to the nature of the market, people want to use their information to profit.  What does this mean for investors?  It means that all available information can be included in the price of a security without any single provider of information being able to profit from the information that they contributed.

So in short, it’s really really hard to beat the market.

Original post at pwlcapital.com

Risks Worth Taking

Wealth creation takes place when cash flow is steady, there is time to recover losses, and risk is tolerable. 

It's not uncommon for the ability to take risk in the market to be confused with the desire to gamble.  There are some risks worth taking, and some risks that can turn an investment account into a sophisticated platform for placing bets.

Of course, it's a lot of fun to do research and be immersed in the latest information about a company or an industry with the hopes of taking action before the market does.  Consider, though, the amount of other individuals, and more importantly institutions and mutual funds, that are trying to do the same thing.

By the time you read a Bloomberg News headline, the market has already reacted.  By the time the company you're following discovers a new reserve, institutions have already started trading.  The ability of the collective players in the market to price a security as soon as new information develops is intimidating.

It's easy to think that with enough research, it should be possible to outsmart the market by predicting new information before it happens, but new information develops randomly.  If we could predict all new information accurately we wouldn't need the market to create wealth.

So what's a risk worth taking?   It has been proven through years of research that small cap and value stocks produce superior returns over the long term.  Constructing a portfolio tilted toward these asset classes can increase expected returns without relying on speculation.  With these tilts in place, diversifying globally, and across asset classes can almost eliminate non-systematic risk.  You may never make 200% on a speculative bet, but major losses will likewise be reduced.

In creating wealth, the sequence of returns is just as important as the returns themselves.  It's very difficult to beat the long term compounded returns of a robust portfolio with a series of speculative bets.

This may not sound exciting, and it shouldn't.  Well documented research stands behind these remarks - I'm talking about using science to invest, and science is not nearly as exciting as gambling. 

Market Based Investing

In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management.  The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market.  Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time.  It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.

I am happy to disagree with the idea of predictive investment management, but don’t condone the idea of passive investing either. I stand behind a strategy called market based investing.  It is the idea of harnessing what the market has to offer, while taking advantage of asset classes within the market that have been shown over the long term to produce higher returns than the market itself. The idea is to hold the entire market, and then increase the proportion of certain asset classes relative to the market to take advantage of their higher expected returns. Trying to determine which markets would be the best to apply this strategy at any given time would be betraying a scientific approach in favor of prediction. The solution is to build globally diversified portfolios in order to capture the returns of markets around the world while reducing the impact of any single market.

These globally diversified portfolios tilted towards specific asset classes are then rebalanced systematically to eliminate predictive and emotional tendencies as markets move. Implementing this rules-based system ensures that emotions and predictions are removed from investment decisions, and sets a market based portfolio apart from the active vs. passive debate.

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Understanding the Stock Market

Why People Invest

I already explained what a stock is, so I should have the foundation to go ahead and discuss what the stock market is in some detail.

Before I do that, I need to explain why we want to invest in the first place.  In the chart below you can see some different lines.  The ones to focus on for right now are the orange line, which is a representation of a dollar invested in the US stock market, and the light green line, which is a representation of a dollar invested in US treasury bills.  It is obvious that a dollar invested in the stock market will grow more than a dollar invested in a treasury bill, but why is that?  A treasury bill is issued by the US government and is what is referred to as a risk free investment because it is very unlikely that the US government will fail to pay someone holding a treasury bill.  Being invested in the stock market is riskier because you are owning pieces of companies which can go down in price, even go to zero if the company goes bankrupt.  Investors need to be compensated for taking risks when they are investing in companies, otherwise they would only invest in the treasury bills.

The difference in returns between the treasury bills line and the stock market line is called the market premium, or the amount of investment return over and above a risk free investment that can be expected for investing in stocks.  So when you are saving for a long-term goal, it can make sense to invest in stocks because they will give you a higher expected return over time.  The chart below shows the returns of the total US stock market minus the returns of US treasury bills every year from 1927-2012.  On average, the market premium was 8.05%.  This means that on average, being invested in stocks meant that you could expect a return 8.05% higher than the return from being invested in treasury bills.  Notice that the red bars are years where stocks had negative returns; that is the risk of being invested in stocks rather than treasury bills.

The Market

We know stocks are pieces of ownership of companies that allow individuals to partake in the company's growth and losses.  Partaking in the growth and losses of a company by buying an ownership stake is called investing in the company, and investors receive higher expected returns for being invested in companies because of the risk involved.  All of the investors that buy stocks need a place to buy and sell their stocks, and that is where the idea of the stock markets becomes important.  If there was not a stock market, people that wanted to buy and sell stocks would have to find each other manually; it would be like Craigslist for stocks.  Having consolidated public stock exchanges makes it much more certain that a stock will be available to buy when you want to buy, and you will be able to sell when you want to sell.  This makes stocks much more liquid, or much easier to convert back into money.  If stocks became illiquid they would go down in value drastically because people would not be able to convert their ownership in a company into money when they need to.  The integrity of the stock market is a very important part of investing, and there are safeguards built into public exchanges to ensure that the markets remain liquid.  So it's easy enough to understand that the stock market is just a big public marketplace where investors can buy and sell stocks, but what are people talking about when they say the market is up or down?  Or when they talk about beating the market?  There are different stock markets around the world, and within different markets there are different stock exchanges.  So what is the market that people talk about in the media?

To explain this further I need to explain what an index is.

How an Index Works

You might have heard about the S&P 500, or the S&P/TSX Composite.  These are indexes.  An index is a grouping of stocks that has been selected to represent a particular market.  The S&P 500 is one of the best known indexes in the world; it is 500 stocks that have been selected by Standard and Poor's (a financial research company) to represent the US stock market.  When you hear that the S&P 500 is up, it means that the overall value of all of the 500 stocks included in the index is up.  It is important to keep in mind that although the S&P 500 has been selected by the very smart people at Standard and Poor's to represent the US market, it only contains 500 of the largest, most well known companies that are traded on public exchanges in the US; overall, there are about 5000 companies with stock that trades on public exchanges in the US.  One of the major uses of an index like the S&P 500 is benchmarking.  Benchmarking is using the performance of an index as a tool to compare the performance of other groupings of stocks, or individual stocks.  When you invest in a mutual fund, or have a broker tell you that they will build you a portfolio that will beat the market, they are saying that they will pick a stock or a grouping of stocks that is different from their benchmark index that they think will allow your investment to perform better than investing in the companies in the index.  If a fund invests in American companies it will likely use the S&P 500 as a benchmark index, and a fund that invests in Canadian companies will likely use the S&P/TSX Composite as a benchmark index.  The whole idea here is that if someone has the ability to predict which companies within a market will perform well, they can buy those companies instead of buying the companies in the benchmark index so that their fund will perform better than the index.  Now, because there is a lot of research involved in deciding which stocks will do well and which ones will do poorly, there are fees that have to be paid to the investment manager if they are going to try and beat the market for you.

Investing in the Market

You can choose to invest in an index that has been built to represent a given market for a very minimal cost, or you can choose to pay a significant cost to invest in a fund that is going to try and do better than the index.  It is very easy to invest using both of these methods.  You can buy something called an Exchange Traded Fund (ETF) which will track an index, or an index mutual fund which will do the same.  Companies like Vanguard and iShares allow people to invest in an index of their choice for a very low cost; you can choose to invest in the S&P 500 which we know is 500 of the largest companies listed on US exchanges, or the Russell 3000 which is an index that is designed to represent all  of the companies in the US market, or the MSCI EAFE which represents all developed markets outside of the US and Canada, and the possibilities of indexes to invest in go on forever.  Investing in a fund that will try and beat the market is equally easy to do, companies like Fidelity have plenty of different funds with different strategies designed to outperform a given index.  To illustrate the difference in cost of these two strategies, the Vanguard Total Market Index which invests in 3000 American companies designed to represent the total US market costs you .05% of your investment account to hold, and the Fidelity US All Cap fund which is designed to "seek the best in US equity opportunities" costs you 2.4% of your investment account to hold.  Both of these funds allow you to invest in the American market, but one is designed to do whatever the market does, and the other is designed to beat the market.

Remember Efficient Markets?

I write about markets being efficient often.  Remember that if markets are efficient, all available information is included in the price of a stock.  With that in mind, let's look at the idea of trying to pick which stocks will be the best ones to invest in.  The people that are picking the stocks that will be included in a portfolio that is trying to beat the market are using massive amounts of information to make their investment decisions.  These people will know everything that there is to know about a stock before they select a company to invest in.  But think about all information.  That's a lot of information, and there's new information coming out all of the time.  Even if an analyst does know everything about a stock before they buy it, it is impossible to predict all new information, and all new information will be included in the price of the stock as soon as it becomes available to the public.  So, we should try and get information about stocks before the information is public? No.  That is insider trading which is illegal.  Point is, all information is included in the price of a stock, and new information is random, so stock prices are random.  Still want to try and pick the stocks that are going to beat the market?  Good luck.  My opinion is that if you can't beat them, join them.  Indexes are beautiful tools that should be taken advantage of when constructing a portfolio.  Which indexes?  That will have to be another day's post.

The Grossman-Stiglitz Paradox

I have mentioned this paradox before, so I thought it deserved some discussion.  The Grossman-Stiglitz paradox states:

---

1. If markets are efficient and securities' prices reflect all available information and,

2. obtaining information about securities requires resources (time, money)

Then

1. Why do people commit resources to researching securities at all, and

2. if people don't need to commit resources to researching securities, then how did the prices get right to begin with?

---

To me it is a very simple relationship. If there are people that do believe that there are mispricings to be exploited, they will spend their resources to exploit them. It only takes a few mispricings to make people believe that it is possible to find more mispricings. When mispricings do exist, as soon as enough people exploit them, the prices will tend toward their true value. So, markets are efficient because there are a bunch of people out there that don't think that markets are efficient. It becomes an equilibrium situation.

I remember a discussion with a Carleton University finance professor where I asked what would happen if everyone started to buy the index and stopped trying to beat the market. Following our discussion, if everyone started to buy the index, mispricings would start to develop regularly, and arbitrageurs would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. It really all comes back to psychology; nobody wants to accept being average and moving with the market when there are hot shot managers out there that promise to produce double digit returns. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market.

At the end of the day some people will beat the market, sometimes. Statistically, it is very unlikely that anyone will consistently beat the market over a long period of time, and whenever one manager beats the market, another manager must underperform. I love the idea of active management. It is flashy, glamorous, and exciting. Nobody wants to accept being average, but it is far better to be consistently average than to outperform the market one year and underperform the next. Remember how important the effects of compound returns are in building up wealth.

I say let the stock pickers, the gurus, and the hotshot managers try to beat the market. They get to have fun spending their clients' money to make bets and predictions, and they keep the markets efficient for the rest of us.  To look at it another way, it is all of the dollars paid to active fund managers that keep markets efficient - nothing's free, I'm just glad I'm not the one paying for it.