John Kay columnist for the Financial Times had an excellent piece on the virtues and limits of academic finance in the real world of investing. I couldn’t agree more. My comments in italics.
Financial models are no excuse for resting your brain
By John Kay
Published: January 28 2009 02:00 | Last updated: January 28 2009 02:00
US universities have been widely admired in the past two decades for their investment performance. They were early supporters of private equity and hedge funds and the Yale model has attracted interest among sophisticated investors. But Yale reported in December that its endowment had lost a quarter of its value in the preceding six months. Other institutions are in worse straits.
The model seems to be in question. But the idea behind it - that careful diversification can combine good returns with low risk - is as valid as ever. The problem is that some supporters of that approach put too much blame on sophisticated modelling techniques at the expense of their own knowledge and judgment. Banks made the same error in their risk assessments: their value-at-risk models had similar structure and origins to those in portfolio planning.
Quantitative portfolio management relies on measures of correlations between asset classes. These historical correlations are not universal constants but the products of particular economic conditions. Unless you understand the behaviour that produced them, you cannot assess their durability. In 2007-08, assets that had been uncorrelated were strongly correlated and many portfolio managers were surprised when the diversification they sought proved illusory.”
As many have noted, the only thing that goes up in a down market is correlation.
Underlying causal relations had changed, as they frequently do in business. In the new economy bubble of the 1990s, equities roared ahead while property languished. But during 2003-2008, the availability of underpriced credit, followed by its abrupt withdrawal, affected property and shares in similar ways. Anyone in the financial world knew these things: but computers, churning through reams of data, did not.”
Another interesting aspect of financial markets which makes historical data is suspect is that the actions of investors themselves changes the likelihood that past data relationships will continue into the future. Thus the flood of money into hedge funds and private equities created a condition of too much cash chasing too few profitable opportunities. Thus the potential for attractive returns diminished and the asset class behaved more like conventional assets such as equity mutual funds.:
Asset classifications change their meaning. The alternative asset classes that yielded strong returns in the 1990s for Harvard and Yale were hedge funds and private equity. But the increase in the number of hedge funds and the volume of their assets meant that an investment in the sector - once a bet on an individual's idiosyncratic skills - became more similar to a general investment fund. Hedge fund returns were therefore increasingly correlated with those of other investments..
Private equity was once a punt on small entrepreneurs. A manager with good judgment could make money from a few hits in a diversified portfolio. But by 2006 the sheer size of private-equity funds led them to focus on well established businesses. Such investments were a geared play on the stock market. They no longer spread risk: they concentrated it. Worse, many uncorrelated assets appeared uncorrelated in the past only because they were thinly traded and infrequently valued. Pressures to "mark to market" revealed the underlying correlations.
For alternative asset classes such as hedge funds and private equity whatever excess returns might have existed disappeared when adjusted for the risk caused by leverage, the lack of liquidity and the lack of transparency (inability to value the investments in a naccurrate and timely manner). The liquidity risk has come to the fore as hedge funds have erected “gates” invoking clauses in their contract which allow them to suspend client withdrawals and private equity funds have invoked clauses that require investors to provide more capital to the funds The lack of transparency is apparent in the difficulty of both types of managers to value their portfolio. And with the lack of access to credit many are no longer able to use leverage to generate excess returns. In fact when one adjusts for the risk of leverage, the liquidity and transparency issues, it would be difficult to argue that these “alternatives” off an attractive risk/reward profile relative to traditional asset classes.
In contrast to the more exotic “uncorrelated assets” as hedges in a financial crisis, it seems the more traditional assets, particularly government bonds have held up well. Personallay I am not as confident of gold as a hedge..
But, during the credit crunch, traditional forms of diversification have done what they are supposed to do. Gold, trading at about $650 per ounce before the credit crunch, is nearing $850. UK government stocks show a total return of 23 per cent from conventional bonds and 15 per cent from indexed bonds from July 2007 to December 2008: for global sovereign bonds, the sterling returns are 75 per cent and 41 per cent.”
I would add one more example. One of the more consistent “anomalies” in financial market is that “value” stocks provide higher returns that the overall market without a significant increase in risk (as measured by standard deviation). Probably the most common means of screening for value is the use the measure for book to market. The higher reported book value to the market price of the stock the deeper “value” the stock is. Yet large cap value stocks performed dismally in the current crisis.
The reason would be apparent to anyone that turned off the computer and opened the newspaper. If one used reported book to value to screen for value stocks a large number of financial stocks would show up as “value stocks”. Yet the “value” proved illusory, the reported book value kept getting revised downwards. The stock prices were low relative to reported book value because the market was skeptical of the reported book. With each markdown of assets the stock price fell and the financial sttocks had a more “attractive” book to market leaving more of the in the quantitatively generated value portfolio Furthermore the fate of these stocks and their companies is most dependent on factors outside of the financial markets namely the actions of government decision makers (not exactly a risk facor that is easily quantified). The value of equity in these companies could be wiped out or propped up as a result of such decisions.
The consequences of not taking into account the overweighting of vulnerable financials created by the book to market screening were apparent during recent months. For the last six months of 2008 a major index fund using this methodology underperformed the overall market by just under 7%. Yet looking at longer term data the value portfolio outperforms the overall market with only slightly more volatility for 5,10 and 15 years.John Kay’ss conclusions should be taped over the computer screen of everyone working in investing:
“Diversification is a matter of judgment not statistics. A model will tell you only what you have already told the model and can never replace, though it can enhance, an understanding of market psychology and the factors that make for successful business. As a student of finance, I never expected to see the efficient risk-return frontiers I drew on the blackboard feature in PowerPoint presentations to meetings of trustees: or that these trustees would view the numbers that emerged as statements of fact rather than illustrations of possibilities
People who were persuaded by these analyses have been badly hurt. Some will never pay heed to quantitative investment analysis again. Others will place equally blind faith in some new and fanciful construction. Both reactions are mistakes. Financial models are indispensable. So is scepticism in their application.”
John Kay's latest book on finance and investment, The Long and the Short of It, was published on January 20