ECON 422A: FINANCE AND INVESTMENTS LECTURE 10: EXPECTATIONS AND THE INFORMATIONAL CONTENT OF SECURITY PRICES Mu-Jeung Yang Winter 2016 c 2016 Mu-Jeung Yang
OUTLINE FOR TODAY I) Informational Efficiency: Neoclasscial vs. Behavioral Economics II) Performance of Mutual Funds
Informational Efficiency: Neoclasscial vs. Behavioral Economics
INFORMATIONAL EFFICIENCY: THE ISSUES Informational Efficiency: the degree to which security prices reflect available information on assets. Why informational efficiency matters: Asset prices determine risk-compensation and insurance premia, determining costs for households from insuring against (labor income) risk and providing for retirement. Asset prices determine the allocation of capital, so informational efficiency matters for the allocation of capital and hence the economy-wide productivity.
NEOCLASSICAL ECONOMICS Rational Expectations: investors make correct guesses on average", i.e. if they make forecasting errors, they are not systematic. Example: investors look at past data from an environment that does not change too much and extrapolate into the future. They will be correct on average as they apply the LLN. Expected Utility: given correct expectations or probabilities from the LLN, investors use state-utility functions to weights good vs. bad states.
EFFICIENT MARKET HYPOTHESIS Efficient Market Hypothesis: security prices reflect all current information" on the payoffs, risk and other characteristics of the asset. Weak EMH: current information" includes past price information and all available historical information. Semi-Strong EMH: current information" includes publicly available financial statements, forecasts etc. Strong EMH: current information" includes all information that any person can have, including insider information.
BEHAVIORAL ECONOMICS Larry Summers: There are idiots out there. Look around!" Information Processing Biases: Memory bias: overweight of recent observations. Example: Tech stocks in the 2000s. Overconfidence: tendency of decision makers to overestimate the precision of their guesses and own forecasting abilities. Barber and Odean (2001) document that single men trade too actively on their accounts and realize lower returns on their portfolio than women, due to transaction costs. Representativeness-Bias: tendency to extrapolate from few observations Risk Evaluation Biases: Framing: how a risky investment is presented to you matters Regret Avoidance: loosing on unconventional investments induces more disutility. DeBondt and Thaler (1987) argue that high book-to-market value firm are out of favor" and can be considered unconventional investments. Similarily, small firms might be considered relatively unknown are therefore unconventional...
TWO IMPOSSIBILITY PROPOSITIONS Impossibility of complete informational inefficiency: In the presence of at least some rational traders, markets cannot be perfectly timed. Suppose you know an asset price increases tomorrow, then rational traders will start buying today so prices already rise today and not tomorrow. Impossibility of complete informational efficiency: Suppose publicly observable asset prices already would incorporate all information. Then if information-acquisition is costly, no trader would have any incentive to research the asset. But then information about the asset would not be incorporated into its price. Bottomline: real markets have some (major) rational traders who operate under costly information acquisition. There must be some rents on the table, the question is whether these are purely temporary and larger than the cost of information acquisition!
Performance of Mutual Funds
FUND PERFORMANCE AND EFFICIENT MARKETS: BASIC ISSUES Types of equity funds you can invest your money in: Active Portfolio Allocation Strategies: managers actively trade in the market with your money using all types of strategies, including market timing, technical analysis, fundamental analysis etc. You pay a fee for the money manager s services. Passive Portfolio Allocation Strategies: portfolio composition is typically pinned down by a benchmark index like the S&P 500 and only changes if index composition changes. Claim: if the Behavioral Approach to Finance works better, we should see the results by seeing that active portfolio managers easily outperformed passive strategies by exploiting the idiots that Larry Summers referred to.
DOES PREDICTABILITY IMPLY INFORMATIONAL INEFFICIENCY? CAPM is an example for predictability: high Beta stocks outperform low Beta stocks. Does this imply markets are not efficient? No! Returns are higher in response to higher common risk! Now if you know that high beta stocks are predicted to go up, why don t people just borrow money and buy high-beta stocks to time the market? Remember: if people buy, then higher stock price today P t would lower capital gains P t+1 P t, lower returns and therefore destroy the forecasted higher return. Answer: With that investment, risk people take is also increasing! This prevents people from buying stocks in large amounts, even as they know that returns will be high!
BENCHMARKING Fama: Market Efficiency means that deviations from equilibrium expected returns are unpredictable based on currently available information. But equilibrium expected returns can vary through time in a predictable way, which means price changes need not be entirely random." Should a portfolio manager who earns high returns because he buys high beta stocks be considered a skillful investor? No! Anybody can generate high returns by taking on more common risk! Consequence: CAPM predicts that mutual funds should be compared to the performance of the market portfolio!
ACTIVE MANAGEMENT Many mutual funds report very high returns compared to the market portfolio: do active managers deserve their fees? With an average of 2.5 % of returns, management fees are very high! Over a typical lifetime investment horizon (30-40 years), this is means that 80% of compounding returns ends up in the hands of money managers! When in our financial system essentially money managers, marketers of investment products and stock brokers put up zero percent of the capital and assume zero percent of the risk, yet receive fully 80% of the return, something has gone terribly wrong (...) John Bogle, Vanguard
BENCHMARKING WITH THE MARKET PORTFOLIO: IMPACT OF FEES
BENCHMARKING WITH THE MARKET PORTFOLIO: POST-FEE RETURNS IGNORING SURVIVORSHIP BIAS
BENCHMARKING WITH THE MARKET PORTFOLIO: SURVIVORSHIP BIAS Fund category Benchmark Index Percent outperformed All Domestic Equity S&P 1500 60.6% All Large-Cap Funds S&P 500 60.8% All Mid-Cap Funds S&P Mid-Cap 400 77.2% All Small-Cap Funds S&P Small-Cap 600 66.5% All Multi-Cap Funds S&P Small Cap 1500 61.9% Global Funds S&P Global 1200 60.0% International Funds S&P 700 88.6% Emerging Market Funds S&P/IFCI Composite 90.0% TABLE : Fraction of US equity funds outperformed by benchmark, taking survivorship bias into account. Source: Malkiel (2010)
BENCHMARKING WITH THE MARKET PORTFOLIO: PERSISTENCE Fund Type AAR, 70s AAR, 80s Top 20 Equity Funds, 70s +19.0% +11.1% Average of all equity funds +10.4% +11.7% TABLE : Top performers of 70s vs. market proxy. Source: Malkiel (2010) Fund Type AAR, 80s AAR, 90s Top 20 Equity Funds, 80s +18.0% +13.7% S&P 500 Index Fund +14.1% +14.9% TABLE : Top performers of 80s vs. market proxy. Source: Malkiel (2010) Fund Type AAR, 90s AAR 00s Top 20 Equity Funds, 90s +18.0% 2.2% S&P 500 Index Fund +14.9% 0.9% TABLE : Top performers of 90s vs. market proxy. Source: Malkiel (2010)
CONCLUSION: WARREN BUFFETT AND HEDGE FUNDS This lecture concludes our discussion of risk premia. Bottomline: you should get systematic reward for taking risk. Anything else is random and temporary profits. This is the heart of informational efficiency. Informational efficiency looks pretty much alive and kicking, despite numerous obituaries over the years. Two groups of people who are still not convinced: Hedge Funds and Warren Buffett. For you to think about: is the persistent performance of Warren Buffett a counterexample to market efficiency? Hedge Funds claim to generate Alpha by trading market neutral", i.e. make profits in up and down markets. To evaluate this claim one needs to understand derivatives markets better...