Analysts’ recommendations ‘beat most funds’

From the Financial Times:

Broker stock picks can help investors outperform most mutual funds, research by one of the largest hedge funds has suggested.

While most asset managers have long dismissed analysts’ recommendations as anything but reliable, traders and academics at GLG – the $21.5bn London hedge fund manager – have found otherwise.

Based on a database of the daily recommendations it received from European brokers for the past four years, the hedge fund found that a portfolio following analysts’ tips, and holding them for three months, would outperform 75 per cent of mutual funds.

Such a portfolio delivered annualised returns of between 2.8 per cent and 6.4 per cent above benchmarks and after fees in each of those four years.

GLG said the research was some of the first to be conducted into the value of equity analysts’ calls since the scandals and subsequent reforms that rocked brokerages after the telecoms and tech bubble.

“When you look at the returns the average active manager tries to beat benchmarks by, we think the outperformance of recommendations is reasonably good,” said Sandy Rattray, an asset manager at the fund.

GLG’s findings were based on all the recommendations from salespeople at a range of European brokerages it had received since 2005, based on a single daily “pick” given to the fund from each.

Read the full story here

Is The Market Rational?

This article ran in Fortune in 2002. If you never read it before, you should. If you have read it, it’s worth your time to read it again. It’s written by Justin Fox. He went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. You can read the exchange below. Also, from this article, Justin wrote a recently published book that you should read. It’s called The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”

“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

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Why Is September Bad for Stocks?

From Morningstar Advisor:

The answer to this question lies in Nassim Taleb’s bestseller Fooled by Randomness. If you haven’t read it (you should), let me sum up the book in one sentence: We humans have this amazing ability to see a pattern where there is none.

The three worst stock market crashes all happened in October. Do you see a pattern here? If you do, you are fooled by randomness. A sample size of three signifies nothing statistically. That does not prevent us from associating October with market crashes.

Now that this “pattern” is public knowledge, thanks to the financial media, guess what investors do in September? They sell. That’s why September is the worst month for stocks on average, even worse than the supposedly crash-prone October.

Krugman: How Did Economists Get It So Wrong?

Paul Krugman wrote a lengthy piece in the New York Times Magazine today. It is a very hard critique and analysis of the failure of current macro and financial economic thought, which didn’t even come close to predicting the current financial malaise. I don’t agree with all of it, particularly his love affair with Keynesian economics. But it is still very worthy of your time and a recommended read. A point where I agree with Krugman: the failure of EMH.

Below is an excerpt:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

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Arthur Zeikel “On Thinking”

These are two great quotes from Arthur Zeikel. Read these and truly think about them.

“Thinking, good thinking that is, is a lonely sport.  This may explain why so many of us do it so poorly.  Good thinking is also an inefficient process.  It takes a lot of thinking to come up with those few good, new ideas that are clearly worth thinking about – ideas that can be exploited in the marketplace.  Particularly, as Seldon so accurately noted in 1912, ‘Most coming events cast their shadow before, and it is on that intelligent speculation must be based.’

At the heart of the thinking process is the need to anticipate change correctly, and on a timely basis.  Investment thinkers must develop for themselves a model, or systematic perception, as to how markets really work.  Those believing strongly in the efficient market hypothesis are, of course, relieved of such undertakings.  However, as is becoming increasingly clear, portfolio theory does not fully explain security price movements, either here or abroad, or tell us too much about how to achieve better-than-average performance.  Most practitioners of active money management need to improve their thinking procedures.”

“The consensus view is usually wrong because it’s based on a more-or-less simple extrapolation of past trends and events and does not effectively incorporate change into expectations.  Theory tells us that value-changing events occur in a random fashion and cannot be predicted with any accuracy or consistency.  This is not so.  There is a flow to the news because there is a flow to the events that make the news.  Stock prices begin reflecting new developments before it is generally recognized that these developments have taken place.”

The Single Best Way to Beat the Market

This is a great article on investing by Dr. Scott Brown of Investment U.

For decades, economists and academics have tried to define exactly how the stock market works – and the best way to profit from its moves.

In the 1950s, one argument stated that short-term market activity results in the law of one price – i.e., that buying and selling mispriced shares of the same stock forces a single price to dominate.

Then came the “modern portfolio theory,” which claimed that investors simply couldn’t beat the market averages. This so-called “market efficiency theory” was the impetus behind the formation of the Vanguard 500 Index Fund (NYSE: VFINX) – the world’s largest mutual fund.

Score one for the stuffy “efficiency theorists.”

But while they congratulated each other over brandy and cigars, a little-known professor spoiled the party in the 1980s with a straightforward study that is still the driving force behind one of the most lucrative wealth-building approaches today…

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Fundamental Value Investors: Characteristics and Performance

I came across this interesting working paper from the SSRN. From the first paragraph:

This paper adds to the research on the issue of market efficiency. Rather than developing a quantitative trading rule that may or may not be implementable in the real world, or examining the returns of a broad cross-section of mutual fund managers who presumably have no skill on average, we analyze 2912 hedge fund manager investment recommendations posted to the invite-only internet community, Valueinvestorsclub.com from January 2000 to June 2008. The professionals involved with this exclusive site are paid for performance and must discover inefficiently priced assets and determine if the costs of pursuing them (noise-trader risk, liquidity risk, distress risk, macro risks, trading costs, and so forth) are worth the benefits. We answer a simple question: do the value investors in our sample have stock picking skills?

Read the paper here

John Mauldin on MPT

How Did We Get It So Wrong:

So how did we get it so wrong? How did we get here? Let’s go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We’ve taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, “How many of you believe in the efficient market hypothesis?” Something like two or three raised their hands. “How many of you teach it?” All of them raised their hands.

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it’s not. It’s barely an art form. It’s voodoo. That’s what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it’s about as bloody as sheep entrails. CAPM… poor Harry Markowitz’s Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50^th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, “Oh, you missed the whole concept of correlation and assets. Correlations change.”

And he started drawing quadratic equations in the air. But because I was standing in front of him, he was drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he’s right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes — see what happens? You get long-term positive results.”

And they would project that into the future. But they didn’t project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

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How EMH Has Damaged the Financial Industry

Welcome to the new Along The Margin (AtM). To get things started, the first post is of a most excellent speech by James Montier of Société Générale in London. Here is a sample:

The Efficient Market Hypothesis, according to Shiller, is one of the most remarkable errors in the history of economic thought. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brainwashing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed it. Only two hands stayed up! And we wonder why funds and banks, full of the best and brightest, have made such a mess of things.

Part of the reason is that we have taught economic nonsense to two generations of students. They have come to rely upon models based on assumptions that are absurd on their face. And then they are shocked when the markets deliver them a “hundred-year flood” every 4 years. The models say this should not happen. But do they abandon their models? No, they use them to convince regulators that things should not be changed all that much. And who can argue with a model that was the basis for a Nobel Prize?

Great stuff! You can read the whole speech after the jump…

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