index investing

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Book review: Finding Alpha: The Search for Alpha When Risk and Return Break Down by Eric Falkenstein.

This book presents mostly convincing arguments that refute the basic principle of CAPM that riskier investments are rewarded with higher returns, and the relation between risk and returns is better explained by modeling investors as wanting high returns relative to other investors rather than high absolute returns. But the quality of the arguments is quite variable. Much of the book assumes a good understanding of finance theory. If you don’t understand the importance of a Sharpe ratio, you’re not in his target audience.

I was not convinced by his most heavily emphasized empirical claim, that returns on equities are unrelated to beta because controlling for size eliminates the apparent relation. There’s enough connection between size and risk that this raises many questions he doesn’t answer (e.g. JB Berk, A critique of size-related anomalies). But later on he devotes a chapter to a wide variety of evidence that overcomes these concerns, and somewhat supports his claim that for riskier investments, the correlation between risk and return is negative (for the safest investments, it’s positive). And the authoritative Fama and French paper has more convincing evidence about beta – even without controlling for size, the correlation between beta and returns vanished during the 1963 to 1990 period.

He claims that the equity risk premium is effectively zero for a typical investor. His attempt to add up the different adjustments is confusing. He concludes with a table showing size adjustments to that standard estimate that add up to a mind-boggling 15 percent, which would result in a “premium” of -9 percent or so. But adding them is clearly wrong – the tax adjustment assumes the absence of some of the other adjustments. Still, the arguments he assembles from other researchers imply a good chance that the sign of the equity risk premium varies with the time period over which it’s measured.

He suggests some strategies to invest more wisely as a result of the ideas he presents, which he aptly summarizes as “selling hope relative to the market” (i.e. treating volatile stocks as overpriced due to a hope premium). But claiming this produces “superior returns, with less risk however measured” is too strong. Financial risk is not the only relevant measure of risk. Following his advice has social risks that he hints at elsewhere. Being invested in boring stocks in a bubble impairs your ability to engage in some interesting conversations, and you won’t make up for that by mentioning how you outperform the market in times when other want to avoid remembering their investments. Is it possible to minimize both kinds of risks by investing token amounts in ways that trendy folks are talking about, and investing most of your money to maximize your Sharpe ratio? Or does that require too much cognitive dissonance?

The book encourages pessimism, especially about the effects of people wanting relative wealth, and makes disturbing claims such as “Envy is necessary for compassion”.

He provides a number of other good ideas about investing, such as the possibility that the internet bubble adds a big anomaly to many data sets used for backtesting.

I just noticed some confused arguments between Jeremy Siegel and Standard and Poors over how to aggregate earnings for companies in a stock index to produce a meaningful report of what the companies in the index earned.
See here and here.

Siegel provides an example involving percent changes in Exxon-Mobil and Jones Apparel. But that has a weak resemblance to what S&P is doing. A more accurate analogy to what S&P is doing would use changes to market cap rather than percent changes. If Jones Apparel declined in market cap by $10 billion, it would hurt the index just as badly as a $10 billion decline in Exxon-Mobil’s market cap. Looked at that way, S&P’s approach looks sensible.

But since Jones Apparel has a market cap of less than $1 billion, the current bankruptcy laws make it far-fetched that Jones Apparel could lose more than $1 billion in market cap.

If you’re using earnings as a proxy for the health of the economy, S&P’s method doesn’t create a problem – the bankruptcy laws affect who loses money, but the money is still lost. But for an investor, Siegel has a point which is half right.

Siegel’s solution of weighting earnings by market cap may work well under any realistic conditions, but has no sensible theory behind it, and can fail badly under some far-fetched conditions. Imagine that Jones Apparel reports an unexpected one-time windfall of $1 trillion, which ought to raise the market cap of Jones Apparel by about $1 trillion. The way S&P computes S&P 500 earnings, an investor looking at S&P 500 earnings would see a strong hint that the value of the S&P 500 ought to rise by about $1 trillion. But under Siegel’s method, the initial effect on S&P 500 earnings would suggest a barely noticeable rise in the value of the S&P 500 of under $1 billion. Then at some point the Jones Apparel market cap would soar and the S&P 500 earnings would be recomputed with much different weights and investors would see a much different picture. So Siegel has proposed something which could result in a potentially large change in reported S&P 500 earnings without any change in the what shares someone who invests in the S&P 500 holds and without any changes in reported earnings.

Morningstar has a method (PDF) designed for evaluating portfolios that uses a harmonic weighted average and ignores companies with negative earnings. That has advantages, but the magnitude of losses provides some hints about how far a company is from profitability, so an ideal method should pay some attention to losses.

Siegel mentions comments by Shiller that suggest Shiller has better (but possibly impractical) ideas. I doubt Shiller’s analysis provides as much support for Siegel’s argument as Siegel claims.

Any sensible investor looks at a multi-year average of earnings along the lines suggested by Shiller, which minimizes the problems associated with faulty weighting of earnings.

For those investors who (unlike me) can’t afford to do fundamental analysis on a large number of companies (and if you can’t afford to analyze thousands of companies, you’re probably using a questionable method to select which ones to analyze), there’s a new class of ETFs which sounds like fixes some of the worst problems with typical stock funds.
Most people invest in funds that are based on a capitalization weighted index, which means that any time there’s a bubble affecting some of the stocks in the index, the fund is buying those stocks at the peak. The more popular those funds are, the easier it is to create bubbles in the stocks they buy.
There’s a new ETF (symbol PRF) that weights its holdings on dividends instead, which will sell stocks that are affected by bubbles (except in the unusual case where the company increases its dividend in step with the bubble).
The Political Calculations blog mentions similar strategies which appear to work about as well (the dividend weighting selects against small immature companies, and it ought to be possible to avoid that).
Weighting on revenues sounds like it works well, although it overweights retailers and underweights successful pharmaceutical companies and oil producers that find cheap sources of oil.
Weighting on the number of employees should work (although that underweights companies that outsource).
I’m somewhat partial to weighting on book value, but instead of the standard book value, I’d use tangible book value plus an estimate of amortized R&D expenses.
Shorting the 5 or 10 companies with the largest market capitalizations would probably be a good way to invest a modest portion of a portfolio in a way that would reduce risk and improve returns.
These strategies do have the potential to underperform if they becomes as popular as buying and holding S&P 500 funds was around 2000, but it will take some time to become that trendy, and even if it does there will probably still be funds using unpopular versions of fundamental weighting that will remain good investments.

Book Review: Unconventional Success : A Fundamental Approach to Personal Investment by David F. Swensen
This book provides some good advice on how an amateur investor can avoid sub-par results with a modest amount of work. It starts by describing why good asset allocation rules should be the primary concern of the typical person.
I found this quote especially wise: “While hot stocks and brilliant timing make wonderful cocktail party chatter, the conversation-stopping policy portfolio proves far more important to investment success.” Fortunately for those of us who make a living exploiting the mispricing of fad-chasing investors, the most valuable points of this book aren’t in the kind of sound bite that will make them popular at cocktail parties.
But even if you choose investment ideas for cocktail party conversation rather than for building wealth, you should be able to find some value in his explanations of how to avoid being ripped off by fund salesmen and why ETFs are better than most mutual funds.
His attacks on the mutual fund industry are filled with redundant vitriol that may cause some readers to quit in the middle. If you do so, don’t miss table 11.3, which gives an excellent list of ETFs that most investors should use. I was surprised at how much I learned about the differences between good and bad ETFs from this book.
His arguments against investing in foreign bond funds are weak. I suspect he overestimates the degree to which foreign equities diversify exposure to currency risks.
He advises investing more in U.S. equities than in equities of the rest of the world combined, even though his reasoning implies more diversification would be better. But I’ve been slow enough to diversify my own investments this way that I guess I can’t fault him too severely.
He has a plausible claim that not-for-profit organizations that provide investment vehicles on average treat customers more fairly than for-profit funds do, he goes overboard when he claims not-for-profits have no conflict of interest. The desires for job security and large salaries create incentives that would cause many investors to be fleeced if they switched to not-for-profits without becoming more vigilant than they have been.
His faith in the U.S. government is even more naive. He says “U.S. Treasury Inflation-Protected Securities, which provide ironclad assurance against inflation-induced asset erosion”, “Treasury … bondholders face no risk of default”, and “The interests of Treasury bond investors and the U.S. government prove to be better aligned than the interests of corporate bond investors and corporate issuers. The government sees little reason to disfavor bondholders.” But a close look at the CPI shows that indexing to it provides very imperfect inflation protection (e.g. its focus on rents hides the effects of rising home prices), and the current reckless spending policies combined with large foreign holdings of U.S. bonds can hardly avoid creating a motive for future politicians to inflate wildly or default.