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«1. Scene setting Content: 1. Scene setting 1 The 300 Club believes that modern portfolio theory and practice are failing institutional 2. How it all ...»

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The Death of Common Sense:

How elegant theories contributed

to the 2008 market collapse

Prof. Amin Rajan

CEO, CREATE-Research Views expressed here are those of the

author, who is solely responsible for any

amin.rajan@create-research.co.uk errors and omissions.

1. Scene setting Content:

1. Scene setting 1 The 300 Club believes that modern portfolio theory and practice are failing institutional

2. How it all began 2 investors at a time when their depressed funding levels and high covenant risks require smarter ways of investing. 3. A dangerous comfort blanket 4 Investor confidence is now at its lowest ebb in living memory. The scale of the losses inflicted by the Lehman collapse in 2008 and the sovereign debt crisis in 2011 are 4. A bullet dodged 7 immediate causes, but confidence had been eroding over the last decade.

5. The moment First and foremost, the buy-and-hold strategy was not working, as equities were of reckoning 9 outperformed by bonds over a long period; second, nor was the barbelling approach, as

6. What’s all this got to do actual returns diverged markedly from expected returns for most asset classes; third, nor was with efficient markets? 11 diversification, as excessive leverage ramped up the correlation between historically lowly correlated asset classes.

7. What next? 13 These fault lines gave investing poor press after the unprecedented scale and speed of selloffs in 2008. The prevailing doom and gloom caused a herd-like rush into passive funds, as armchair pundits projected the here-and-now into the future. Rational debate was conspicuous by its absence. It is time for a sombre stock-take.

The 300 Club aims to up the ante by delivering dispassionate analyses of the problems that our industry faces, and the actions that it needs to take. Accordingly, this is the first paper in a new series. It sets the scene for the subsequent papers.

It aims to:

• Describe the modern portfolio theory which has profoundly influenced the thinking of successive generations of investors and policy makers since the 1960s • Review the empirical evidence produced by independent experts to assess how modern portfolio theory has stood the test of time • Assess the role that modern portfolio theory played in the great financial crash of 2008 • Highlight the subject areas that need to be addressed, if a vibrant investment industry is to emerge from the ashes of the recent meltdown.

Our narrative starts with Harry Markowitz, the pioneer of modern portfolio theory. His famous paper on portfolio selection was a game changer [Markowitz, 1952]. Till then, there was no cogent theory of investment: only rules of thumb and folklore. Investors of 1952 thought the same thoughts and talked the same language as investors a century previously.

2| The 300 Club | The Death of Common Sense | April 2012 Markowitz was the first to make risk the centrepiece of portfolio management. The novelty

of his approach was summed up by his famous insight:

“Investing is a bet on an unknown future… you have to think about risk as well as return”.

He thus inspired the intellectual origin of the two concepts that have since dominated the burgeoning literature on portfolio theory as we know it today: the capital asset pricing model (CAPM) and the efficient markets hypothesis (EMH).

In the CAPM, an investor selects a portfolio at a given time t which produces a return at time t+1. The model assumes that investors are risk averse. When selecting their portfolios, they care only about the mean and variance of their one-period investment return. The model is also called the mean-variance model since investors seek to minimise the variance of portfolio return, given expected return; and maximise the expected return, given variance.

Before long, two other related concepts were invented in the investment landscape: efficient markets and active management. It was argued that by factoring in all known information into prevailing stock prices, an efficient market bears out all the predictions of the CAPM.

Thus, based on a priori reasoning, this argument also inferred that active management adds no value: in an efficient market nobody has an information advantage.

The edifice of modern financial theory is mainly constructed around CAPM and the EMH.

We review the evidence on each in order to show how they contributed to the current financial crisis.

Our review is deliberately detailed: it aims to show how the evolution of the theory over time has side-tracked into trivia and inadvertently missed the big picture of how the financial markets really work.

2. How it all began The CAPM originated from the work of the Nobel Laureate William Sharpe [1970]. He

advanced the idea that each investment contains two distinct risks:

• Systemic risks: as the name implies, these are all-pervasive market risks that cannot be diversified away. They affect investor sentiment directly and market volatility indirectly.

Interest rates, recessions, inflation and wars are examples of factors that affect the price of all securities, notwithstanding their business fundamentals. Diversification is no answer to systemic risks that affect all assets indiscriminately.

• Idiosyncratic risks: these risks, in contrast, are specific to individual stock and can be diversified away as an investor increases the number of stocks in his/her portfolio. As the name implies, it represents the component of a stock’s return that is uncorrelated with general market movements. The only reason why an investor should earn more, on average, by investing in one stock rather than another is that one is riskier than the other.

The CAPM’s starting point is the risk-free rate – typically a yield on a government bond: it is the minimum return that investors expect. However, it goes on to argue that investors in equities also demand an added premium to compensate them for taking the extra risk. This risk premium is derived by calculating the expected return from the market as a whole less the risk-free rate.

–  –  –

In the academic world, CAPM rode high for the best part of two decades with early tests creating a consensus that the model is a good description of the expected returns. Coupled with the model’s simplicity and intuitive appeal, these tests pushed the CAPM to the forefront of financial theory of markets [Fama and French, 2004].

However, these authors also show that since the late 1970s, there has been mounting evidence that the variation in expected return is unrelated to market beta alone. Their exhaustive summary of various studies shows that certain factors ignored by CAPM have a significant role in influencing future returns.

They include:

• Price-earnings ratios • Company size as measured by market capitalisation • Debt-equity ratios that measure leverage • Book-to-market equity ratios.

Fama and French went on to consider whether these seemingly ‘spurious’ results might be the result of data dredging: publication-hungry researchers scouring the same US data on returns and unearthing contradictions that occur in specific samples by chance. However, they dismissed this possibility as these additional factors were also identified as significant in other independent studies, using Japanese and European data.

These other studies also show that CAPM ignores investors’ behavioural biases, they often over-extrapolate past performance resulting in stock prices that are too high for growth firms and too low for distressed firms. When the over-reactions are eventually corrected, value stocks tended to end up with high returns and growth stocks with low returns.

This is a far cry from CAPM’s key premise that investors care only about the mean and variance of distributions of one-period portfolio returns. In two previous papers, Fama and French [1993, 1996] refine the original specification of the CAPM and include two other factors: company size and book-to-market equity ratios.

Later refinements included two more factors. The first was the momentum effect: stocks that do well relative to the market over the previous three to twelve months tend to continue to do well for the next few months [Carhart, 1997]. The second concerned cash flows: stocks that do well relatively also have high expected cash flows.

These and other refinements are a matter of detail. The substantive argument is that CAPM’s two-point inference on active management has been sorely challenged. Namely, that expected returns are solely influenced by market beta and it is impossible to beat the market by developing special insights into company-related factors. Evidence on both these points is weak, at best. Yet, the proponents of CAPM still continue to reject active management by its a priori assumptions.

For them, the centrality of trade-off between risk and expected return continues to infuse all investment decisions. Even alpha is defined as returns above or below what the CAPM predicts. The twin notions, that the market is hard to beat and investors are rational, are now conventional wisdom, even among those who declare they know how to outperform.

As Fama and French conclude [2004]:

“The CAPM, like Markowitz’s portfolio model on which it is built, is nevertheless a theoretical tour de force. Despite its seductive simplicity, the CAPM’s empirical problems invalidate its applications.” 4| The 300 Club | The Death of Common Sense | April 2012 Bernstein [2007] sums it up succinctly by stating that the situation is identical to what Louis Menand, the Pulitzer Prize-winner, had to say about Freud’s famous tract, Civilisation

and Its Discontents:

“The grounds have been entirely eroded for whatever authority it once enjoyed as an ultimate account of the way things are, but we can no longer understand the way things are without taking it into account.” Much the same observation can be made about CAPM’s intellectual twin: the efficient markets hypothesis, a deceptively simple notion that has become a lightning rod for its disciples and opponents alike.

3. A dangerous comfort blanket Despite numerous modifications, the basic thrust of the EMH has not changed much since

the Nobel Laureate Paul Samuelson first proposed it:

• Individual investors form expectations rationally • Expectations are based on all available information • Markets aggregate information efficiently and • Equilibrium prices incorporate all information.

In a seminal article [Samuelson, 1965], he argued that prices fully reflect all available information. In an efficient market, price changes cannot be predicted with any realistic degree of accuracy, since they already incorporate the information and expectations of all market participants.

The underlying idea is that in a large, active marketplace for publicly traded securities, vigorous competition among thousands of investors will drive speculative profits to zero. To the extent that speculative trading is costly, speculation must be a loser’s game.

On this argument, passives are bound to beat actives that seek to exploit mispriced assets relative to a risk-adjusted benchmark, since the invisible hand of the market works faster than any single investor.

Samuelson’s concept of informational efficiency has a Zen-like counterintuitive flavour [Lo, 2004]. The more efficient the market, the more random are the price changes generated by it. In the extreme case of efficiency, price changes are totally random.

The implications are clear. If prices are unforeseeable, then:

• Their future direction is random • They follow a bell curve distribution • They nullify active management.

Until the EMH was subjected to a battery of empirical tests, the received wisdom was simple: when new information emerges, the news spreads very quickly and is instantly incorporated into the price of securities.

–  –  –

Unsurprisingly, the hypothesis is linked with the concept of a ‘random walk’ in the finance literature to caricature a price series where all subsequent price changes display arbitrary departures from previous prices.

On this argument, the price of a financial asset always reflects all available information relevant to its value. Deviations from equilibrium value cannot last long. Investors with information on under-valued assets will drive up their prices and make money in the short term. Beating the market in the long run is a fool’s game. Markets are omnipotent. Active management doesn’t work.

This belief has spawned today’s $4 trillion index fund industry. While the history of the Dow Jones Industrial Average dates back to 1896, it is worth emphasizing that this index was simply a market proxy, not an investment idea. The earliest indices were not created to evaluate manager performance, but to provide a representative outcome for the stock market as a whole.

However, as technology developed to recreate market portfolios and observers noted that fewer managers were beating their benchmarks, enterprising asset managers saw an opportunity to deliver market representative returns at rock-bottom costs. As indices proliferated, the EMH became a de facto investment strategy in its own right [Sahai and Poor, 2011].

So widespread was the acceptance of the EMH that another Nobel Laureate [William Sharpe, 1991], had no hesitation in brandishing its detractors as being wholly economical

with the truth:

“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.” But with the 2008 market meltdown, the knives were out.

Writing for The Washington Post in June 2009, financial journalist and best-selling author

Roger Lowenstein pulled no punches:

“The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient market hypothesis.” In a similar vein, writing in his quarterly letter in January 2009, Jeremy Grantham, a highly

respected money manager at GMO, said:

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