Examination of the rapidly growing “quant funds” (mutual funds based on quantitative analysis).
Highlights
A capacity audience came to hear Richard Weil, CEO of Janus Capital and former COO of Pimco, deliver the keynote dinner address. Weil emphasized five current challenges for security analysis. First, relative valuation must be done in a global context, as investors continue to broaden their search beyond domestic assets. Second, equity analysts must pay more attention to a company's capital structure. Third, the increasing impact of government policies on firms in different countries and industries requires analysts to forecast those policies and their likely impacts. Fourth, the trend toward increased asset price volatility induces a need to trade more frequently; those used to buy-and-hold strategies need to adjust to this reality. Fifth, the "fat-tails" present in returns distributions necessitate careful analysis of investors' cumulative return shortfalls, and portfolio strategies to control the downside risk.
He also made several points of interest to all active fund managers. Historically, active fund management beat indexing more often during down markets than during bull markets. There is promise in some parts of the fixed income universe, but the muni space is probably not one of them. He foresaw more state and local asset sales to improve fiscal situations, much as Chicago has done. In response to a question concerning his own management thrusts, Weil succinctly summarized two: a need to become more global in orientation, and the pursuit of additional operating efficiencies.
Panel: Are Conventional Finance Doctrines Relevant for Investors
Jamie Cornehlsen, CIO of Dunn Warren Investment Advisors and an officer of CFA Colorado, moderated a wide-ranging panel discussion of the relevance of finance dogma for the coming years. Wendy Pirie, Director of Curricular Projects for the CFA Institute, reviewed both the process for creating and the content of the CFA Candidate Body of Knowledge (CBOK). The CBOK is designed to incorporate "best practices" in content and pedagogy, using a conservative design approach to help prevent current fads or other topical material from replacing tried-and-true subjects. Still, there is a required reading devoted to the subject of market efficiency, that does incorporate largely empirical findings about seemingly anomalous properties of returns, as well as insights from behavioral finance.
Download Pirie Presentation
David Merkel, author of the well-known Aleph Blog, started by noting that many have cited the down market associated with the financial crisis as evidence that the Efficient Markets Hypotheses (EMH) no longer applies. While Merkel is not convinced by arguments advanced by those pundits, he does believe that many investors are too slow to react to useful information and may hang on to losing positions too long and that institutional investors may turn down good ideas that are not in accord with current practices (e.g. acting on a herd mentality). He cited numerous financial anomalies -- some of which were explored later in this conference -- as evidence that conventional finance dogma needs to be modified. He asserted that many quantitatively-oriented hedge and mutual funds employ statistical factor models (that aren't grounded in conventional finance dogma) to guide their portfolio strategies. As a result, they find similar return factors, and employ similar strategies (e.g. momentum-based). As their collective efforts exhaust the abnormal returns to be earned, the funds tend to employ more leverage to continue the party, which leads to further saturation. As returns go south, they start liquidating positions, creating further downward movement in a viscious cycle of mass selling-driven losses driving more selling and losses. Hence the attempt to exploit anomalies eventually sows the seeds of its own destruction, in accord with the implication of a conjecture that financial markets evolve toward efficiency in any event.
Download Merkel Presentation
Sebastien Page, a PIMCO Executive VP who heads the client analytics group, presented a summary of PIMCO's own statistical factor model and how it is used to derive their portfolio strategy. He noted that these strategies will still generate returns with a fat left-hand tail, i.e. a much higher probability of disaster than would be calculated under the conventional bell-shaped (i.e. Gaussian) assumption about return distributions. Because such disasters may wipe out a decade of otherwise solid returns, Page advocated the use of derivatives to control that downside risk, despite their cost.
Download Page Presentation
Richard Long, Manager of Investment Strategies for Contango Capital Advisors, stressed the difficulties of advising long-term investors who were scared by the aftermath of the financial crisis. While customers aren't always right, their opinions must be respected by advisors who hope to continue serving them.
The Use and Interpretation of Investment Anomalies
In accord with the conference theme, two talks explored statistical findings for implementable investment strategies that appear -- at least at first glance -- to contradict implications of the EMH. Iowa State Prof. Travis Sapp provided advice for mutual fund investors seeking to exploit momentum-type effects, i.e. buy funds that had unusually high returns when compared to other funds. For example, rank funds in order of their cumulative returns over the last 6 months, invest in the top 10% of those, and hold them for periods up to a year. A different but correlated strategy is to rank funds in accord with nearness to their respective 12 month high net asset values. He presented historical statistics indicating that both raw and risk-adjusted returns to such strategies would have been pretty good.
Download Sapp Presentation
This theme was extended by Ronan Heaney, Senior VP and Director of Research for Westpeak Global Advisors. Heaney summarized the aforementioned momentum stock anomaly as well as the venerable value stock anomaly (i.e. buy stocks with relatively high book-to-market ratios). Heaney found that these two strategies' returns have historically been negatively correlated. Applying the conventional reasoning that favors diversification, Heaney advocated investing in a diversified portfolio of two index portfolios constructed by Westpeak, one based on momentum and the other based on value. Not surprisingly, historical statistics indicate that this would have performed well in the past.
Download Heaney Presentation
In the best academic tradition, Prof. Tarun Chordia of Emory University put these sorts of strategies under the magnifying lens of a skeptic. First, he reproduced many of the statistical findings in support of anomaly portfolios. But then he turned to a detailed examination of the individual stocks that account for much of those portfolios' abnormal performance. He found that had many anomaly researchers excluded stocks with low S&P ratings (BBB- or below), they would not have found abnormally high historical returns. This is largely due to what happens to those stocks' returns in the months before and after ratings downgrades. For example, returns of these low-rated stocks tend to be negative prior to downgrades, and rise thereafter. Portfolios will do well if formed in a way that shorts low-rated stocks while they continue to drift downward, and buys them while they continue to rebound from downgrades. This is what some proposed momentum strategies will unintentionally do as a side-effect of their compositional rules that ignored ratings. Because stocks rated BBB- or below comprise less than 10% of the total market capitalization, those strategies' good performance would vanish if large amounts of investor capital were shifted into them, much as would happen to some proposed microcap strategies.
Keynote Luncheon Address: Chester Spatt
Well-respected (and liked!) Prof. Chester Spatt, Director of the Center for Financial Markets at Carnegie Mellon University, described his perspective as an academic who served a term as Chief Economist and Director of the SEC's Office of Economic Analysis.
Prof. Spatt argued that a core weakness in SEC rulemaking is the weakness of the cost-benefit analyses used to support its regulatory proposals and rulings. In part because the SEC is lawyer-driven, these analyses are not always done in accord with the best principles devised by academic economists. He elucidated some of those principles: regulators should devise clear "rules of the game" for market participants, and then stick to them in order to build credibility that is currently lacking. Such rules should duly consider and adjust for the natural conflicts of interest inherent among important players (e.g. ratings agencies). An additional impediment to imposing even well-founded regulation is regulated firms' ability to "shop" for regulators by either lobbying to change the regulatory authority or by choice of jurisdiction (e.g. incorporating in another country). In light of all this and the practical difficulties inherent in applying principles advocated by academic economists, Spatt holds that the SEC should make more use of sunset provisions that would force ex-post examinations of regulations' effects.
Download Spatt Presentation