Investing Expertise

Can analysts, experts and gurus really give you an investing/trading edge? Should you track the advice of as many as possible? Are there ways to tell good ones from bad ones? Recent research indicates that the average “expert” has little to offer individual investors/traders. Finding exceptional advisers is no easier than identifying outperforming stocks. Indiscriminately seeking the output of as many experts as possible is a waste of time. Learning what makes a good expert accurate is worthwhile.

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Debating Active Share as Fund Performance Predictor

“Measuring the Level and Persistence of Active Fund Management” (pro) and “Fund Activeness Predicts Performance?” (con) summarize debate on the ability of Active Share, how much portfolio holdings differ from a benchmark index, to predict mutual fund performance. The authors of the con paper summarized in the latter (principals of AQR Capital Management) assert that “neither theory nor data justify the expectation that Active Share might help investors improve their returns.” In his June 2015 paper entitled “AQR in Wonderland: Down the Rabbit Hole of ‘Deactivating Active Share’ (and Back Out Again?)”, Martijn Cremers rejoins the debate by examining the methodology and motives of the con paper. Using data on active U.S. equity mutual funds from the original research, and holdings/performance data for seven AQR Capital Management funds offered to retail investors that concentrate in U.S. stocks as available through December 2014, he finds that: Keep Reading

AAII Stock Screens

A reader asked: “The American Association of Individual Investors (AAII) has a lot of strategies they have been paper-trading over many years at Stock Screens. It seems like every strategy builds upon a well-known investing book or otherwise publicized strategy from the last 40 years. Have you ever done an evaluation of those performance results?” According to AAII: “These approaches run the full spectrum, from those that are value-based to those that focus primarily on growth. Some approaches are geared toward large-company stocks, while others uncover micro-sized firms. Most fall somewhere in the middle.” AAII provides performance histories, risk-return statistics and characteristics for all screens. AAII cautions that: “The impact of factors such as commissions, bid-ask spreads, cash dividends, time-slippage (time between the initial decision to buy a stock and the actual purchase) and taxes is not considered.” Using monthly returns and turnovers for the equally weighted portfolios generated by the available 63 screens during January 1998 through May 2015 (209 months), along with contemporaneous returns for SPDR S&P 500 (SPY), Vanguard Small Cap Index Fund (NAESX) and Vanguard Total Stock Market Index Fund (VTSMX), we find that: Keep Reading

Active Investment Managers and Market Timing

Do active investment managers as a group successfully time the stock market? The National Association of Active Investment Managers (NAAIM) is an association of registered investment advisors. “NAAIM member firms who are active money managers are asked each week to provide a number which represents their overall equity exposure at the market close on a specific day of the week, currently Wednesdays. Responses can vary widely [200% Leveraged Short; 100% Fully Short; 0% (100% Cash or Hedged to Market Neutral); 100% Fully Invested; 200% Leveraged Long]. Responses are tallied and averaged to provide the average long (or short) position or all NAAIM managers, as a group [NAAIM Exposure Index].” Using historical weekly survey data and weekly Wednesday-to-Wednesday dividend-adjusted returns for SPDR S&P 500 (SPY) over the period July 2006 through June 2015 (460 surveys), we find that: Keep Reading

Competitive Market Perspective on Fund Manager Skill

Do any mutual funds reliably generate significant alpha and, if so, do fund investors receive this alpha? In their June 2015 paper entitled “Active Managers Are Skilled”, Jonathan Berk and Jules Van Binsbergen examine interactions among equity mutual fund gross alpha, assets under management, fees and net alpha. To measure a practical gross alpha, they benchmark active mutual fund gross performance against an historical best-fit linear combination of net returns from contemporaneously available Vanguard funds. To account for the effects of mutual fund size, they measure monthly dollar value added by the fund manager as gross alpha times assets under management. This approach accounts for competition among funds, whereby investors chase an outperforming fund until its alpha drops to zero. They then estimate fund manager skill as average monthly valued added divided by the standard error of the monthly value added series. Using gross monthly returns and fees for a broad survivorship bias-free sample of of active equity mutual funds and net monthly returns for Vanguard mutual funds during January 1977 through March 2011, they find that: Keep Reading

Real-world Equity Fund Performance Benchmarks

Do equity style mutual funds look more attractive when benchmarked to matched style stock indexes than to more theoretical factor models of stock returns? In their April 2015 paper entitled “On Luck versus Skill When Performance Benchmarks are Style-Consistent”, Andrew Mason, Sam Agyei-Ampomah, Andrew Clare and Steve Thomas compare alphas for U.S. equity style mutual funds as calculated with conventional factor models and as calculated with matched Russell style indexes. The factor models they consider are the 1-factor capital asset pricing model (CAPM), the Fama-French 3-factor model (market, size, book-to-market) and the Carhart 4-factor model (adding momentum). They consider both value (net asset value)-weighted and equal-weighted portfolios of mutual funds. They also perform simulations to control for differences in the precision of alpha estimates due to differences in fund sample sizes. Using monthly gross and net returns and equity styles for 2,384 surviving and dead U.S. diversified equity funds, and returns for Russell equity style indexes and market/size/value/momentum factors, during January 1990 through December 2011, they find that: Keep Reading

Fund Activeness Predicts Performance?

Are mutual fund managers whose holdings deviate most from their benchmarks the best performers? In their April 2015 paper entitled “Deactivating Active Share”, Andrea Frazzini, Jacques Friedman and Lukasz Pomorski investigate whether Active Share is a reliable indicator of future mutual fund performance. Active Share measures the distance between a portfolio and its benchmark, ranging from zero for a portfolio that is identical to its benchmark to one for a portfolio with no holdings in common with its benchmark. They consider both theoretical arguments and empirical analysis, with the latter focused on disentangling Active Share and benchmark effects. Using holdings and performance data for actively managed U.S. equity mutual funds during 1980 through 2009, they find that: Keep Reading

Can Investors Outsmart Smart Beta ETFs?

Do smart beta exchange-traded funds (ETF), which systematically tilt holdings to capture one or more factor premiums (such as size, value, momentum, quality, beta and volatility), offer net value to investors? In the April 2015 initial draft of his paper entitled “How Smart are ‘Smart Beta’ ETFs? Analysis of Relative Performance and Factor Timing”, Denys Glushkov assesses whether smart beta funds beat their benchmarks and whether they effectively time targeted factor premiums. After categorizing smart beta ETFs into 15 portfolios based on factor themes and weighted by fund capitalizations (rebalanced monthly), he evaluates performance of these portfolios versus three types of benchmarks: (1) passive benchmarks chosen by the ETF providers, capitalization-weighted within 15 matching portfolios (rebalanced monthly to corresponding smart beta ETF weights); (2) risk-adjusted versions of these self-declared benchmarks; and, (3) tradable capitalization-weighted blends of market, value and size funds, matched to smart beta ETF portfolios based on inception dates (rebalanced annually to original weights). The blended benchmark addresses the concern that the returns of self-declared benchmarks are realistic/gross of reformation costs and tests whether smart beta funds add value to a simple and relatively passive capitalization-weighted portfolio with size and value tilts. Using monthly returns for 164 U.S. equity smart beta ETFs and 49 distinct benchmarks during 2003 through 2014, and detailed historical holdings of most of these funds, he finds that: Keep Reading

Incorporating the Experience of the Financial Crisis

How should financial education incorporate the experience of the 2007-2009 financial crisis? In their May 2014 publication entitled Investment Management: A Science to Teach or an Art fo Learn?, Frank Fabozzi, Sergio Focardi and Caroline Jonas summarize the current approach to teaching finance theory and examine post-crisis criticisms and defenses of this approach via review of textbooks and studies and through interviews with finance professors, asset managers and other market players. Based on these sources, they conclude that: Keep Reading

Exploiting Unusual Changes in Hedge Fund Holdings and Short Interest

Can investors exploit the combination of unusual changes in hedge fund long positions and unusual changes in short interest for individual stocks? In the February 2015 version of their paper entitled “Arbitrage Trading: The Long and the Short of It”, Yong Chen, Zhi Da and Dayong Huang examine the power of three variables to predict stock returns:

  1. Abnormal hedge fund holdings (AHF), the current quarter aggregate hedge fund long positions in a stock divided by the total shares outstanding minus the average of this ratio over the four prior quarters.
  2. Abnormal short interest (ASR), the current quarter short interest in a stock divided by the total number of shares outstanding minus the average of this ratio over the four prior quarters.
  3. The difference between AHF and ASR as a measure of imbalance in hedge fund trading.

They also examine how AHFSR interacts with ten widely used stock return predictors: book-to-market ratio; gross profitability; operating profit; momentum; market capitalization; asset growth; investment growth; net stock issuance; accruals; and, net operating assets. To measure the effectiveness of each predictor, they each quarter rank stocks into fifths (quintiles) based on the predictor and then calculate the difference in average gross excess (relative to the risk-free rate) returns of extreme quintiles. Using quarterly hedge fund SEC Form 13F filings and short interest data for a broad sample of U.S. stocks (excluding small and low-priced stocks), along with data required to compute stock return predictors and risk factors for these stocks, during 1990 through 2012, they find that: Keep Reading

Exploiting Interaction of Hedge Fund Holdings and Short Interest

Do changes in hedge fund holdings and short interest in a stock together predict its returns? In their January 2015 paper entitled “Short Selling Meets Hedge Fund 13F: An Anatomy of Informed Demand”, Yawen Jiao, Massimo Massa and Hong Zhang test whether joint changes in aggregate hedge fund holdings and short interest of a stock relate to its future returns. They define a contemporaneous increase (decrease) in aggregate hedge fund holdings and decrease (increase) in short interest as indicative of informed long (short) demand for a stock. They relate informed demand to abnormal return, the return of the stock relative to that of its style benchmark based on size, book-to-market and prior-period return. Using size/value characteristics, monthly returns, quarterly short interest and holdings from quarterly SEC Form 13F filings of 1,397 hedge funds for 5,357 U.S. stocks during 2000 through 2012, they find that: Keep Reading

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