Efficient Markets & Active Portfolio Management

Efficient Markets & Active Portfolio Management Chris Lamoureux, PhD Head of Finance Estes/Neill Professor of Finance University of Arizona Don Seeley's Class August 29, 2003

Efficient Markets Can we use publicly available information to “beat the market?” Note that this question is not: • Are all investors rational? • Are most investors rational? • Do market prices always correctly reflect fundamental values? Don Seeley's Class August 29, 2003

Beating the Market The reason the answer to this question is not self-evident is the enormous “noise-to-signal ratio” in the stock market. Beating the market is a construct that must control for risk. It would result from either or both of: • Timing Skill / Chance • Selection Skill / Chance Don Seeley's Class August 29, 2003

Timing In Sept., 2001, I heard a money manager say: We are not arrogant enough to think that we can time the market. Warren Buffet has said that he doesn’t know anyone who knows anyone who can successfully time the market. Of course, what he also implied is that they are arrogant enough to think that they can beat the market by selecting good stocks. Don Seeley's Class August 29, 2003

Timing 2 In spite of sentiment like this, there is good empirical evidence to suggest that expected returns of major asset categories such as stocks do vary over time in somewhat predictable ways. As an example, stocks generally do better when: • Interest Rates are Low • P/E multiples are low • Dividend Yields are High Don Seeley's Class August 29, 2003

Timing 3 A problem with such historical correlations is that the effects are probably not causal and may reflect changing levels of risk and/or risk premia. Another problem is data availability. Most of what we think we know comes from US stock market 1920 – 2000. Don Seeley's Class August 29, 2003

Stock Picking Presumably an active manager selects a stock because she feels it will: • Itself “beat the market,” and • Be a good portfolio fit with the other holdings. Analysis that suggests that the stock will “beat the market” is either: • Fundamental, or • Technical. Don Seeley's Class August 29, 2003

Fundamental Analysis • Macroeconomic Perspective • Demographic patterns • Interest Rates • Economic Growth • Technology • Tastes • Industry Analysis • Company-Specific Analysis • Management Discussions • Customer Analysis • Technological Assessment Don Seeley's Class August 29, 2003

Company-Specific Analysis Example: Roxbury has the engineer who led the Pentium Pro development team as analyst. He spends half his time on the road interviewing design engineers in the silicon chip industry. Don Seeley's Class August 29, 2003

Analysis Caveats It is not enough to be right. Warren Buffet’s example of the airline industry. The question is competitive forces and how those will affect corporate profits. Furthermore, a key issue is why your “insight” is not already reflected in prices. Healthcare Sector. Virtually every analyst today is bullish on health care. - Aging of America, Inelastic Demand, Good holding in recession , . . . Don Seeley's Class August 29, 2003

Healthcare Example Let’s assume that all that is true, then why would prices not reflect this? The prices presumably do, and also reflect probabilities of increased regulation, increased bargaining power of HMO’s, etc. Don Seeley's Class August 29, 2003

The EvidenceAnnualized Returns, after fees, but not considering loads or taxes Don Seeley's Class August 29, 2003

The EvidenceAnnualized Returns, after fees, but not considering loads or taxes – Only funds that existed when Vanguard started (Aug., 1976) Don Seeley's Class August 29, 2003

Summary No evidence that managed portfolios can beat the market. True for: Mutual Funds, Pension Funds, and individual investors. Although the fee structure of mutual funds implies that they may not attract or properly motivate the top talent. (Contrast to hedge funds, for example.) Don Seeley's Class August 29, 2003

Then Why this Class? Delegated Portfolio Management is a lot more than picking stocks. • Fiduciary Relationship • Solution to Agency Problems at Institutional Level. • Encourage Risk Taking at Retail Level. • Communication with Client – Risk / Posture, etc. • Control and organizational structure • Good analysis is valued – esp. the ability to communicate. (Practical finance is storytelling.) • Appreciate how important systematic forces are. Don Seeley's Class August 29, 2003

Geographic Opportunities At the very least you should ask why or how do I have a comparative advantage in this position relative to the rest of the market. In illiquid / new markets near arbitrage opportunities may exist for short periods of time. Example: Adjusted for risk mutual fund managers earn + 1.84% per year on investments within 100 kms of fund hq. Don Seeley's Class August 29, 2003

Geography of Investment 2 Further, local stocks avoided by manager underperform local stocks held by risk-adjusted 3% per year. Implication: Fund managers have access to “inside information” about local stocks that they exploit to earn abnormal profits. (Recall the original definition of market efficiency involved publicly available information.) Don Seeley's Class August 29, 2003

How to Contact Me. Chris Lamoureux Head of Finance and Estes/Neill Professor of Finance Eller College of Business University of Arizona Tucson, AZ 85721-0108 www.bpa.arizona.edu/~finhome/lam/lamhome.html (520) 751-8339 Don Seeley's Class August 29, 2003

Efficient Markets & Active Portfolio Management