Friday, October 29, 2010

What do Finance Professors talk about at conferences?

Here are a few links to a series of posts by FinanceProfessor which provide nice little summaries of some papers that he found interesting at the recent Financial Management Association conference in New York.   They provide a nice insight into some of the current research topics and also go some way to answering the question "so what do Finance academics do research on?"

First list here, part 2 here, part 3, part 4 and part 5

Good stuff.

Tuesday, October 26, 2010


I was in NYC for the Financial Management Association's annual meetings last week and I snapped this pic of the Nasdaq marketsite on Times Square.   Keepin' it classy NASDAQ!

TIPs selling off negative yields

So the big news in the world of TIPS (inflation protected bonds) is that they are selling off a negative yield.  To be clear, this is the real return, not the nominal return on these instruments.  The view is that investors are willing to accept a negative real return in exchange for at least some inflation protection.
My colleague, Steve Allen expands upon this...

HT: Mike (one of my students)

Tuesday, October 19, 2010

Twitter predicting the stock market? I doubt it.

A recent paper by some computer science folks at Indiana finds that the mood on twitter can predict movements in the Dow Jones Industrial Average.  The paper argues that this is evidence against the efficient markets hypothesis (EMH).

Lets take a look at a few potential criticisms that I have of the paper.
1. The paper argues that
"First, numerous studies show that stock market prices do not follow a random walk and can indeed to some degree be predicted ... thereby calling into question EMH’s basic assumptions"
Out of the papers that are cited to support this, only one (#8) is actually published in a journal that I have heard of and that paper is referring to thinly trading stocks.  Journal quality matters and it matters a whole lot when we are looking at such a fundamental theory as the EMH.  If the authors had cited numerous studies from leading finance journals, then they would have been on solid ground.  The fact that they didn't speaks very loudly.  This is either shoddy authorship, or the work of someone who just doesn't understand the subject.  The evidence for the EMH is very, very strong. 

2. The paper claims that there is evidence of online chatter predicting other things.
"Recent research suggests that news may be unpredictable but that very early indicators can be extracted from online social media (blogs, Twitter feeds, etc) to predict changes in various economic and commercial indicators. This may conceivably also be the case for the stock market. For example, [11] shows how online chat activity predicts book sales. [12] uses assessments of blog sentiment to predict movie sales."
Again, the authors demonstrate their complete lack of understanding of the EMH hypothesis.   There is no surprise that online buzz is related to movie sales.  The EMH states that you cannot use publicly available information to earn a profit above the risk adjusted rate of return.   It doesn't say you can't predict how well a movie would do.

3. There is a long list of things that are supposed to predict the market, that include: super bowl winners, hemlines and sunspots.  In all cases, these are confusing correlation with causation.

4. The paper doesn't do an out of sample test.  Any trading rule that is found to be revealed in past data must be then tested in new data.

5. The paper ignores trading costs.  What are the potential returns that could be earned by trading on this information?  What are the costs of implementing the strategy?

6. The results could be driven by a few events.   For example, because the markets are not open on weekends and if bad news originated on the weekend and then was twittered (tweated?) over the weekend, it would appear that you could predict returns.  However, because the markets are closed, there is no way that the bad news could be impounded in to prices.  Thus the illusion of predictably would be created.  There is evidence that in 2008 a lot of bad news happened on the weekends.

7.  Finally, let's just assume for a minute that these authors had found a way to reliably predict the Dow 30 using publicly available information, and could do so and make a profit.  By publishing this information, they basically rule out any chance of making massive profits from their research.   

Unfortunately, this paper is on the verge of going viral.  A google search of "can twitter predict the stock market" yields 348,000 hits.  However, a search of "can justin bieber predict the stock market" yields 968,000 hits.  No doubt, it will be picked up and written about in numerous news outlets (see my earlier post on how well journalists understand finance).

Thursday, October 14, 2010

State pension fund return assumptions...part deux.

recently posted about the return assumptions used by state pension funds.  Most seem to use around 8% which seemed a bit high.  In order to back out the expected return on equities that an 8% overall return implies, you have to make an assumption about the asset allocation of the fund.   My colleague, Doug Pearce kindly provided Federal Flow of Funds data which shows the actual composition of state pension funds (in aggregate).  This data is here.  The state fund data is item L119.  I took the liberty of putting the data in the graph below.  (Note the 2010 data is for the second quarter).

We can see that on average, states had about 70% of their allocation in stocks.   Going back to my original analysis, if we assume an 8% expected return on the portfolio and 3.9% risk free rate, we can solve for the expected return on the equity part.

8% = R(TBond)*wbond + R(Equity)*wequity

8% = 3.9*0.3 + R(Equity)*0.7
Solve for the R(Equity) = (8 - 3.9*0.3)/0.7 = 9.75%

An assumption of a 10% return for equities seems more reasonable and roughly in line with the back of the envelope calculation I did last week.   But it doesn't end there.

Another colleague, Robert Clark (who does research in this area) suggested I take a look at the work of Joshua Rauh.   Josh Rauh is a Professor at Northwestern who has written several excellent papers on the whole topic of state pension funds.   In particular, his piece (with Robert Novy-Marx) in the Journal of Economic Perspectives is very readable and highly recommended.   I've linked here to a version on his website.

Novy-Marx and Rauh paint a grim picture of state pensions.  First, they point out that an asset allocation that is 70% equities is far too risky.   Remember that we are talking about an 8% expected return here.   The big word is "expected".   In finance, an expected return means that on average we might expect to earn 8%, but we also expect a wide range of other possibilities.   For large stocks in the US this range could easily be +/- 20% for 2/3 of the time.   Of course, it is argued by many that in the long run, stocks should earn their expected return even if there are short term ups and downs in the market.  But Novy-Marx and Rauh argue that the duration (average maturity) of pension fund liabilities is about 15 years.   Considering that we are in year 11 of a flat market, this means that many funds need the next 4 years to be pretty spectacular to make that 8% average.

Second, and perhaps even more disturbing, is that state pension funds use their assumed expected return to present value the liabilities of the fund.   This makes no sense as the liabilities are virtually risk free to the extent that the state has promised to pay them and is unlikely to renege.  This is more than a mere accounting artifact, as by using a too high discount rate, states are, in effect, undervaluing their pension liabilities.  They are making what they owe look much smaller.

Novy-Marx and Rauh attempt to quantify how much state pension funds are underfunded just based on the use of the wrong discount rate.  The results are quite shocking.  They estimate that the liabilities of state funds to be about $5.17 trillion as of the end of 2008 compared to the $1.94 trillion in actual assets. Thus there is a funding shortfall of $3.23 trillion.  This equates to a short fall of about $161,500 per plan participant.

Finally, the authors point out that just because personal retirement accounts might hold a high level of equities doesn't mean that state pension funds should do the same.  A state pension fund has to meet the clearly defined annuity obligations to its participants.   A personal retirement account (like a 401-k) is really just a means on transferring wealth through time.  Although it is worth noting that Zvi Bodie strongly advocates very heavy allocations to risk free securities in personal pension portfolios also.

The conclusion?  States, and taxpayers are in trouble.  No doubt we'll keep kicking this massive debt down the road, but it isn't going to go away.

Footnote to North Carolina residents - our state pension fund is in better shape than most.  For one, they only use a 7.25% return assumption.

Wednesday, October 13, 2010

Taleb "sue the nobel prize committee"

The author of "Black Swan", Nassim Taleb, says that investors should sue the Nobel Prize committee for legitimizing the work of Markowitz, Miller and Sharpe.  Taleb made his name by arguing that standard portfolio theory understates the likelihood of severe events.  He's clearly got a flair for garnering publicity, but I really think his 15 minutes are up.

I've posted on Talib before.

In other news, Taleb is planning to sue the estate of the Wright Brothers for losses incurred because of airplane crashes.

Tuesday, October 12, 2010

An ancient tale with no empirical support.

Fama and French answer the question:
"Some researchers argue that a market timing strategy based on buy/sell signals generated by a 50- or 200-day moving average offers a more appealing combination of risk and return than a buy-and-hold approach. What is your view?"

Economic Misconceptions

The marginal revolution blog has an interesting post about students' misconceptions about economic theory.  The comments following are also pretty interesting.

Wednesday, October 6, 2010

So what happened to that TARP money?

My colleague, Steve Allen, blogs that the $700bn paid out for TARP has mostly been paid back.  It looks like we won't see much of the $300 bn paid to Fannie and Freddie though.  

We're also waiting to see how much the GM IPO will raise.  Recent reports indicate that it might not go as well as had been hoped...

Nobel Prize Predictions has a prediction market for who will win the Nobel prize in economics.  Notably the top two are Richard Thaler and Robert Shiller who are both behavioral economists.  

The ipredict market is basically a betting market where you can buy a contract on Thaler for about 33 cents which will pay a $1 if Thaler wins.

I won't even get into the issue of the efficiency of the market that is predicting a win by an opponent of efficient markets.

Tuesday, October 5, 2010

Investing in Gold

From time to time I get asked by students whether people should invest in gold.   The obvious attraction is that it has seen huge price appreciation.  The huge negative is that it is very risky.   Here's a nice article the briefly summarizes some of the arguments for and against gold.

Link via Greg Mankiw's blog.

Monday, October 4, 2010

The AP doesn't know what a value weighted index is.

I've pretty much come to the conclusion that most journalists who write about finance don't really know much about finance.  That's because they have degrees in journalism, so they know lots about ... (I'll figure that bit out later).

Anyhow, consider this gem from the AP.

As soon as the total value of the company's shares edges above Exxon's, Apple will take over the top spot in the Standard and Poor's 500, the market index used by most professional money managers.
That means that billions of dollars invested in funds that track the index will have to shift their holdings to reflect Apple's new weighting. Exxon, meanwhile, may see its share price fall from the same effect. That slide could be accelerated by hedge funds and technical traders who make bets based on the rebalancing of major indexes and would be primed to short the shares of Exxon.

This is, of course, completely and utterly untrue.  The S&P 500 is a value weighted index.  If you hold the stocks in it, their weights in your portfolio will adjust at exactly the same rate as the weights in the index.  That's the beauty of a value weighted approach.

Note to finance students.  Don't believe all that you read on the interwebs.

Note to would be finance journalists:  Take some finance classes.

HT: Felix.