The Downside Of Academic Finance

by: Cullen Roche

Originally Published June 06, 2016

Max Planck once said that science advances one funeral at a time. In the fields of finance and economics, it seems like we progress one plague at a time. That is, it usually takes decades' worth of testing and evidence to prove that something really doesn't work in the monetary world. So you can have really bad ideas that persist for no good reason other than the fact that we can't disprove them.

I got to thinking about this as I was reading Ben Carlson's superb website "A Wealth of Common Sense."¹ Ben has written a very good post about the upside of academic finance. In short, he says that people (finance people in particular) have a tendency to oversimplify things when they're criticizing academics and Modern Finance. And he's dead right. Modern Finance, which I praise in my new paper on portfolio construction is a superb guide to understanding the most important facts in finance. As I note in the paper, most of the great insights in modern finance have been discovered. The rest of us can only stand on the shoulders of giants and hope to be seen or provide something remotely useful. But that does not mean that these theories or insights are all correct or without limitations. Perhaps, Paul Krugman stated it best when he said:

[an economic model is] a simplification of reality designed to provide useful insight into particular questions.

Precisely! You could say the exact same thing of Modern Finance and its generally useful models of the world. But we also have to understand the limitations of those models. In Dr. Krugman's case, I once argued that he was overstating the efficacy of the IS/LM model. More recently, I've been critical of the Efficient Market Hypothesis and Factor Investing which I think have actually confused investors more than helped.

In fairness, most of the criticism of Modern Finance comes from the high fee active investing community who sells the hope of "market beating" returns in exchange for the guarantee of high fees. They criticize things like the Efficient Market Hypothesis (EMH) because they need to sell the idea that they can beat the market and still charge high fees. I obviously reject that whole notion of trying to "beat the market" and emphasize the importance of low fees. But interestingly, I am also critical of some parts of Modern Finance. Specifically, I'd like to discuss a Burton Malkiel quote that Ben offers:

What efficient markets are associated with which is wrong is that efficient markets mean that the price is always right - that the price is exactly the present value of all of the dividends and the earnings that are gonna come in the future and the price is perfectly right. That's wrong. The price is never right. In fact, prices are always wrong. What's right is that nobody knows for sure whether they're too high or too low. It's not that the prices are always right, it's that it's never clear that they are wrong…the market is very, very difficult to beat.

This is a nice example of something that is not a very useful simplification of reality. The reason is that no one needs to understand the EMH to understand why a more active strategy underperforms a less active strategy. One need only understand William Sharpe's arithmetic of active investing.² That is, the average active investor MUST, by definition, underperform the less active investor because the more active investor generates the average return of the market minus taxes and fees while the less active investor generates the average return of the market minus their LOWER taxes and fees.

This has nothing to do with how "efficient" the market is.² Whether assets are priced correctly or incorrectly does not change the fact that the arithmetic of the markets will still hold. In fact, if there were no frictions at all (no taxes and fees), then active investing wouldn't even be worse than less active investing. The "efficiency" of the market does not explain why the market is hard to beat! Further, the fact that asset prices are consistent with a random walk in the short term does not mean the EMH is right. It just means that asset prices don't follow a predictable pattern.

Now, I admit that I am getting bored in my old age and getting way too granular about my complaints, but I don't have a front porch to sit on with a shotgun taunting my neighbour's children so this forum will have to suffice.³ And I have to object aggressively to the idea that the EMH has any upside at all.4 In fact, I'd argue that it's now causing more confusion than anything else as it propagates the myth of passive investing and promotes the high(er) fee more active uses of factor investing. As a result, we now have high fee hedge fund strategies, high fee momentum trading funds and high fee advisors all passing themselves off as "passive" strategies or academically reviewed "factor" strategies when the reality is that these are nothing more than high fee active strategies that have gained credibility thanks in large part to the downside of Modern Finance.5

Of course, understanding the limitations of a model doesn't mean the basic understandings from those models are wrong. The basic foundations of Modern Finance and portfolio construction are incredibly important. But understanding the limitations of these models will also help you sidestep some of the theoretical land mines that still plague the world of finance.

¹ - I used to repost Ben's posts on Pragcap before I got too busy to do that. I probably should have kept it up as he writes a better blog than I do.

2 - See William Sharpe, The Arithmetic of Active Management.

³ - I imagine this problem will be resolved before I am gone from this Earth.

4 - Yes, that's right. I did argue in this post that multiple Nobel Prize winners use basic models that I think are wrong. I forgive you if you now think I am an arrogant or idiotic turd.

5 - You've gotta love the world we're now in where a hedge fund ETF charging 0.97% per year with 81% annual turnover gets to call itself "passive."