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Wesley R. Gray, Ph.D. has studied and been an active participant in financial markets throughout his career. After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and... More
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Alpha Architect
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Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors
  • Beware Fees And Tax Inefficiency

    Everyone knows there is no such thing as a free lunch, but in investing you often have to pay for a lot more than just lunch, and the lunch you get may not be what you expected. In particular, the fees associated with the investment management process tend to be high, making it hard to beat a passive market index, and the product you receive is almost inevitably highly tax inefficient, making after-tax market outperformance even less likely.

    The game of financial intermediation begins with framing. Consider how fees are framed by money managers: fees are expressed as a percentage of assets under management. Take an actively managed stock fund with an annual expenses on the order of 1.5% of assets under management (the so-called "expense ratio"). At first glance, this may not seem like a large number. Yet, if we scale such fees against a rate of return earned, they can appear dramatically higher. If your return is, say, 5% (and in a world of ultra-low yields that's not bad), then a 1.5% fee is a full 30% of the return generated. Intuitively, to us anyway, that seems like an excessive portion of what may be a generous estimate for near-term stock market returns. In fact, Wes mentioned to me a while ago that his retirement plan offered the PIMCO bond fund at 70 basis points for the fixed income option. The yield on the fund was around 100 basic points, which means 70% of the return was eaten by fees. Aye, carumba!

    Taking a step back, what is it exactly that you are buying for this 1.5% fee? The answer, at least for most people, is that you are paying to outperform the market. But in order to even match the market, the active manager has to therefore outperform the market by 1.5%. Is that easy to do, or hard to do? Here's a back of the envelope perspective. A recent Morningstar study tracked 682 actively managed funds in the large cap, value/growth blend category over a 10-year period, and calculated the standard deviation of returns at 1.52%. This is practically identical to our typical 1.5% fee. This suggests that a fund must generate performance that is a full standard deviation above the mean in order to match the market, and the standard normal distribution suggests that about 84% of funds will fall below this threshold, meaning 16%, or about one out of six, will match or exceed this one-sigma figure. One out of six. Think about rolling a dice and coming up with a six. You never get one when you need it, right? So investors are paying this 1.5% fee in order to get exposure to this longshot 1 in 6 chance they will beat the market. That's just nuts. The vast majority of investors will lose this bet. But wait, it gets worse. We are just considering the expense ratio - we could also assess the effects of taxes, as well as trading commissions, which are not reflected in the expense ratio.

    First, there are taxes - federal, state, and local. Turnover generates a return-killing blend of long and short-term realized capital gains. It is safe to say that the average actively managed fund is highly tax inefficient, and the higher the rate of turnover, the greater the tax inefficiency. Second, all the trading involved while turning over the portfolio 2X per year also increases the costs of managing the fund through trading and transaction costs. The SEC does not currently require commissions to be factored into expense ratios, but the numbers can be comparable, with commissions/impact/spread costs totaling 100+ basis points per year, or more.

    Another related category of expense that can be reflected in commissions: the particularly odious "soft dollars," which involve hidden costs. Soft dollars are payments made by means other than the payment of "hard" dollars (cash). A quick example will make the point. Let's say your money manager wants five new Bloomberg terminals. One way for him to get them is to simply pay for them himself, out of the fees he is charging you. But we know he doesn't want to do that, since he would rather buy himself a Porsche. A second way is for him to pay for them, and expense them to you directly. But he doesn't like that option either, since you might object. Therefore another attractive way for him to proceed is to make an opaque soft dollar arrangement with his brokerage firm. It works like this. He says to the brokerage, "I will direct all of my trading to your firm over the next six months, if in return you let me use five of your Bloomberg terminals." The manager gets the Bloomberg terminals, and the broker gets a bunch of trading commissions that more than offset the cost of the terminals, and the investor loses-a Wall Street Love Story in the making.

    Again, if the money manager pays cash, there is an entry on the books, and the manager has to either a) pay for the terminals himself, or b) disclose and expense them out to the investors. In this example, if the manger uses soft dollars, he can avoid disclosure, and simply pay by directing business to his broker or paying slightly higher commissions. The bottom line? The new Bloomberg expense gets buried in trading costs, and the investor foots the bill even though they can't directly see it.

    Then there are sales charges, with initial, deferred and redemption fees, as well as penalties for not maintaining a minimum balance, or market timing. You couldn't dream this stuff up if you were a Hollywood writer. We could go on, but we are starting to feel ill talking about all these fees.

    We look to a money management heavyweight, David Swenson, for a synopsis of the all-in effects of all these various fees:

    A miniscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent (annual) margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.

    -David Swenson, CIO of the Yale University Endowment

    We roughly approximated that perhaps 1 out of 6 funds could beat the market after a 1.5% management fee, but when we add the effects of taxes, commissions and other expenses, David Swenson estimates that ratio falls to perhaps 1 out of 25. Holy schnikes!

    We also had our minds completely blown by a recent news piece, which described how many mutual funds are beginning to hold….wait for it…ETFs in their portfolios. Yes, you can now pay that 1.5% expense ratio for the privilege of having your fund manager pick for you the right ETF, which of course has its own separate fee, leaving you paying fees on fees. As an astute market observer puts it in the article: "It's just being lazy. Buy stocks. It's what people are paying you for."

    At the end of the day, what sensible investors should seek are a few very simple things. Minimal expenses. High tax efficiency. Transparency. Intelligent investment process. It's not that hard. It is reasonably argued that mutual funds, in the aggregate, are a tremendous disservice to the investing public, because of the factors discussed above. Unfortunately, you as an investor are on your own to navigate your way through dangerous financial straits, and avoid the fees and turnover that can sink your ship. The task can be daunting, but knowledge goes a long way, so always be learning. Snake oil can be a great product, but we'd prefer you avoid it whenever possible.

    Sep 19 3:54 PM | Link | Comment!
  • Neuroeconomics - the Endocrine System and Shifting Risk Preferences

    The Chinese philosopher Sun Tzu counseled us to "know thine enemy."  At Turnkey Analyst we are always curious about anything that affects our financial decision making, since we believe the enemy is often us.  Recently we did some reading about a curious branch of neuroeconomics that deals with shifting risk preferences: the implications are startling.

    Since most on Seeking Alpha spend more time thinking about central bank regulation than central nervous system regulation, allow me to provide a brief overview of your body's regulatory apparatus: the endocrine system.  The endocrine system produces, stores, and manages hormones in your body that have a big impact on how you feel and behave.  Likewise, your body can provide input to the endocrine system that tells it what it needs to do in a given situation.

    The system can thus act as a feeback loop, with conditions driving internal chemistry, which then affect how we react to those conditions.  So for example, if we see a grizzly bear, we all know that the body triggers the release of adrenalin into the bloodstream, producing the famous "fight or flight" response.

    Our body produces many different chemicals which produce various responses.  For instance, testosterone can generate mental and physical energy, while cortisol, produced in response to stress, decreases sensitivity to pain, and heightens our memory functions.  Even subtle environmental cues can affect your body chemistry: dancing to the Argentine tango has been shown to reduce cortisol levels in saliva.

    John Coates is a neuroscientist at Cambridge University who has done research in the area of how the natural production of these steroid hormones can drive risk seeking or risk avoidance behavior.  He believes hormones affect financial markets to a greater degree than is commonly believed.  He and another neuroscientist, Joe Herbert, sampled the saliva of a group of London traders for the presence of testosterone and of cortisol, both before and after several trading days.

    They found that higher levels of testosterone tended to be predictive of trading success:

    As you can see from the box and whisker plot above, the traders who had more testosterone at the beginning of a trading day were clearly more profitable than their counterparts who started with less testosterone.  In a recent follow-on study, Coates determined that it was not a trader’s skill (as measured by the Sharpe ratio) that is enhanced by testosterone, but merely his willingness to assume risk.  It should come as no surprise that testosterone appears to be correlated with risk-seeking behavior.

    Coates has compared the testosterone-fueled successful trading outcomes to nature’s “winner effect,” whereby when an animal wins a fight, its testosterone levels are increased, giving it an advantage in the next contest.  Coates extrapolates that, in a rising market, we might see a financial winner effect, with waves of irrational exuberance driven by the systematic and self-reinforcing ratcheting up of testosterone and risk taking by participants over time.  Obviously, of course, if taken to extremes (or if the market turns), this can lead to dangerous outcomes.  Indeed, in a separate study reviewed by Coates, testosterone was administered to subjects, who then demonstrated a preference for high variance, negative expected return decks of cards over low variance, positive return decks.

    Asked to describe an example of this enhanced risk-seeking effect, Coates replied:

    “During the dot-com bubble, people who were working with me displayed all the classic symptoms of mania: They were euphoric, delusional, and overconfident; they couldn’t put a coherent sentence together; and they were unusually horny, judging from the number of lewd comments and the amount of porn that was showing up on their computer screens. No one had actually looked medically at what happened to traders when they were caught up in a bubble. But they were changing. It was like they were on drugs.”

    Scientifically valid, no.  Hopped up on testosterone, yes.  So here we can see how a financial bubble, or any sustained positive upward market move, could potentially be maintained, or even accelerated by our internal chemistry.

    Fascinating.

    Now let’s turn to the cortisol results.

    When Coates and Herbert designed their study, they thought maybe cortisol, created in response to stress, would be correlated with trading losses.  They found no such relationship.  Instead, they discovered two things.  First, cortisol responded to the standard deviation of a trader’s P&L.  So as the variance of a trader’s returns increased, so did his cortisol levels.  But something else was going on in the data.  They thought it must be some uncertainty the traders were dealing with, and this led to a second discovery: cortisol was produced in response to volatility in the markets.  As it turns out, the traders had their biggest exposure to German markets.  Below are cortisol levels for the traders as plotted against the implied volatility of options on German Bunds:

    The R-squared on the regression is 86%, a pretty impressive figure.  It would seem the traders’ cortisol levels are consistently preparing them for big market moves.  Now a little bit of cortisol can be helpful in many ways; it can aid in motivation, attention and memory.  But chronic production of cortisol causes problems; it can produce anxiety, negative memories, and imaginary threats.  Coates and Herbert concluded that the strong relationship between cortisol and volatility suggests that collective endocrine profiles may paradoxically then affect markets.  How?  Consider the condition of “learned helplessness.”

    In a ghoulish experiment, dogs who were given a repeated adverse stimulus that they could not avoid, eventually stopped trying to escape, and subsequently exhibited signs of clinical depression.  The same thing can happen in bear markets.  Persistently elevated cortisol levels could cause market participants to mimic learned helplessness, potentially contributing to a market’s downward move, as fatigued and immobile traders stay on the sidelines.

    We can see that testosterone and cortisol are the body’s signs for market risk and return.  When they are present at elevated rates for prolonged periods, they can cause traders to make irrational choices that can exaggerate market trends.

    What is the true underlying role of biology in financial markets?  Behavioral economics offers some tantalizing clues, but neuroeconomics provide some perhaps even more profound possibilities.  Maybe the better question is: what is the extent to which these powerful hormones affect our financial lives?  While the jury is still out -- pending more research -- I am going to say hormones have a significant effect.  Envision a market with up and down moves reinforced by a rich tide of hormones coursing through the systems of tens of millions of traders.  Financial literature abounds with statistical examples of how multiple sigma events continue to defy implied Gaussian probability distributions.  Is it really such a farfetched notion that the collective endocrine system of market participants could be a principal driver of these extreme moves to both the upside and the downside?  Armed with an intuitive sense of how our bodies can affect our financial decisions, we can see yet another endogenous roadblock that impedes us from making rational investing choices, and exacerbates market manias and panics.

     


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Oct 24 10:29 AM | Link | Comment!
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