The flimsy foundation of academic finance

Are "factors" fatal flaws, or the exceptions that prove the rule?

The indexing edge

The small investor of today can credit Jack Bogle, founder of the Vanguard Group, for popularizing the index fund.

The index fund emerged from humble beginnings in the mid-1970s, and at the time few realized how huge a victory it was for small investors. Think about it—before Vanguard, there were gatekeepers standing between you and the stock market, extracting prodigious amounts of juice from your portfolio. If you’re young enough, you probably don’t know that the full-service stockbroker used to be the only way for individuals to buy stocks directly, and they actually charged hundreds of dollars for each trade. Then came the mutual fund, which allowed for diversification of small accounts but at a cost of 2 or 3 percent per year on your money.

Bogle is a hero because he dropped an atomic bomb on this racket. Like Jesus kicking the money-changers out of the temple, he played a large part in cleaning up an industry that put itself before its clients. He gave small investors an opportunity to diversify their holdings in a low-cost fund and preached a gospel of common sense with easy-to-follow rules.

Creating an ultra-low-cost, purely passive investment vehicle for the everyman was a shot across the bow of the financial industry. For the small investor, I would argue that it remains the preferred solution to build portfolios, despite its flaws.

Do you believe in “efficient” markets?

Passive investing is based on a theory called the Efficient Market Hypothesis (EMH), upon which most academic finance rests. The hypothesis states that, at any given time, share prices reflect all publicly available information. If EMH is true, then we shouldn’t try to pick individual stocks.

As the EMH theorizes, there are millions of investors around the world, all trying to find mispriced stocks. Through all of their buying and selling, the cumulative impact of their research is reflected in market prices.

For example, if enough people think that Microsoft is expensive, they will sell the stock. If others think it’s cheap, they will buy the stock. The equilibrium point, where the stock currently trades, is theoretically the “correct” value for the company, reflecting all publicly available information. So you can save yourself the effort of trying to pick stocks. Just buy everything and go along for the ride.

Through the EMH we developed the concept of index investing, which has been a tremendous force for good, democratizing investing for the masses and bringing down unnecessary expenses. For the small investor, it’s hard to recommend any investment strategy other than a low-cost index fund or ETF. Even large institutional investors often index vast portions of their equity portfolios in an effort to capture the stock market return with the lowest possible costs. (This is what they call earning “beta,” and I always recommend you start asking common-sense questions once they bring out the Greek letters.)

Exceptions to the rule

I’m not trying to write a full critique of the EMH here, but suffice it to say that even “passive” investors who hang their proverbial hat on this theory make adjustments to its practical application. Many things get in the way of a “pure” EMH existing in the real world, including behavioral investing quirks, transaction costs, and the impact of insider information, to name a few.

In fact, the same group of researchers that developed the EMH went on to identify a couple of major anomalies that have persisted over time. Anomalies that, if their claims of market efficiency were correct, should not exist.

The first is the “small firm” anomaly, which states that, over long periods of time, the shares of smaller companies outperform those of larger companies.

The second major anomaly is the “low book value” or “value” anomaly, which shows outperformance for the shares of companies that trade at a low multiple of “book” value (the carrying value of assets on the company’s balance sheet).

Even though these anomalies were identified a long time ago, they have persisted for decades, which doesn’t make sense if you believe in the EMH, right? After all, the public knowledge that they exist should be enough to cause investors to bid up the prices of small value companies, eliminating the ability to earn excess returns by investing in them! So the academic finance guys have spent decades trying to explain why these anomalies exist.

In the meantime, though, they play along. Given the persistence of these anomalies, they have actually been incorporated in what is commonly known as the Three Factor Model, where academic finance practitioners will recommend a very diversified portfolio with a “tilt” towards what they call the small company and value factors, in order to capture the premium offered by these factors.

In fact, I think by 2014 they introduced a Five Factor Model. Apparently there are more factors being discovered. Like asteroids. I’m pretty sure that they’re up to a Six Factor Model now.

The more the number of factors expands, the more useless the theory becomes, but that’s just my simple-minded opinion. Keep in mind, these are less “factors” than “exceptions.” And enough exceptions should make a theory quite useless, no?

In The (Mis)Behavior of Markets, mathematician Benoit Mandelbrot ruthlessly demolishes academic finance by demonstrating that the models on which it is built are dangerously simplified. He writes:

And the high priests of modern financial theory keep moving the target. As each anomaly is reported, a “fix” is made to accommodate it… But such ad hoc fixes are medieval. They work around, rather than build from and explain, the contradictory evidence… So again, why does the old order continue? Habit and convenience. The math is, at bottom, easy and can be made to look impressive, inscrutable to all but the rocket scientist. Business schools around the world keep teaching it. They have trained thousands of financial officers, thousands of investment advisers. In fact, as most of these graduates learn from subsequent experience, it does not work as advertised; and they develop myriad ad hoc improvements, adjustments, and accommodations to get the jobs done. But still, it gives a comforting impression of precision and competence.

What’s the practical application of academic finance?

In my experience, all of the tinkering and analysis of academic finance appeals to a specific type of person. I especially find that scientists and engineers appreciate the supporting data behind the theory, and that, as in science itself, the research rests on constant advancement and falsifiability. For the right person, the anomalies are a feature, not a bug. If this is you, and this is an investment strategy you can believe in, that’s awesome.

I find that for most people, and especially for investment novices and entrepreneurs, academic finance does not resonate. Academic finance takes something simple (owning a piece of a business) and complicates it with mathematical formulas, incoherent graphs, and Greek letters.

Some anomalies are durable. Most are ephemeral. As soon as they are discovered and made public, they no longer work. Constantly adapting your portfolio to chase these temporary anomalies is another risk of putting too much faith in academic finance.

I think most people are looking for something more durable. Not research that changes conclusions several times over a lifetime, but rather—and almost like religion—a timeless set of principles. Luckily, it actually exists. And it’s also been supported by research. Sounds like the best of both worlds. Was this whole post just a long commercial for my book? Maybe!