Rationality and indexation
“Are investors rational?” is a question that surely springs to mind when one recalls the equity market exuberance of the 1990s, the severe selling following the bursting of the TMT bubble in 2000, and the speculative rally during 2003. Today, however, despite concerns about interest rates, oil prices, global growth, and geopolitical tensions, financial markets look relatively tranquil.
Volatility has decreased and most equity markets are trading within narrow ranges. So why then do followers of the efficient market hypothesis (EMH) and passive (or index) investment management approaches not rejoice? Is this because they understand that equity markets are dominated and driven not by economists, but by more ordinary folk?
In recent years, the passive investment management industry has blossomed, nourished by the substantial growth of net inflows. Indeed in the US, by the end of 2000, total assets benchmarked to the S&P500 exceeded $1trn (e0.8trn). In the main this growth has been supported by the acceptance of the theoretical assumptions of EMH, which presumes that the prices of financial assets such as equities are rationally based on all available information. According to this theory, even if there are irrational investors they would be driven out of the market by rational investors due to arbitrage activity. As a result, investors cannot consistently earn a higher return than the market average by stock selection.
The debate over whether ‘active’ investment managers can consistently outperform ‘passive’ managers is a familiar one. However, new insights into how risk budgets are allocated have determined that the basis for the current debate is too simplistic. As previously mentioned, during the past 30 years passively managed (or index tracking) assets have grown substantially as institutional investors have adopted a barbell asset allocation strategy, ie, a small active allocation used to accent a core passive holding. In essence, this was an attempt at balancing the hope for gain against the concern about risk.
This loyalty to index tracking made some sense during the long equity bull market, where many active equity managers found the strong index (beta) returns difficult to better. But in today’s low-return environment, investors must make their investments work harder, as the payoff to beta is expected to be small. Large allocations to strategies that depend on beta and short-term drivers such as momentum may need to be re-evaluated. In contrast, equity strategies that depend upon fundamental stock-level analysis to achieve alpha should be investigated further. The trend which currently advocates the allocation of funds toward low tracking-error equity strategies and away from passive strategies is evidence of this new way of thinking.
Indeed the term ‘index tracking’ suggests passive investment management and implies it provides investors with a high degree of predictability. However, an index tracking strategy rarely perfectly mimics the underlying index, especially during periods of high index activity, such as changes in industry leadership.
Recent work by Research Affiliates1 has further highlighted the imperfections of certain indices. In their piece ‘Redefining indexation’ the team asserted that market capitalisation-weighed indices often held far greater positions in overvalued stocks than undervalued stocks, as prices are significantly more volatile than a company’s true fundamental value. Another issue is that capitalisation-weighted indices often favour companies that are supported by momentum trading. It is argued that they apportion a larger weight to companies which investors’ believe will experience stronger growth.
In theory, the price of securities is determined by demand and supply: that is, investors’ consensus of future expectations pitted against the availability of securities issued by the firm. Simply put, investors buy and sell securities based on their expectations about the future – typically regarding the future profitability and risk characteristics of the firm issuing the securities.
Insight provided by Nobel Prize economists George Akerlof, Michael Spence, and Joseph Stiglitz2 on markets with information asymmetries, suggest that investors can become victims of adverse selection among firms. For example, in new exciting sectors where analyst coverage is still sparse (such as information technology or biotechnology) a collection of distinct firms may appear identical to uninformed investors. Better-informed professional investors, however, may have greater access to research about the future profitability and characteristics of such firms. Therefore, in stock markets where uninitiated investors also trade, firms with less than average profitability may be frequently overvalued. Only when uninitiated investors ultimately discover that these firms are ‘low quality’ do share prices fall. This suggests that a potential source of alpha is available to all investors who try to generate a better information set.
It is hard to separate yourself from the crowd. Investors are all influenced by one another and when they have insufficient information, they often speculate. It is also not remarkable that interactions between investors which seem rational can actually lead to irrational thinking which may push markets out of balance.
‘Anchoring’ is a prime example of this, whereby investors’ decisions are shaped, rightly or wrongly, by the memory of a previous experience or suggestion. Indeed, investors can often be influenced despite being aware that the information does not come from a better informed source. This tendency, when combined with the human habit of cognitive dissonance – holding a belief which is plainly at odds with the evidence – can damage wealth. This means that whereas institutional investors may be too focused on tracking error as a risk measure, private investors go for names they recognise and are influenced by short-term news flow. With the points made above in mind, therefore, it can be argued that neither stocks held in an index, nor those that receive high levels of press coverage make particularly good investments.
Such insights from the school of behavioural finance provide an explanation of what causes anomalies in financial markets. By using psychology and the decision-making sciences, it argues that investors commit errors because they rely on rules of thumb (that is, back of the envelope calculations or heuristics). The cycles of information gathering, opinion forming and decision-making are the results of cognitive and emotional reasoning. Under certain circumstances, investors systematically make errors in judgment or mental mistakes. These mental mistakes can cause investors to form biased expectations regarding the future that, in turn, can cause securities to be mispriced.
The psychological idea that has so far had the greatest impact on finance is ‘prospect theory’. This was developed by Daniel Kahneman and Amos Tversky3 who found that people are ‘loss averse’: they have an asymmetric attitude to gains and losses, and regularly miscalculate probabilities of outcomes.
Loss aversion does not only lead investors to defer selling stocks that have depreciated significantly, but also stops investors buying stocks that have started to appreciate. As an example, Fama and French4 conducted seminal studies examining the returns of cheap stocks and found that the value effect, ie, cheap stocks outperform expensive stocks, was pervasive in the US and Europe. An explanation for this is that investors overestimate the time it takes for an unsuccessful company to turn around. It is thus unlikely that any index tracking investor can achieve the best possible combination of risk and return.
This is an irrational world. Pricing anomalies do occur due to irrational intelligence. Even long-term investors rely on mental anchors in an increasingly-complex world. It is these anchors that may drive stock prices away from fundamentals. There is no guarantee therefore that the consensus expectation, ie, the herd, is correct or that the index is the safest place for risk-averse investors.
Christian E Elsmark is director and head of investment services, T Rowe Price Global Investment Services based in London
1. Robert Arnott, Jason Hsu and Phil Moore, “Redefining indexation”, Research Affiliates LLC, 2004.
2. George Akerlof, Michael Spence and Joseph Stiglitz – Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2001 “for their analyses of markets with asymmetric information”.
3. Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk”, Econometrica, 263–291, 1979.
4. The Journal of Finance, Volume LIII, No 6, December 1998