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Thanks for the news flash that alerts to a potential change in CalPERS money management selection philosophy.
CalPERS unhappiness with performance delivered by the active management sleeve of their total immense portfolio is not surprising. It is consistent with patterns recognized, at least partially, for decades. Active portfolio managers, even at the institutional level, are challenged by a treacherous road.
Some of that challenge is caused by the professionalism of the competition, all of whom are struggling to uncover and promptly react to few and slim market inefficiencies. It was an easier task when 80 % of market trades were completed by amateur private investors; today, that trade statistic has inverted to an 80 % trading done by money managers. These guys are so smart, so well informed, and so quick to act that they cancel each others advantages out.
The data over decades demonstrate that, on average, we individual investors suck. We all too frequently underperform well chosen benchmarks. That is not my assertion, but are documented findings from industry studies reported by DALBAR annually, and from academic research. I have posted these observations several times on MFO. Here is a repeat recent Link to DALBAR:
Not only do we misjudge our market entry/exit points, but we compound the error by selecting a replacement fund that underperforms the replaced fund. We fire the replaced fund because of recent disappointing outcomes, and hire the replacement fund because of recent superior outcomes. Unfortunately, the equity marketplace has a strong pull to a regression-to-the-mean. So one mistake is reinforced by a second mistake. That’s the sad record.
Again, this is not merely my assertion, but is documented by academic studies. A University of California academic, Terrance Odean, published on this subject in 1993 after examining 100,000 individual trader records. The stocks purchased underperformed the market by 2.7 % while those they sold outperformed the market by 0.5 % in the next year. Odean’s paper on his research is titled “Why Do Investors Trade Too Much?”.
If there’s any good news here it is that professional money managers also suck. I suppose misery loves company. In truth, it is likely that the pros do not suck as much as we do. Often the pros do outrun market returns. However, that advantage is illusive, frequently very transient, and returns are highly asymmetric.
Illusive in the sense that only a small fraction of pros manage to generate excess return; transient in the sense that performance persistence is doubtful at best; and asymmetric in a sense that active management produces minor excess returns after costs yet increase risk because of the real likelihood of huge underperformance. Active managers worry over this realization.
Over the last decade, large institutional agencies are recognizing the challenges to active management, and are responding accordingly. More and more institutional portfolio sleeves are moving into the passive management category.
CalPERS already allocates about 50 % of its portfolio’s value to the passive Index discipline. I expect that when a final decision is made, an even stronger commitment to Index investing will be executed. Only few active managers generate positive Alpha, excess returns.
One final time, this not merely my assertion, but is backstopped by solid research. The paper is titled “ Performance and Persistence in Institutional Investment Management”. It is authored by Busse, Goyal, and Wahal. Here is a Link to this 2010 study:
It’s a long 40 page paper, so I’ll quote directly from a part of its abstract.
“ …. aggregate and average estimates of alphas are statistically indistinguishable from zero. Even though there is considerable heterogeneity in performance, there is only modest evidence of persistence in three-factor models and little to none in four-factor models.”
Regardless of this consistent and overwhelming evidence, investors, of both the individual and the institutional cohorts, persistently favor active over passive policies. Only 16 % of resources find a pathway to Index products. It is informative that institutional agencies commit a relatively higher percentage to passive holdings than private investors do.
There is a lesson here. Ah, but hope is eternal. It’s also wasteful.
Reply to @MJG: I'm quite a fan of Odean and Barber. Okay, I admit it - confirmation bias. But my bias is different from yours, which goes to show that one can take away from his writing different points. (I feel that this is a good, not bad attribute of his writing and research - it is not dogmatic.)
What he studies is behaviorial investing. He's right that the typical investor underperforms. Me, I'm from Lake Wobegon, where everyone is above average
First, a little clerical detail - lots of papers show up on the internet in multiple revisions, different formats, dates, etc. What I dug up under the title you provided was this 2006 Summary. In it, he says that the most active 20% of investors underperform the least active 20% by 7.2%/year (perhaps a transposition of your 2.7% figure?). The summary does say that the stocks investors sell outperform their replacement stocks by over 2% (your net figure was 3.2% = 2.7% + 0.5%). No big deal - a later version, and similar values.
In any case, he shows that individual investors don't trade rationally (big surprise). They trade too much (negative correlation between trade frequency and returns, due in part to transaction costs); they tend to trade even more online; they underdiversify; they speculate.
But if individual investors are so bad, someone must be wining - the institutional investor. Quoting: "Our research indicates that on average, individual investors lose, while institutional investors gain." Not a good argument for CalPERS to get out of the active management game. This research was based on trading in Taiwan (not having similar US data available), and showed, at least there (and admittedly different market) that institutional investors outperformed the market by 1%/year.
In general, I find Odean's results stand for the proposition that one can beat the market, especially with limited trading, but likely only before considering costs, and only if one trades rationally. See, e.g. The Behavior of Individual Investors (Sept. 2011). In the paper's abstract, he (and Barber) fault investors for limited attention spans (influenced by the news of the moment), naive trading, lack of diversification. In the first section, they note that "several studies provide intriguing evidence that some institutions are able to earn superior results." Again, calling into question CalPERS leaving the game. They reiterate that it's the individual investors who are the typical losers ("subpar investors").
"In theory, investors hold well diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. In practice ... they trade frequently and have perverse stock selection ability ...[,] hold poorly diversified portfolios .... and ... are unduly influenced by media and past experience."
I'd like to believe that I'm closer to the former theoretical investor than the latter "real" one. I do follow his "prescriptive advice to buy and hold low-fee, well-diversified portfolios." That doesn't have to be the whole market. And institutions should be able to do even better.
Thank you for the excellent reply to my post, and for the diligent work that you did to access a summary of Odean’s earlier research.
I too much admire the collaborative studies that Brad Barber and Terrance Odean complete. This pair gets considerable mileage from their work. The foundational data sets have traveled extensively. I suspect that the numbers that I cited are contained in this later version of his original thesis studies:
I said “suspect” since I did not directly quote from his original report. I lifted the specific values from Chapter 13 of Charles Ellis’s book “Winning the Loser’s Game”. Ellis provides a convenient summary that is easy to understand. But it is a secondary source so errors are possible.
The Link that I referenced has one of Odean’s observations that my wife truly treasures. He concludes that “Using the same data, Barber and Odean (1999b) find that men trade more actively than women and thereby reduce their returns more so than do women.”
Professional money managers do have a competitive edge over private investors. Recall that I noted “In truth, it is likely that the pros do not suck as much as we do. Often the pros do outrun market returns.”
But it is a hard battle for them since they are now mostly matched against a smart, skillful, fully funded research, committed opposing professional team with huge financial incentives. It’s like two superb pro football teams neutralizing each other’s superior talents, and ending the game in a scoreless (zero Alpha) tie. Ugh!
The second reference that I provided addresses this aspect of the equity universe. In general, these professional outfits do not add sufficient excess returns to offset the added costs of their operations. The institutional tide is definitely moving against the active investment community.
Like you, my portfolio is populated by some actively managed assets that feature low cost operations, a rather infrequent trading profile, lower turnover rates, and seasoned managers. I hold these positions for lengthy timeframes to allow market cycles to test these managers. I do eliminate poor earlier choices.
But my portfolio also contains a mix of passive Index products. These lower my cost structure still further, and add stability to the overall portfolio performance. The record suggests that I am mildly successful using my style of portfolio management and risk control.
Again, like you, I believe I’m a Lake Wobegone resident. Of course, constant monitoring is the penalty for that residency since outcomes can change super quickly.
Comments
Thanks for the news flash that alerts to a potential change in CalPERS money management selection philosophy.
CalPERS unhappiness with performance delivered by the active management sleeve of their total immense portfolio is not surprising. It is consistent with patterns recognized, at least partially, for decades. Active portfolio managers, even at the institutional level, are challenged by a treacherous road.
Some of that challenge is caused by the professionalism of the competition, all of whom are struggling to uncover and promptly react to few and slim market inefficiencies. It was an easier task when 80 % of market trades were completed by amateur private investors; today, that trade statistic has inverted to an 80 % trading done by money managers. These guys are so smart, so well informed, and so quick to act that they cancel each others advantages out.
The data over decades demonstrate that, on average, we individual investors suck. We all too frequently underperform well chosen benchmarks. That is not my assertion, but are documented findings from industry studies reported by DALBAR annually, and from academic research. I have posted these observations several times on MFO. Here is a repeat recent Link to DALBAR:
http://www.google.com/search?hl=en&source=hp&q=dalbar+2012+qaib&gbv=2&oq=DALBAR+2012+&gs_l=heirloom-hp.1.1.0l2j0i22i30l3.1346.6876.0.10626.12.11.0.1.1.0.245.1544.0j10j1.11.0...0.0...1c.1.ALMzKkivuJo
Not only do we misjudge our market entry/exit points, but we compound the error by selecting a replacement fund that underperforms the replaced fund. We fire the replaced fund because of recent disappointing outcomes, and hire the replacement fund because of recent superior outcomes. Unfortunately, the equity marketplace has a strong pull to a regression-to-the-mean. So one mistake is reinforced by a second mistake. That’s the sad record.
Again, this is not merely my assertion, but is documented by academic studies. A University of California academic, Terrance Odean, published on this subject in 1993 after examining 100,000 individual trader records. The stocks purchased underperformed the market by 2.7 % while those they sold outperformed the market by 0.5 % in the next year. Odean’s paper on his research is titled “Why Do Investors Trade Too Much?”.
If there’s any good news here it is that professional money managers also suck. I suppose misery loves company. In truth, it is likely that the pros do not suck as much as we do. Often the pros do outrun market returns. However, that advantage is illusive, frequently very transient, and returns are highly asymmetric.
Illusive in the sense that only a small fraction of pros manage to generate excess return; transient in the sense that performance persistence is doubtful at best; and asymmetric in a sense that active management produces minor excess returns after costs yet increase risk because of the real likelihood of huge underperformance. Active managers worry over this realization.
Over the last decade, large institutional agencies are recognizing the challenges to active management, and are responding accordingly. More and more institutional portfolio sleeves are moving into the passive management category.
CalPERS already allocates about 50 % of its portfolio’s value to the passive Index discipline. I expect that when a final decision is made, an even stronger commitment to Index investing will be executed. Only few active managers generate positive Alpha, excess returns.
One final time, this not merely my assertion, but is backstopped by solid research. The paper is titled “ Performance and Persistence in Institutional Investment Management”. It is authored by Busse, Goyal, and Wahal. Here is a Link to this 2010 study:
http://www.hec.unil.ch/agoyal/docs/persistence_jof.pdf
It’s a long 40 page paper, so I’ll quote directly from a part of its abstract.
“ …. aggregate and average estimates of alphas are statistically indistinguishable from zero. Even though there is considerable heterogeneity in performance, there is only modest evidence of persistence in three-factor models and little to none in four-factor models.”
Regardless of this consistent and overwhelming evidence, investors, of both the individual and the institutional cohorts, persistently favor active over passive policies. Only 16 % of resources find a pathway to Index products. It is informative that institutional agencies commit a relatively higher percentage to passive holdings than private investors do.
There is a lesson here. Ah, but hope is eternal. It’s also wasteful.
Best Wishes.
I'm quite a fan of Odean and Barber. Okay, I admit it - confirmation bias. But my bias is different from yours, which goes to show that one can take away from his writing different points. (I feel that this is a good, not bad attribute of his writing and research - it is not dogmatic.)
What he studies is behaviorial investing. He's right that the typical investor underperforms. Me, I'm from Lake Wobegon, where everyone is above average
First, a little clerical detail - lots of papers show up on the internet in multiple revisions, different formats, dates, etc. What I dug up under the title you provided was this 2006 Summary. In it, he says that the most active 20% of investors underperform the least active 20% by 7.2%/year (perhaps a transposition of your 2.7% figure?). The summary does say that the stocks investors sell outperform their replacement stocks by over 2% (your net figure was 3.2% = 2.7% + 0.5%). No big deal - a later version, and similar values.
In any case, he shows that individual investors don't trade rationally (big surprise). They trade too much (negative correlation between trade frequency and returns, due in part to transaction costs); they tend to trade even more online; they underdiversify; they speculate.
But if individual investors are so bad, someone must be wining - the institutional investor. Quoting: "Our research indicates that on average, individual investors lose, while institutional investors gain." Not a good argument for CalPERS to get out of the active management game. This research was based on trading in Taiwan (not having similar US data available), and showed, at least there (and admittedly different market) that institutional investors outperformed the market by 1%/year.
In general, I find Odean's results stand for the proposition that one can beat the market, especially with limited trading, but likely only before considering costs, and only if one trades rationally. See, e.g. The Behavior of Individual Investors (Sept. 2011). In the paper's abstract, he (and Barber) fault investors for limited attention spans (influenced by the news of the moment), naive trading, lack of diversification. In the first section, they note that "several studies provide intriguing evidence that some institutions are able to earn superior results." Again, calling into question CalPERS leaving the game. They reiterate that it's the individual investors who are the typical losers ("subpar investors").
"In theory, investors hold well diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. In practice ... they trade frequently and have perverse stock selection ability ...[,] hold poorly diversified portfolios .... and ... are unduly influenced by media and past experience."
I'd like to believe that I'm closer to the former theoretical investor than the latter "real" one. I do follow his "prescriptive advice to buy and hold low-fee, well-diversified portfolios." That doesn't have to be the whole market. And institutions should be able to do even better.
Hi msf,
Thank you for the excellent reply to my post, and for the diligent work that you did to access a summary of Odean’s earlier research.
I too much admire the collaborative studies that Brad Barber and Terrance Odean complete. This pair gets considerable mileage from their work. The foundational data sets have traveled extensively. I suspect that the numbers that I cited are contained in this later version of his original thesis studies:
http://faculty.haas.berkeley.edu/odean/papers current versions/doinvestors.pdf
I said “suspect” since I did not directly quote from his original report. I lifted the specific values from Chapter 13 of Charles Ellis’s book “Winning the Loser’s Game”. Ellis provides a convenient summary that is easy to understand. But it is a secondary source so errors are possible.
The Link that I referenced has one of Odean’s observations that my wife truly treasures. He concludes that “Using the same data, Barber and Odean (1999b) find that men trade more actively than women and thereby reduce their returns more so than do women.”
Professional money managers do have a competitive edge over private investors. Recall that I noted “In truth, it is likely that the pros do not suck as much as we do. Often the pros do outrun market returns.”
But it is a hard battle for them since they are now mostly matched against a smart, skillful, fully funded research, committed opposing professional team with huge financial incentives. It’s like two superb pro football teams neutralizing each other’s superior talents, and ending the game in a scoreless (zero Alpha) tie. Ugh!
The second reference that I provided addresses this aspect of the equity universe. In general, these professional outfits do not add sufficient excess returns to offset the added costs of their operations. The institutional tide is definitely moving against the active investment community.
Like you, my portfolio is populated by some actively managed assets that feature low cost operations, a rather infrequent trading profile, lower turnover rates, and seasoned managers. I hold these positions for lengthy timeframes to allow market cycles to test these managers. I do eliminate poor earlier choices.
But my portfolio also contains a mix of passive Index products. These lower my cost structure still further, and add stability to the overall portfolio performance. The record suggests that I am mildly successful using my style of portfolio management and risk control.
Again, like you, I believe I’m a Lake Wobegone resident. Of course, constant monitoring is the penalty for that residency since outcomes can change super quickly.
Best Wishes.