Investing Expertise

Several readers have inquired or commented about the accuracy of  Standard and Poor’s quarterly S&P 500 earnings estimates. How accurate have they been? Since late 2005, we have tracked the evolving bottoms-up S&P 500 year-over-year quarterly operating earnings growth estimates for 2006-2009 at roughly biweekly intervals. During the early part of this period, we recorded the average of the publicly available Standard and Poor’s and Reuters earnings estimates (generally similar). During the latter part, we recorded only the Standard and Poor’s estimates. Using evolving earnings forecasts for 2006-2009, we find that: Keep Reading

Do new mutual funds bring fresh alpha to the marketplace, outperforming until the market catches up and extinguishes it? In their August 2008 paper entitled “Performance and Characteristics of Mutual Fund Starts”, Aymen Karoui and Iwan Meier examine the performance and portfolio characteristics of U.S. equity mutual funds launched during 1991-2005. Using monthly return, quarterly holdings and fund characteristics/fee data for 1,374 U.S. domestic equity mutual funds and 828 fund starts over this period, they conclude that: Keep Reading

Can outperforming hedge funds readily convert assets into cash for fund investors? In their October 2008 paper entitled “Hedge Fund Alphas: Do They Reflect Managerial Skills or Mere Compensation for Liquidity Risk Bearing?”, Rajna Gibson and Songtao Wang study the effect of market-wide liquidity risk (the time and costs of transforming a given position into cash and vice versa) on the performance of various hedge fund portfolio strategies. The strategies they consider are: Convertible Arbitrage, Dedicated Short Bias, Emerging Markets, Equity Market Neutral, Event-Driven, Fixed Income Arbitrage, Global Macro, Long/Short Equity Hedge, Managed Futures and Multi-Strategy. Using performance data for a broad sample of live (2,743) and defunct (1,955) hedge funds during 1994-2006 and contemporaneous measures of market-wide (U.S. equities) liquidity, they conclude that: Keep Reading

Do expert investors outperform more by being in the right sectors (top-down economic analysis) or by picking the right stocks (bottom-up firm analysis)? In their November 2008 paper entitled “Impact of Sector Versus Security Choice on Equity Portfolios”, Jason Hall and Ben McVicar investigate the relative impact on equity mutual fund returns of industry sector allocation versus individual stock picks. They perform this investigation by constructing sector-neutral and stocks-within-sector-neutral benchmarks. Using data for 3,350 U.S. equity mutual funds over the period 1980-2005 (113,614 fund-quarter observations), they conclude that: Keep Reading

Are short sellers and expert equity analysts generally in synch or out of synch? What does it mean when short sellers and analysts disagree? In their September 2008 paper entitled “Trading Against the Prophets: Using Short Interest to Profit from Analyst Recommendations”, Michael Drake, Lynn Rees and Edward Swanson investigate whether investors/traders can earn abnormal returns by trading on information provided by expert sell-side analysts (recommendations and recommendation changes) and short sellers (short interest). In their tests, they rebalance portfolios quarterly, hold for six months and adjust returns for firm size. Using a large sample of quarterly return, short interest and analyst recommendation data for the period 1994-2006 period, they conclude that: Keep Reading

We occasionally get requests from readers to review the claims stated by an online investing/trading advisory service or investment manager. Most such web sites do not provide enough information to perform a quantitative review. Here is compilation of key points to consider in evaluating the claims of advisory services: Keep Reading

Exceptional performance can stem from: (1) doing something others are doing, but doing it better; and (2) doing something different. Do hedge funds that have innovative strategies (do something different) systematically outperform? In their August 2008 paper entitled “Strategy Distinctiveness and Hedge Fund Performance”, Ashley Wang and Lu Zheng construct a “Hedge Fund Strategy Distinctiveness Index” (SDI) and test the predictive power of this index for future hedge fund returns. Specifically, they define SDI as [1 – R-squared] from a two-year regression of the returns for an individual hedge fund against the average returns of funds with the same investing style. This index represents the percentage of variation in a fund’s returns not explained by the variation of its peer’s returns. Using monthly return data for 2767 live and dead hedge funds over the period January 1994 through June 2007, they conclude that: Keep Reading

Can investors count on continued outperformance from hedge funds with exceptionally strong recent returns? In their July 2008 paper entitled “The Performance Persistence of Equity Long/Short Hedge Funds”, Markus Schmid and Samuel Manser apply a flexible portfolio-based approach to investigate the persistence of raw and risk-adjusted returns for long/short equity hedge funds. Using return and holdings data for 1,150 long/short equity hedge funds over the period 1994-2005, they conclude that: Keep Reading

How do the typical portfolio and performance of self-directed investors differ from those of investors who employ financial advisors? Do financial advisors systematically add value by providing information to, and tempering the irrationalities of, individual investors? In his March 2008 paper entitled “The Influence of Financial Advice on Individual Investor Portfolio Performance”, Marc Kramer compares the investment portfolio content and performance of advised and self directed investors in the Netherlands. Using portfolio data for a diverse mix of 15,675 individual Dutch investors over the 52-month period from April 2003 to August 2007, he concludes that: Keep Reading

How can investors and speculators tell foolish, theoretical and practical investing/trading schemes apart? In his August 2002 paper entitled “Cranks, Academics and Practitioners”, former head of quantitative strategies at Goldman Sachs Emanuel Derman briefly circumscribes this question. He notes that:

“…[A]s I skimmed through the crank file I found it hard to feel superior. Instead, …I always saw a pale reflection.”

“Holy [the crank], holey [the academic], wholly [the practitioner]. Which approach is best? Sometimes you can’t even tell which approach is which. Finance, after nutrition and psychology, may be the field in which it’s hardest to distinguish between a really enthusiastic academic or practitioner and a genuine crank…”

“Crankademic? Pranktitioner? The real thing? Can one devise a Turing test to tell the difference? The mind reels, boundaries blur, not a bad thing really.”

In summary, it seems that nature to a significant degree favors diversity over survival of the fittest.

Consider reading the entire one-page essay.