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drag on portfolio returns, and may explain why active money managers underperform the market. The reason trading costs are large is that they include not just brokerage costs, but also the costs associated with the bidask spread, the price impact created by trading, and the cost of waiting. The reason they are difficult to control is that actions taken to reduce one component of the trading cost tend to increase the other components.
Trading costs do not impose a uniform burden on all investment strategies. They punish short-term, information-based strategies far more than they do long-term, value-based strategies; they affect strategies that focus on less liquid assets far more than they do strategies that are built around liquid assets. No matter what the strategy, though, it is the portfolio manager’s job to manage trading costs, given the constraints of the strategy, and earn an excess return that covers these costs.
Taxes can also have significant implications for investment strategy. Since you get to keep only after-tax profits, the tax costs generated by different investment strategies has to be an important factor in which strategy you choose. With any given investment strategy, you can try to reduce your tax bill by trading less often, tax-based trading, or the use of tax shelters.
E X E R C I S E S
Pick a company that you are familiar with, in terms of its business and history. Try the following:
1.Evaluate how much trading there was in your stock in the most recent periods by looking at:
a.Trading volume (in shares and value) in the most recent period.
b.Changes in trading volume over prior periods.
c.Turnover ratios (trading volume/number of shares outstanding). Compare to the average turnover ratios for other companies in the
sector.
2.Evaluate the magnitude of trading costs on your stock by:
a.Finding the bid and ask prices currently for the stock and the resulting spread.
b.Estimating the spread as a percentage of the current stock price.
c.Keeping track of changes in that spread, especially during periods of market stress.
3.Break down the returns you would have made on the stock in recent years into dividends and price appreciation. Estimate how much you would have paid in taxes on the stock each period if you had held it in your portfolio.
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Lessons for Investors
The brokerage costs, which are often the most explicit costs of trading, represent only a small portion of the total trading cost. There are at least three other costs associated with trading: the bid-ask spread that you bear at the time of trading, the price impact that you have as a result of trading, and the cost of waiting to trade.
While large investors may have an advantage over small investors when it comes to brokerage costs and even the bid-ask spread—they often enjoy a narrower spread—they face much larger price impact and waiting costs than small investors do.
The drag imposed by trading costs on returns will depend on what type of stocks you invest in (it will be higher for smaller, less liquid stocks) and how much you trade (higher turnover will create higher trading costs).
As an investor, you get to spend after-tax income, not pretax income. The portion of your returns that will be devoured by taxes will depend, like trading costs, on what you hold (dividend-paying stocks will create larger tax bills) and how much you trade (more trading will generate more taxes).
CHAPTER 6
Too Good to Be True? Testing Investment Strategies
As investors, we are constantly bombarded with sales pitches from experts claiming to have found the secret formula or the magic model that guarantees investment success. Buy stocks using this strategy, they say, and you will get a portfolio that has low risk and high returns. While you do not want to rule out the possibility that such strategies exist, it pays to be skeptical. In this chapter, we look at how to test investment strategies. In the process, we will also examine what we mean when we say that markets are efficient and cannot be beaten or that markets are inefficient and can be
beaten.
Market efficiency is a concept that is controversial and attracts strong views, pro and con, partly because of differences about what it really means, and partly because it is a core belief that in large part determines how an investor approaches investing. We provide a simple definition of market efficiency and consider the implications of an efficient market for investors.
W H Y D O E S M A R K E T E F F I C I E N C Y M A T T E R ?
The question of whether markets are efficient, and if not, where the inefficiencies lie, is central to choosing your investment philosophy. If markets are, in fact, efficient, the market price provides the best estimate of value, and the process of valuation becomes one of justifying the market price. As an investor, you would not then try to pick undervalued or overvalued stocks or try to time the market. Instead, you would diversify across a broad band of stocks and not trade often.
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If markets are not efficient, the market price may in fact be wrong, and which investment philosophy you pick will depend on why you believe markets make mistakes and how they correct them. Those investors who can find these misvalued stocks and time the market correction, then, will then be able to make higher returns than other investors, thus accomplishing the very difficult task of beating the market. But what if markets are really efficient and you mistakenly pick stocks, thinking they are inefficient? You will bear both the cost of the resources you spend (in terms of time and money) in picking stocks and the additional taxes and transaction costs of this strategy. Consequently, you will end up with a far lower return than that earned by your neighbor who invested her wealth in an index fund.
Examining where and when there are market inefficiencies can also help us in the far more prosaic task of picking investment strategies. A value investor, for example, may have to decide between low price-to-book value (PBV) ratio stocks and low price-earnings (P/E) ratio companies. The evidence may yield a clue as to which strategy is more effective in highlighting undervalued stocks, In addition, market inefficiencies can provide the basis for screening the universe of stocks to come up with a subsample that is more likely to have undervalued stocks. Given the number of stocks that you get to pick from, this not only saves time for you as an investor but increases the odds significantly of finding undervalued and overvalued stocks. For instance, studies suggest that stocks that are neglected by institutional investors are more likely to be undervalued and earn excess returns. A strategy that screens firms for low institutional investment (as a percentage of the outstanding stock) may yield a subsample of neglected firms, which can then be analyzed to arrive at a portfolio of undermisvalued firms. If the research is correct, the odds of finding undervalued firms should increase in this subsample.
E F F I C I E N T M A R K E T S : D E F I N I T I O N
A N D I M P L I C A T I O N S
Market efficiency means different things to different people. To those who are true believers in efficient markets, it is an article of faith that defines how they look at or explain market phenomena. To critics, it indicates an academic notion of infallible and supremely rational investors who always know what the true value of an asset is. In this section, we first define an efficient market and then follow up with a discussion of implications for investment strategies.
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W h a t I s a n E f f i c i e n t M a r k e t ?
In its most general sense, an efficient market is one where the market price is an unbiased estimate of the true value of the investment. Implicit in this derivation are several key concepts:
Contrary to popular view, market efficiency does not require that the market price be equal to true value at every point in time. All it requires is that errors in the market price be unbiased—that is, that prices can be greater than or less than true value for individual stocks, as long as these deviations are random.1
The fact that the deviations from true value are random implies, in a rough sense, that there is an equal chance that any given stock is undervalued or overvalued at any point in time, and that the deviation is uncorrelated with any observable variable. For instance, in an efficient market, stocks with lower price-earnings (P/E) ratios should be no more or no less likely to be undervalued than stocks with high P/E ratios.
If the deviations of market price from true value are random, it follows that no group of investors should be able to consistently find undervalued or overvalued stocks using any investment strategy.
M a r k e t E f f i c i e n c y , I n v e s t o r s , a n d I n f o r m a t i o n
Definitions of market efficiency have to be specific not only about the market that is being considered but also about the investor group that is covered. It is extremely unlikely that all markets are efficient to all investors at all times, but it is entirely possible that a particular market (for instance, the New York Stock Exchange) is efficient with respect to the average investor. It is also possible that some markets are efficient while others are not, that a market is efficient with respect to some investors and not to others and in some time periods more than others. This is a direct consequence of differential tax rates and transaction costs, which confer advantages on some investors relative to others.
Definitions of market efficiency are also linked with assumptions about what information is available to investors and reflected in the price. For instance, a strict definition of market efficiency that assumes that all information, public as well as private, is reflected in market prices would imply
1Randomness implies that there is an equal chance that stocks are underor overvalued at any point in time.
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that even investors with precise inside information will be unable to beat the market. One of the earliest classifications of levels of market efficiency was provided by Eugene Fama, who argued that markets could be efficient at three levels, based on what information was reflected in prices.2 Under weak form efficiency, the current price reflects the information contained in all past prices, suggesting that charts and technical analyses that use past prices alone would not be useful in finding undervalued stocks. Under semistrong form efficiency, the current price reflects the information contained not only in past prices but in all public information (including financial statements and news reports), and no approach predicated on using and massaging this information would be useful in finding undervalued stocks. Under strong form efficiency, the current price reflects all information, public as well as private, and no investors will be able to consistently find undervalued stocks.
I m p l i c a t i o n s o f M a r k e t E f f i c i e n c y An immediate and direct implication of an efficient market is that no group of investors should be able to consistently beat the market using a common investment strategy. An efficient market would also carry negative implications for many investment strategies.
In an efficient market, equity research and valuation would be a costly task that would provide no benefits. The odds of finding an undervalued stock would always be 50–50, reflecting the randomness of pricing errors. At best, the benefits from information collection and equity research would cover the costs of doing the research.
In an efficient market, a strategy of randomly diversifying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs, would be superior to any other strategy that created larger information and execution costs. There would be no value added by portfolio managers and investment strategists.
In an efficient market, a strategy of minimizing trading (i.e., creating a portfolio and not trading unless cash is needed) would be superior to a strategy requiring frequent trading.
It is therefore no wonder that the concept of market efficiency evokes such strong reactions on the part of portfolio managers and analysts, who view it, quite rightly, as a challenge to their very existence.
2E. F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25 (1970): 383–417.
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It is also important that there be clarity about what market efficiency does not imply. An efficient market does not imply that:
Stock prices cannot deviate from true value; in fact, there can be large deviations from true value. The only requirement is that the deviations be random. This also implies that large market corrections (a price jump or drop is consistent with market efficiency.
No investor will beat the market in any time period. To the contrary, approximately half of all investors,3 prior to transaction costs, should beat the market in any period.
No group of investors will beat the market in the long term. Given the number of investors in financial markets, the laws of probability would suggest that a fairly large number are going to beat the market consistently over long periods, not because of their investment strategies but because they are lucky. It would not, however, be consistent if a disproportionately large number of these investors used the same investment strategy.4
In an efficient market, the expected returns from any investment will be consistent with the risk of that investment over the long term, though there may be deviations from these expected returns in the short term.
N e c e s s a r y C o n d i t i o n s f o r M a r k e t E f f i c i e n c y Markets do not become efficient automatically. It is the actions of investors, sensing bargains and putting into effect schemes to beat the market, that make markets efficient. The necessary conditions for a market inefficiency to be eliminated are as follows:
The market inefficiency should provide the basis for a trading scheme to beat the market and earn excess returns. For this to hold true:
The asset or assets that are the source of the inefficiency have to be traded.
The transaction costs of executing the scheme have to be smaller than the expected profits from the scheme.
3Since returns are positively skewed (i.e., large positive returns can be well above 100% but the worst case scenario is that you lose 100%), less than half of all investors will probably beat the market.
4One of the enduring pieces of evidence against market efficiency lies in the performance records posted by many of the investors who learned their lessons from Ben Graham in the 1950s. Probability statistics would have to be stretched to explain the consistency and superiority of their records.
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There should be profit-maximizing investors who:
Recognize the potential for excess return.
Can replicate the beat-the-market scheme that earns the excess return.
Have the resources to trade on the asset or assets until the inefficiency disappears.
There is an internal contradiction in claiming that there is no possibility of beating the market in an efficient market and then requiring profitmaximizing investors to constantly seek out ways of beating the market and thus making it efficient. If markets were in fact efficient, investors would stop looking for inefficiencies, which would lead to markets becoming inefficient again. It thus makes sense to think about an efficient market as a selfcorrecting mechanism, where inefficiencies appear at regular intervals but disappear almost instantaneously as investors find them and trade on them.
P r o p o s i t i o n s a b o u t M a r k e t E f f i c i e n c y A reading of the conditions under which markets become efficient leads to general propositions about where investors are most likely to find inefficiencies in financial markets.
Proposition 1: The probability of finding inefficiencies in an asset market decreases as the ease of trading on the asset increases. To the extent that investors have difficulty trading on an asset, either because open markets do not exist or because there are significant barriers to trading, inefficiencies can persist for long periods.
This proposition can be used to shed light on the differences between different asset markets. For instance, it is far easier to trade on stocks than it is on real estate, since stock markets are much more open, trading is in smaller units (reducing the barriers to entry for new traders), and the asset itself does not vary from transaction to transaction (one share of IBM is identical to another share, whereas one piece of real estate can be very different from another piece a stone’s throw away). Based on these differences, there should be a greater likelihood of finding inefficiencies (both undervaluation and overvaluation) in the real estate market than in the stock market.
Proposition 2: The probability of finding mispricing in an asset market increases as the transactions and information cost of exploiting the inefficiency increase. The cost of collecting information and trading varies widely across markets and even across investments in the same market. As these costs increase, it pays less and less to try to exploit these inefficiencies.
Consider, for instance, the perceived wisdom that smaller companies that are not followed by analysts or held by institutions are more likely to
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be undervalued. This may be true in terms of gross returns, but transaction costs are likely to be much higher for these stocks since:
They are often unlisted or listed on a dealer market, leading to higher brokerage commissions and expenses.
Due to their illiquidity and the fact that they are low-priced stocks, the bid-ask spread becomes a much higher fraction of the total price paid.
Trading is often thin on these stocks, and small trades can cause prices to change, resulting in a higher buy price and a lower sell price.
Once you consider the transaction costs, you may very well find that the excess returns you perceived in these stocks are gone.
Corollary 1: Investors who can establish a cost advantage (either in information collection or in transaction costs) will be more able to exploit small inefficiencies than other investors who do not possess this advantage.
There are a number of studies that look at the effect of block trades on prices and conclude that while they affect prices, investors will not be able to exploit these inefficiencies because of the number of times they will have to trade and their transaction costs. These concerns are unlikely to hold for a specialist on the floor of the exchange, who can trade quickly, often and at no or very low costs. It should be pointed out, however, that if the market for specialists is efficient, the value of a seat on the exchange should reflect the present value of potential benefits from being a specialist.
This corollary also suggests that investors who work at establishing a cost advantage, especially in relation to information, may be able to generate excess returns on the basis of these advantages. Thus, the Templeton funds, which started investing in Japanese and other Asian markets well before other portfolio managers, were able to exploit the informational advantages they had over their peers to make excess returns in Asia in the early stages of the boom.
Proposition 3: The speed with which an inefficiency is resolved will be directly related to how easily the scheme to exploit the inefficiency can be replicated by other investors. The ease with which a scheme can be replicated itself is inversely related to the time, resources, and information needed to execute it.
Since very few investors single-handedly possess the resources to eliminate an inefficiency through trading, it is much more likely that an inefficiency will disappear quickly if the scheme used to exploit the inefficiency