Sharpening the Arithmetic of Active Management

Sharpening the Arithmetic of Active Management

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  Sharpening the Arithmeticof Active Management Lasse Heje Pedersen November 2017 Professor of Finance, Copenhagen Business School and NYU Principal, AQR Capital Management
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  Disclosures The information setforth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. Please refer to the Appendix for more information on risks and fees. Past performance is not a guarantee of future performance. This presentation is not research and should not be treated as research. This presentation does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the speaker nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the speaker will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the speaker guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. The information in this presentation may contain projections or other forward‐looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely. Neither AQR nor the speaker assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of AQR, the speaker or any other person as to the accuracy and completeness or fairness of the information contained in this presentation, and no responsibility or liability is accepted for any such information. By accepting this presentation in its entirety, the recipient acknowledges its understanding and acceptance of the foregoing statement. 2
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  Academics vs. academicsAcademics vs. practitioners Active vs. Passive: Efficient vs. Ineffective Eugene Fama Nobel Prize 2013 Robert Shiller Nobel Prize 2013 Efficient! Inefficient! William Sharpe Nobel Prize 1990 Either way, passive wins on average “Passive investing is worse than Marxism” Bernstein, L.P. 2016 I challenge all these views 3
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  4 Sharpe’s “Arithmetic ofActive Management For illustrative purposes only. Image courtesy of http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1990/sharpe-bio.html William Sharpe Nobel Prize 1990 It must be the case that (1) Before costs: average active return = passive return (2) After costs: average active return < passive return “ “ These assertions … depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required. “ “
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  Sharpe’s “Arithmetic ofActive Management 5 For illustrative purposes only. Image courtesy of http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1990/sharpe-bio.html Focus first on returns before fees Results for net returns follow from higher fees for active Sharpe’s starting point: market = passive investors + active investors market return = average (passive return, active return) Passive investing defined as holding market-cap weights market return = passive return Conclusion: market return = passive return = average active returnWilliam Sharpe Nobel Prize 1990
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  Sharpe’s arithmetic doesnot hold in the real world for several reasons: First Objection: • Informed (i.e. good) vs. uninformed (i.e., bad) managers • Informed managers can outperform even if the average doesn’t Broader Objection: • Can you be passive by being inactive? 6 Sharpening the Arithmetic of Active Management For illustrative purposes only. Past performance is not a guarantee of future performance.
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  7 Even a “Passive”Investor Must Trade Source: Sharpening the Arithmetic of Active Management (Pedersen 2016). Shows path of an investor starting in a given year (1926, 1946, 1966, 1986, 2006) with the market portfolio and not trading thereafter. Market portfolio is all stocks included in the Center for Research in Security Prices (CRSP) database. For illustrative purposes only. Past performance is not a guarantee of future performance. Please read important disclosures in the Appendix. The fraction of the market owned by an investor who starts off with the market portfolio but never trades after that (i.e., no participation in IPOs, SEOs, or share repurchases). Each line is a different starting date.
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  Sharpening the Arithmeticof Active Management Sharpe’s hidden assumption: • Market never changes and passive investors trade to their market-cap weights for free • This assumption does not hold in the real world: − IPOs, SEOs, share repurchases, etc. − Index inclusions, deletions Relaxing this assumption breaks Sharpe’s equality • When passive investors trade, they may get worse prices • Passive investors deviate from “true market” So active can be worth positive fees in aggregate • Empirical questions: − Do they actually add value? − If so, how much? More than their fees? • Adding value requires that the market is inefficient 8For illustrative purposes only. Past performance is not a guarantee of future performance. = ≠
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  For S&P 500and Russell 2000 (Petajisto, 2011) • Price impact from announcement to effective day has averaged: − +8.8% and +4.7% for additions and −15.1% and −4.6% for deletions • Lower bound of the index turnover cost: − 21–28 bp annually and 38–77 bp annually 9 Trading by a “Passive” Investor: Indices Source: Sharpening the Arithmetic of Active Management (Pedersen 2016). Turnover from 1926-2015 for equity indices (S&P500 and Russell 2000) and corporate bond indices (BAML investment grade and high yield indices), and turnover is computed as sum of absolute changes in shares outstanding as a percentage of total market value in the previous month. “Other” includes mergers that may not require trading. For illustrative purposes only. Past performance is not a guarantee of future performance. Please read important disclosures in Appendix.
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  Efficiently inefficient securityand asset management markets Inefficient Shiller (1980) Fama (1970) Inefficient Definition: efficiently inefficient markets • Inefficient enough that active investors are compensated for their costs • Efficient enough to discourage additional active investing Said differently: • These markets must be difficult – but not impossible – to beat • Grossman and Stiglitz (1980): “equilibrium degree of disequilibrium” 10 Security Markets vs. Asset Management Markets Source: AQR, Efficiently Inefficient (Pedersen 2015). Security markets Asset management markets Efficient Fama (1970) Shiller (1980) Fama (1970)
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  11 Efficiently Inefficient Markets Source:AQR. For illustrative purposes only. Information Search Informed investors Good securities Bad securities Uninformed investors Informed asset managers Uninformed asset managers
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  Efficiently Inefficient: SecurityMarkets Several styles have historically outperformed • Value, momentum, quality, carry, low-risk Failure of the Law of One Price: • Stocks: Siamese twin stock spreads • Bonds: Off-the-run vs. on-the-run bonds • FX: Covered interest-rate parity violations • Credit: CDS-bond basis Bigger anomalies when • Information costs for managers are high • Search costs for investors are high Conclusion: security markets are • Not fully efficient • Efficiently inefficient 12Source: AQR. For illustrative purposes only. Past performance is not a guarantee of future performance. Informed investors Good securities Bad securities Uninformed investors Informed asset managers Uninformed asset managers
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  “Old consensus” inthe academic literature: • Active mutual funds have no skill: Looks only at average manager, Jensen (1968), Fama (1970) “New consensus” in the academic literature • Skill exists among mutual funds and can be predicted: Fama and French (2010), Kosowski, Timmermann, Wermers, White (2006): “We find that a sizable minority of managers pick stocks well enough to more than cover their costs. Moreover, the superior alphas of these managers persist” • Skill exists among hedge funds: Fung, Hsieh, Naik, and Ramadorai (2008), Jagannathan, Malakhov, and Novikov (2010), Kosowski, Naik, and Teo (2007): “Top hedge fund performance cannot be explained by luck” • Skill exists in private equity and VC: Kaplan and Schoar (2005) “We document substantial persistence in LBO and VC fund performance” Conclusion: asset management market is efficiently inefficient Good managers exist, but picking them is difficult (requires recourses, manager selection team, due diligence, etc. 13 Efficiently Inefficient: Asset Managers Source: AQR. For illustrative purposes only. Past performance is not a guarantee of future performance. Informed investors Good securities Bad securities Uninformed investors Informed asset managers Uninformed asset managers
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  Efficiently Inefficient: Investors Institutionalinvestors outperform retail investors • Gerakos, Linnainmaa, and Morse (2015) “Institutional funds earned annual market-adjusted returns of 108 basis points before fees and 61 basis points after fees” Larger institutional investors outperform smaller ones • Dyck and Pomorski (2015) Follow the smart money • Evans and Fahlenbrach (2012) “Retail funds with an institutional twin outperform other retail funds by 1.5% per year” Conclusion: efficiently inefficient investors • Evidence that more sophisticated investors can perform better • These educate themselves and spend resources picking managers 14 Sources: Gerakos, Joseph, Juhani T. Linnainmaa, and Adair Morse (2016), “Asset manager funds,” working paper. Evans, Richard, and Rudiger Falhenbrach (2012), “Institutional Investors and Mutual Fund Governance: Evidence from Retail – Institutional Fund Twins”. Dyck, Alexander, and Lukasz Pomorski (2015), “Investor Scale and Performance in Private Equity Investments” and (2011), “Is Bigger Better? Size and Performance in Pension Management.” For illustrative purposes only. Past performance is not a guarantee of future performance. Informed investors Good securities Bad securities Uninformed investors Informed asset managers Uninformed asset managers
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  Implications of Sharpe’szero-sum arithmetic: • Active loses to passive after fees • Money flows passive  markets less efficient • Surprisingly active still loses • Eventually all money leaves active, sector is doomed What happens if everyone is passive? All IPOs successful regardless of price • Everyone asks for their fraction of shares Initial result: boom in IPOs Eventual result: doom • Opportunistic firms fail • Equity market collapses • People lose trust in financial system • No firms can get funded • Real economy falters 15 Conclusion: The future of asset management – Doom? For illustrative purposes only. Image Courtesy of http://dc.wikia.com/wiki/Wonder_Woman_Vol_1_601 Good For Me Good for You
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  Conclusion: The Futureof Asset Management My arithmetic: • Suppose active loses to passive after fees • Money flows to passive  markets less efficient • Active becomes more profitable  new equilibrium, no doom The future of asset management • Passive will continue to grow, but towards a level<100% • Systematic investing and FinTech will continue to grow • Active management will survive, pressure on performance and fees Capital market is a positive-sum game • Issuers can finance useful projects • Passive investors get low-cost access to equity • Active managers compensated for their information costs 16For illustrative purposes only Good For Me Good for You
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  Disclosures 17 This document hasbeen provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered and it is not to be reproduced or redistributed to any other person. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE PERFORMANCE. There is a risk of substantial loss associated with trading commodities, futures, options and leverage. Before investing carefully consider your financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when engaging in leverage, trading futures, commodities and/or granting/writing options one could lose the full balance of their account. It is also possible to lose more than the initial deposit when engaging in leverage, trading futures and/or granting/writing options. All funds committed should be purely risk capital. AQR Capital Management (Europe) LLP, a U.K. limited liability partnership, is authorized by the U.K. Financial Conduct Authority (“FCA”) for advising on investments (except on Pension Transfers and Pension Opt Outs), arranging (bringing about) deals in investments, dealing in investments as agent, managing a UCITS, managing an unauthorized AIF and managing investments. This material has been approved to satisfy UK FCA COBS 4.