Monday, November 7, 2016

Market Efficiency and the Impact of Passive Investing

            In recent weeks the Wall Street Journal has been reporting on the increasing move to passive index investing as opposed to active management.  As reason for the move, the Journal points to the inability of active managers to beat the market after taking account of the fees they charge.  The implication is that the market is simply too efficient to justify active management fees.  There are two, now somewhat ancient lines of academic research, that are still highly relevant to the issues investors face in the current environment.

            First, in the early 1980s, Richard Roll and I and Joseph Stiglitz and Sanford Grossman demonstrated that markets can never be fully efficient.  Market efficiency, after all, is not due to some natural phenomenon.  It is the result of careful research by fundamental investors.  If those fundamental investors cannot earn a fair rate of return on the resources they put into investment research they will cut back.  But as fundamental investors cut back and indexing becomes more common, prices will begin to diverge from fair value making investment research more profitable. As a result, economic theory predicts that the market must be sufficiently inefficient to allow at least sophisticated investors to earn a fair return on their efforts by identifying mispriced securities.

            Second, William Sharpe demonstrated that it is a mistake to equate market efficiency with the inability of active investors, as a group, to outperform passive indexes.  A simple example illustrates why this is so.  Divide investors into two groups: passive investors who hold the market index and active investors who engage in research in an attempt to beat the market.  Suppose that in a given year the return on the market index is 10%.  By definition passive investors who index the market will also earn 10%.  But that means that active investors, as a group must also earn 10%, before costs.  Given the costs of active investing, active investors as a group must always do worse than passive investors.  As Sharpe stresses, this result has nothing to do with market efficiency – it is an arithmetic identity.  Even in the most wildly inefficient market passive investors as a group would still outperform active investors as a group taking account of costs and fees.  What is true is that if the market is highly efficient, so that few securities are mispriced, there is likely to be little superior or inferior performance among the class of active investors.  Conversely, if the market is more inefficient then the more sophisticated investors, who can identify mispriced securities, will benefit at the expense of less informed active investors.  But in either case, Sharpe’s arithmetic shows that active investors as a group will underperform passive investors, net of fees.

            For investors who think they have the skill to identify mispriced securities, it would be nice to know if the current movement toward indexing has led to increased market inefficiency.  Ideally, there would be an index of market efficiency that investors could use to judge how likely it would be to find mispriced securities.  Unfortunately, there is no such index and there is not likely to be one in the foreseeable future.  Asset prices are so volatile and market conditions are so variable that a reasonable index of “inefficiency” cannot be constructed.  That is why, fifty years after Eugene Fama introduced the idea of market efficiency, scholars are still arguing about how efficient the market is.  There is no evidence that the debate is subsiding.  While conceptually it follows that the move toward passive investing will lead to greater inefficiency, whether there has been any material change in market efficiency thus far is unknown.

Sunday, November 6, 2016

Technology Valuation and Barriers to Entry - A retrospective

       A constant theme of this blog has been the importance of barriers to entry in value creation.  Designing a cool new product will not create value if others can easily copy it.  In that vein, there were four key posts on this site.  It is time for a retrospective.

      A post on September 25, 2014 was entitled "GoPro Investors Have Gone Crazy."  GoPro is a prime example of a company that introduces a cool new product for which there are no significant barriers to entry (in the case of GoPro an action camera).  The market apparently failed to appreciate this fact because on the day of post the stock was trading at $81.31 with a massive P/E ratio.  As competition arose, the stock price tumbled.  Friday it closed at 11.16 down over 86%.

      A similar example is Fitbit which markets watch-like fitness trackers.  Fitbit was trading at $37.09 on October 22, 2015 when I wrote my post, "Not So Fitbit" which argued that the market was wide open to competition including major companies like Apple.  Friday the stock closed at $8.71 down over 76%.

      Tesla has been a common focus of this blog.  The last post was on April 2016, entitled "Tesla is Over $250 - Again," argued that the auto industry is just too competitive for Tesla to traded at multiples an order of magnitude higher than the competition.  At the time of the post, Tesla was trading at $255.47.  Friday the stock closed at $190.56 down over 25%.

     Finally, on November 20, 2015, I posted an article entitled, "Don't Be Square."  The argument there was that payments technology was becoming a hotly competitive business with companies like Apple and Samsung, among others, entering the fray.  On that day Square opened at $13.92.  Friday the stock closed at $12.18 down a meager 12.5%.  In my view, however, this stock has further to fall.  The market has yet to appreciate how fierce the payments battle is likely to become.

   

Friday, November 4, 2016

Global Warming in the Miami Airport

       This week I took a business trip to San Juan Puerto Rico via Miami.  A check of the weather before I left showed 80 degrees in Miami and 84 in San Juan.  Nice warm tropical weather.  To be safe, I packed a light sweather in case of aggressive restuarant air conditioning.

        During the three days I was gone I was freezing the whole time, even with my cotton sweater.  Because I am interested in energy conservation, I carry a digital therometer.  Cooling is highly energy intensive, much more so than heating.  In both the San Juan and Miami airports, where I spent way too much time, my thermometer never got above 69.  I wanted to go outside to warm up, but security presented that.

         Ironically, President Obama was in Miami as well campaigning for Hillary Clinton and mentioned her dedication to addressing climate change.  A first step in that effort is getting the incentives right.  Both Mr. Obama and Ms. Clinton stress the importance of government policy as opposed to market incentives in addressing the issue.  But both airports are run by public authorities and neither seems to have any interest in energy conservation.  I asked several employees, all wearing coats, why it was so cold.  Nobody knew.  In fact, nobody had any idea who set the temperature guidelines.