Monthly Archives: December 2012

Over at Aleph Blog, we have a riff on a popular misconception:

And, maybe, just maybe this means that indexing will have to get to be a much larger proportion of the markets before active managers would have alpha after fees as a whole.

Active managers cannot have, as a whole, alpha, regardless of how much of the market is passive managed.

Let’s simplify, and imagine the market is, for a while, a closed circuit second-hand market (no issuance or redemptions) and entirely managed by 2 managers: one active, who is required to be fully invested (no cash), and one passive with a capitalisation weighted index mandate. For every stock, the passive manager owns, as per their mandate, a fixed proportion P of the total shares in issue. The active manager by definition owns (1-P) of every stock, that is the market portfolio or index.

As external investor preferences between active and passive shift, one manager sells to (buys from) the other, all stocks in the same quantity proportional to their cap. The quantity is set by the passive manager’s mandate, and at all times both managers hold the market portfolio.

But, you will tell me, the passive manager is a price taker, as they have to rebalance as per their mandate. This is correct, at every rebalance the active manager can set the price, and choose to pay more for stocks it finds undervalued and conversely, but regardless of the price they pay, they will keep the market portfolio. The active manager pricing activity, if successful, makes the market externally better priced, and benefits equally both managers and their investors. This is the magic of indexing: it allows passive investors to free ride on the alpha of active investors as it gets incorporated into beta (in our 2 managers world, the active alpha is always zero).

The only ones to benefit differentially from the active managers activity are (external) investors who time switches between passive and active when the active guys have an edge or lost it. Investors passively holding either of the active or passive manager’s funds get the same performance.

Of course, if we bring back the real world the situation is a bit more messy with many investors and many indices, inflows and outflows into the market, and fees, but none of these distractions change the basic mechanics that alpha = 0 at the collective level for active managers, regardless of the proportion of passive managed funds (this is as true for 1% passive as it is for 99.999% passive).

Some argue that there is truly dumb money that is a category apart from passive and active managers, but even money outside funds is managed by people who are not categorically different from passive and active managers who run funds. Even the dumbest retail noise trader is, statistically, a passive manager — intense random trading converges with no trading at the limit — and cannot lose by more than their transaction costs (which can be a lot but are not negative alpha as such) as a category.

This has been observed empirically, with many studies finding that active managers return something really close to the index less fees, pretty much what the simplified model predicts.

Basically alpha is a zero sum game and as a class active mangers cannot outperform the index. With small enough fees it might be worth taking a chance — the positive side of the equation is that active managers cannot collectively underperform by more than the fee drag either.

An interesting and seldom discussed point is that morally, indexing could be seen as a form of theft: at the collective level passive investors benefit from the work of active investors, which is paid for entirely by active investors. It is though saved from the tragedy of the commons by hope internally (which keep some active) and externally by plurality: if the entire stock market was passive, the prices would be set by issuers and investors entering/leaving the stock market as a whole (investing or raising funds elsewhere) which should still result in equilibrium prices (modulo frictions) as long as there’s at least one asset class that is not fully passive (a condition fulfilled structurally by any illiquid enough market).


The Obliquity London portfolio has seen its first sale: the United Drug holding was trimmed down back to initial size after hitting a more than 50% price increase (sale of 1/3 of the holding), according to the systematic rebalancing rule designed to avoid overweights, and incidentally capture bubbles.

I don’t even know why it’s going up that frantically, the main news seems to be that the Irish company’s primary listing is being transferred to London (where it had a secondary listing) from Dublin, which means it will be included in “UK” indices — which are really indices of London-listed companies. I don’t think the “index effect” is that big and can alone justify the price jump — or else I’m clearly in the wrong business.

The momentum seems solid and the automatic rule of selling back to size every time something goes 50% up should capture it, without introducing excess risk, and minimising the downside in case of reversal, which is unavoidable for idiosyncratic bubbles.

Image of containerised electrical generators

Aggreko’s kit (Credit: corporate PR)

The proceeds of this sale and ongoing dividends raised enough cash to have one “mid cap” amount available for a new member. I have chosen Aggreko, a steady boring power rental business which happens to have fallen 20% today due to a 2013 earnings warning. It has been on the shortlist for a while, passes the Obliquity criteria comfortably; and the long term case remains identical, seasonal variations of earnings over a couple of years horizon being no concern. It seems opportune to take the discount even if it might now be on a down trend for some time.

This will probably be the last trades of the year. Standard Chartered and Reckitt Benckiser are still on watch for the reasons discussed earlier.

The worst performers of the portfolio so far: First Group, Intel, and Balfour Beatty have no changed fundamentals of relevance to the strategy and the poor performance of some value plays in the short term is normal. To avoid the value trap though, the rebalancing rule does not buy up to initial weight. If cash becomes available it’s deemed to be better to find a new holding, which helps diversification.

The total return performance of the portfolio so far is pleasing: up 10.8% versus 4.5% for the reference ETF (iShares MSCI World), in sterling terms since inception. The FTSE 100 is up 6.5% on the same time frame so the London-listing bias is not quite an explanation for the outperformance. I don’t think there’s much to be read in short term performance, but it’s always pleasing to start with a tail wind. I certainly don’t expect to beat the benchmark by that much on a regular basis.

Disclosure: sold some UDG on 29. November; bought AGK on 17. December.

Eric Falkenstein notes that virtually all returns come from overnight price movements. Beyond the implications related to the low volatility anomaly, a consequence I find interesting is that it suggests the continuous pricing mechanism of the day session actually suppresses rather than enables the price discovery process. Basically, it seems day sessions are, on average, almost pure noise, with the closing price being pretty much like the opening price.

It could mean it takes closed markets to absorb new information, which is actually not that unbelievable. The way trading sessions are organised would look truly bizarre to a martian, or anyone discovering the markets from a non financial viewpoint. It is a relic from pre-computer times when markets were run as an outcry auction with people shouting at each other in a big room. While this was a remarkably efficient arrangement in the absence of computers, the model was obsoleted by electronic trading, which, after a few decades of rearguard action by incumbents with vested interests, has come to dominate.

Image of Chicago Board of Trade trading pit

Rearguard action (Chicago Board of Trade in 2006, Credit: puroticorico on flickr)

Now despite almost all important markets being electronic, they have kept artefacts from the manual trading era: a trading session which corresponds to working hours at the location of the exchange, which is mainly nonsensical given that people trading financial instruments can be located anywhere, news happen at any time, and the companies or instruments quoted often have global scope. If continuous trading — the ability to trade at any point in time — was particularly useful everything should trade continuously, 24 hours a day, the way foreign exchange markets do. There are no technical difficulties: computer program that run markets and market makers only need to be kept running, and whatever human based monitoring is required can follow the sun as most financial institutions have offices in all countries. It works that way for foreign exchange markets, which trade continuously from Monday to Friday. They still stop at weekends, for no particular reason either, as people don’t stop using currencies at weekends.

If markets were truly 24h continuous, the “all return is overnight” phenomenon could not happen. Why may it be so?

One reason can be that most of the news happens overnight. Given trading days for stocks are typically around 8 hours or so, that covers 1/3 of 5/7 of the days, aka 23% of the time. Add up the habit of publishing company news outside (e.g. after) trading hours to avoid short term funny effects, and that can come to explain some of it.

Another factor I suspect is relevant is that market making algorithms and/or high frequency trading — in so far as they can be distinguished, most HFT is a form or market making — have become so dominant that they often suppress meaningful price moves. It could be at the stock level, where statistical arbitrage will tend to push back information, because it expects the stock to track the most important index it is a member of; or that, simply, enough of the trades are market making (market-neutral agents can trade with each other) that they drown the (single-shot) informed traders in the short term. As many such algorithm will be calibrated during or after the opening of the session and shut down at or before close, this is consistent with the phenomenon observed.

Whatever the reason, it seems the whole sophisticated infrastructure behind continuous trading is redundant. If all return is overnight, we may as well have a daily (or even less for low liquidity instruments) auction and be done with it. This would eliminate the role of (intraday) market makers and their cut — a point auction has no spread — at no loss to investors and final users of capital. The only thing that would be possibly lost is the entertainment value for people following and imagining order in the randomness of intraday moves.

Still, it is vastly improbable that any exchange is going to announce the closing down of their continuous day session to save costs and benefit investors and issuers. Shall we conclude that markets are not (externally) Pareto-efficient?