After what investors have experienced over the last 18 months or so, it is natural to look around and determine if the investment philosophy guiding your portfolio is a proper one. It seems institutions, the proverbial 800-lb gorillas, are moving away from active managers.

The Wall Street Journal published a story, Active Managers Get the Cold Shoulder, on Monday indicating that institutions are questioning the benefit (or lack of benefit) of an active management approach to stock selection.

A quote that easily jumps out is: “Active managers have not given us the added performance in a down market that we hoped for.” These funds can hire anyone they desire and they are backing away from the active manager option.

As a quick review, active managers are those that try and find under-valued securities and insist that the stock is mispriced. They will profit from their purchase when market participants eventually come to their senses and provide a higher value to that stock relative to the overall value of the stock market. These active investors also take into consideration macro level events and surmise that the markets have or have not reflected these events properly in their prices and hence take anticipatory market positions.

A passive or structured investment approach takes a completely different position. It is based on the premise that all known information is already reflected in a stock’s price and even though new/unforeseen events may recalibrate the stock’s price significantly (i.e., volatility) an investor cannot take the known information and consistently use it to outperform another investor.

I have pointed out in our blog the performance shortcomings of an active approach relative to a structured investment approach. See entries on Active Manager performance and Hedge Funds.

We embrace this structured/passive approach. And it seems, based on the article, so are institutional investors with increasing frequency.

In a recent Washington Post article, On Wall Street, the Price Isn’t Right, Roger Lowenstein provides a very effusive review of a book by Justin Fox titled The Myth of the Rational Market. In the article, Roger Lowenstein points out how this book will finally put an end to the failed financial concept of Efficient Markets.

He states that Efficient Markets posits that: “… stock and bond markets are nearly perfect …” In my opinion Roger Lowenstein sets up a straw man argument. There are actually many forms of market efficiency which he could have pointed out in the article by simply directing his readers to general investment websites such as Investopedia. See the following explanation on the different types of Market Efficiency from Investopdedia.

1. Strong efficiency - This is the strongest version, which states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage.

2. Semi-strong efficiency - This form of EMH implies that all public information is calculated into a stock’s current share price. Neither fundamental nor technical analysis can be used to achieve superior gains.

3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today’s stock price. Therefore, technical analysis cannot be used to predict and beat a market.

It comes as no surprise to any one that markets do not perfectly reflect the true price of a company. Are prices 70%, 80%, 90% accurate? This is up for academic debate. The right answer is “for the most part.”

The important takeaway for investors is that the markets do a better job of incorporating new information than an individual investor’s attempt to expose these inefficiencies. Although the book, The Myth of the Rational Market, rails against the mistake of Market Efficiency, it finds little evidence of success among professional money managers in exploiting the inefficiencies its author, Justin Fox, believes are so clearly evident.

He has some kind words for academics who have set up money management firms to apply research on behavioral biases to generate superior returns, but he cites no evidence of their success, perhaps because their results are generally well explained by the standard asset pricing models he is so quick to condemn.

Fox appears frustrated that the evidence of market irrationality appears so clear but the evidence of investor success in exploiting these mistakes is so thin. His brief message to investors toward the end of the book carries an air of resignation-all the effort devoted to identifying flaws in the rational market model doesn’t appear to offer hope of a superior approach. Almost as an afterthought, his practical advice to investors includes the following suggestions:

• “If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you are. You don’t have to stop there. But if you do come up with an idea for beating the market, you need a model that explains why everybody else isn’t already doing the same thing you are.”

• “If you’re picking somebody else to manage your money, the chances of finding a market-beating path are even harder.”

Bottom line: Market Efficiency should not imply in my view that assets are perfectly priced. No reasoned academic would state as much. But what efficiency does imply is that one individual will not consistently (beyond what can be determined by chance) outperform another investor in pricing the market risk.

And this is what is shown with great regularity in the scientific literature. I have pointed this out throughout this blog. See entries on Active Manager performance and Hedge Funds.

http://investmentsignal.net/?tag=performance

http://investmentsignal.net/?tag=hedge-funds

On my drive home from work, I find myself listening to CNBC’s Fast Money because I realize that many of our clients and prospects receive this type of advice on a regular basis and it makes sense to try to keep abreast of popular investment advice.

After the rather dramatic rise in stock prices over the previous month and a half, the focus of these shows seem to be devoted to detecting the next correction, determining the precipitous fate of the dollar, and the extent of any upcoming inflation.

The show Fast Money epitomizes this. After all according to CNBC, these experts “give you the information normally reserved for the Wall Street trading floor, enabling you to make decisions that can make you money.” Well before paying much attention to what they think is next for the market, let’s see how the cast of Fast Money has done. A firm CXO Advisory Group did the heavy lifting for us. This is what they had to say:

The Fast Money experts have on average offered no “fast money.” Average raw cumulative returns for expert picks (black line) are negative for all weeks over the 13-week test horizon (before trading frictions).

The experts as a group perform very similarly to contemporaneous investments in SPY, an S&P 500 proxy (green line) on a cumulative return basis over nearly all of the 13-week test horizon.

The next chart depicts the average raw cumulative returns for the 188 long and 24 short picks of the Fast Money experts. (Short picks are investments that they feel will lose value so they bet against them.) The short picks include six recommendations to buy inverse funds. The long positions by themselves have underperformed SPY over most of the 13-week test period and indicate no stock picking ability.

The short positions alone generate positive cumulative returns for most of the 13 weeks in the test period. (This is the exact opposite of what they wanted.) Declines in the broad stock market over parts of the test period tend to aid the performance of short positions. However, as seen in the previous graph, the short recommendations do not make the experts outperform the overall stock market.

Can we compare the stock picking abilities of individual Fast Money experts?

None of the experts have generated attractive raw returns. In summary, the Fast Money experts as a group probably do not offer fast money with their stock picks, and their stock-picking ability as a group is unimpressive.

It seems to me that the Real Fast Money is actually represented by the general market portfolio. This represents the aggregate investments by all  investors and reflects every-one’s best estimate of how the market should be priced.

And while buying a market portfolio may seem pedestrian and its recommendation to do so will not be able to sustain an hourly trading show, it remains a better option.

As I am quick to point out how most investors fail to outperform a given market, I want to bring to your attention a group of investors that decidedly outperformed the markets and investment professionals.

Recently, a group of investors doubled their money. The article maintains that “they were able to manage their portfolio - in the middle of one of the worst recessions in history - better than most of Wall Street!”

How they did it?
“What we did was just take a risk with the financials - it was beat up at the time, … And we decided to take a risk and see if it would make money - which we did.”

“You just gotta watch the market and watch how it’s going,” Bailey explained. “When it goes up, you take a risk and buy shorts instead of long.”

Who are these investors?
“A team of fifth graders at the Tullar Elementary School in Neenah, Wisconsin, won the state-wide Wisconsin Stock Market Game.” (Want to Make Money on Stocks? Ask a Fifth Grader!)

Will you see them on a nightly business show?
Probably not.

If they had been “investment professionals,” with the same results, would they be making the rounds on the “Mad Money” type of shows?
Possibly.

If stock picking was truly an endeavor based on skill rather than luck you would not see a group of 5th graders outperforming other professionals.

Could you imagine a group of 5th graders building better bridges than trained engineers?

In a recent article, Is Your Fund Pawning Shares at Your Expense?, Wall Street Journal columnist Jason Zweig takes a look at securities lending practices among various mutual funds and finds, in some cases, cause for concern. “Securities lending is sensible and beneficial in the right hands,” he observes, “but can wreak havoc when it is done wrong.” Last year’s turbulent fixed income market led to problems in unexpected places such as money market funds or short-term “enhanced cash” strategies, and a number of lending programs experienced losses associated with reinvestment of collateral backing the securities on loan.

Zweig’s principal gripe is that some fund sponsors keep a portion of the lending revenue even though loaned securities belong to fund shareholders and they bear the risk associated with such activities. He notes approvingly that T. Rowe Price Group and Vanguard Group “rebate all securities-lending income (net of expenses) back to the funds that generated it.” Although not mentioned in the article, Dimensional funds likewise receive 100% of any net lending revenue.

Zweig’s article suggests that fund investors and their advisors should pay close attention to securities lending practices, the allocation of revenue, and the financial incentives for those providing lending services to the fund.

A description of Dimensional securities lending practices appears on page 80 of the DFA IDG/DIG prospectus dated February 28, 2009, and a related risk discussion appears on page 16. A table on page 36 shows net lending revenue for the fiscal year ending October 31, 2008 for twenty-seven funds, with the funds earning a total of $182,252,000. The resulting performance enhancement among these twenty-seven funds for the fiscal year ranged from 0.04% for US Large Company Portfolio to 0.66% for Japanese Small Company Portfolio.

Karmin, Craig. “Securities Lending is Being Squeezed.” Wall Street Journal, October 1, 2008.
Zweig, Jason. “Is Your Fund Pawning Shares at Your Expense?” Wall Street Journal, May 30, 2009.