I recently put the following article written with my friend Rodney Sullivan on SSRN (I mentioned this effort in an earlier blog). Without great surprise, this article should appear in Journal of Portfolio Management next year.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679766
It is about our view on the future of active quant investing. The current active quant investing model is fatally flawed, just like Euro being a flawed currency. Take this analogy further, Euro may yet survive the current crisis, because it is more of a political tool to integrate Europe than a product due to economic rationale. Without a unified fiscal authority, breaking down of cultural and language barriers to allow real free labor movements, it is a doomed currency, with the only uncertainty about its collapse being the timing.
The current active quant investing is similarly flawed. They are mostly riding on some long-term trends unintentionally (e.g., small, value, and momentum). If you take these long term trends away, they got little game going. This means that some smart semi-active ETFs can easily replace them, with the same boom and bust cycle of performance. This also means that clients should not have paid them that much for doing what they are doing today.
When they are against the trends, they have no clue what to do. Even more strange is that in the last few years, I talked to quite a few quant firms and mentioned that they should incorporate some quantitative but not systematic analysis to turn around their performance. Even though some of them made good offers to me, none of them is flexible about their investment approach. I ended up not taking any of those offers because I thought they are doomed, at least in the long-term.
Some of them did start to go down the direction that we discussed in the article. Some of them are looking more into the macro level and try to incorporate more information there. Even there, the only approach is systematic and pure quant, which essentially doomed the effectiveness of the macro push.
The above article provides a decent, yet somewhat incoherent, guide about how quants should change to make their long term business model viable. Rodney was instrumental in moderating the tone of the article, but we still get some hate mails, and we understand there could be many more hatred out there. I am good at making the piece more coherent, but I sometimes cannot hold my punches. So the current state of the article may be the best constrained optimum, given the hate mails we have already got. In the next revision, we will try to make it more coherent yet still moderate enough, and also incorporate any comments we get.
What surprises me is how close minded many of the quants are. Even if the article is completely garbage, there is no need to hate, especially given the sorry state of quants in the last few years (which I correctly predicted in early 2008). At least be open minded and see if there is anything useful there. I would do that myself. Further, I am surprised that no one was flexible enough to at least allow me to have an alternative investment approach under their roof in the last couple of years. Maybe the only alternative is to have a start up to run an independent show, even though that takes a lot of time and preparations.
Saturday, November 13, 2010
Is the U.S. doomed if USD is debased?
There is a lot of fear out there, linking the recent weakness of USD to the long-term doom of the U.S. Even if we do not consider that USD is still not below the level in 2007 on a trade-weighted basis (there was not much of this kind of discussion then), this fear is completely baseless.
We do not have to look far back into history to have so many countries seeing their currency depreciated at some point and then come roaring back to the top of economic form. Among developed countries, Britain and Canada easily come to mind. Was Britain cursed when the pound collapse under Soros attack? One key reason for the recovery of many countries is export driven growth. That aside, using currency to measure a country’s long-term prospect is misguided. It is the economy, stupid ;=). Whenever faster growth and fuller employment happen, either due to currency devaluing or not, the currency is likely to appreciate again.
So in today’s U.S., anything that could help improve growth and employment, including devaluing USD, should be considered as a viable policy tool, and is likely to result in long-term appreciation of USD.
Sunday, October 31, 2010
My view on Mr. Market, maybe more to follow on this topic
Is market efficient? No.
Is market stupid? Many times.
Is it easy to beat the market? Not really.
Is market stupid? Many times.
Is it easy to beat the market? Not really.
Tuesday, October 26, 2010
Should investors react strongly and positively to Citi's earnings news?
Since one of my friends liked this entry, I will expand it a bit more here.
From WSJ today:
"The bank's third-quarter profit was $2.2 billion, up from $101 million a year earlier, with per-share profit of seven cents coming in just above analysts' estimates. The amount the bank set aside for credit losses fell. Revenue rose 2% from a year earlier, to $21 billion, but fell 6% from the second quarter."
The markets react strongly and positively to the positive earnings news from Citi. It actually brought up the whole financial sector, and the whole markets. However, if investors know something about earnings management, the earnings pattern of Citi smells like classical accrual earnings management.
Generally, firms that announce earnings slightly beating zero threshold (e.g., 1 cent per share) or analyst estimates (e.g., if analyst consensus is 6 cents and the announced earnings is 7 cents) are found to be most likely to have managed/fudged earnings. See Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99-126 for further evidence. The academic literature even find that firms may manage earnings just enough so that it is e.g., 0.5 cents about zero or analyst consensus. When the number is rounded up, it becomes 1 cent more than zero or analyst consensus. I am not sure if Citi is using this later roundup tools.
How could firms management earnings? Generally, they could use either accrual or real earnings management (AEM and REM). In AEM, firms exploit the flexibility under GAAP to classify items differently. For example, the following paper show the the main forms of accrual earnings management are as follows:
* Unsuitable revenue recognition
* Inappropriate accruals and estimates of liabilities
* Excessive provisions and generous reserve accounting
* Intentional minor breaches of financial reporting requirements that aggregate to a material breach.
See Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.
So the way that Citi has met and slightly beat earnings expectation is through the third forms above. Although I am not able to check extensively, this pattern makes me suspicious that as one of the masters of the Universe, Citi must know how to do it right so that the trace of earnings management may be less obvious.
Companies also do real earnings management, which include abnormal production to affect costs of goods sold expenses, along with timing sales recognition, R&D and advertising spending, and asset sales. For example, company could cut the current period R&D expenses to meet earnings expectations. They could also slash price and bring forward sales into the current period to management earnings. They could try to realize gains on asset sales to boost up earnings. Different from AEM, REM 1) involves changes in the timing or structuring of operations, investments, and/or financing transactions; 2) have cash flow consequences; 3) do not necessarily reverse automatically; and 4) are more difficult to detect because it is easily disguised as normal operating decisions. In a survey of CFOs, the following paper finds that managers prefer to use REM.
See Graham, J., C. Harvey, and S. Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40, 3-73.
A well known paper by Sloan shows that accrual earnings management can predict future returns. Firms with more AEM to boost up earnings would subsequently outperform in stock prices. The main explanation is that investors do not fully understand the impact of accruals and blindly react to the announced earnings numbers (which is partly fudged). So if that is the case, Citi shareholders are likely to experience some relatively lower returns in comparison to stocks with similar risk/characteristics. This accrual characteristic has been used by buy-side money managers extensively in the last ten years.
See Sloan, R., 1996, Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315.
Similarly to Sloan 1996, I have a recent working paper in which I find that firms practicing more REM to increase earnings would suffer lower future stock returns. See my paper "Real earnings management and subsequent stock returns: at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679832. The paper has been presented at the annual meeting of Chicago Quantitative Alliance, a national organization of mostly buy-side researchers and portfolio managers this September. It has made every top ten downloaded list that fits its category. Part of the paper is likely to be in most every buy-side managers' toolkit in the future.
From WSJ today:
"The bank's third-quarter profit was $2.2 billion, up from $101 million a year earlier, with per-share profit of seven cents coming in just above analysts' estimates. The amount the bank set aside for credit losses fell. Revenue rose 2% from a year earlier, to $21 billion, but fell 6% from the second quarter."
The markets react strongly and positively to the positive earnings news from Citi. It actually brought up the whole financial sector, and the whole markets. However, if investors know something about earnings management, the earnings pattern of Citi smells like classical accrual earnings management.
Generally, firms that announce earnings slightly beating zero threshold (e.g., 1 cent per share) or analyst estimates (e.g., if analyst consensus is 6 cents and the announced earnings is 7 cents) are found to be most likely to have managed/fudged earnings. See Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99-126 for further evidence. The academic literature even find that firms may manage earnings just enough so that it is e.g., 0.5 cents about zero or analyst consensus. When the number is rounded up, it becomes 1 cent more than zero or analyst consensus. I am not sure if Citi is using this later roundup tools.
How could firms management earnings? Generally, they could use either accrual or real earnings management (AEM and REM). In AEM, firms exploit the flexibility under GAAP to classify items differently. For example, the following paper show the the main forms of accrual earnings management are as follows:
* Unsuitable revenue recognition
* Inappropriate accruals and estimates of liabilities
* Excessive provisions and generous reserve accounting
* Intentional minor breaches of financial reporting requirements that aggregate to a material breach.
See Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.
So the way that Citi has met and slightly beat earnings expectation is through the third forms above. Although I am not able to check extensively, this pattern makes me suspicious that as one of the masters of the Universe, Citi must know how to do it right so that the trace of earnings management may be less obvious.
Companies also do real earnings management, which include abnormal production to affect costs of goods sold expenses, along with timing sales recognition, R&D and advertising spending, and asset sales. For example, company could cut the current period R&D expenses to meet earnings expectations. They could also slash price and bring forward sales into the current period to management earnings. They could try to realize gains on asset sales to boost up earnings. Different from AEM, REM 1) involves changes in the timing or structuring of operations, investments, and/or financing transactions; 2) have cash flow consequences; 3) do not necessarily reverse automatically; and 4) are more difficult to detect because it is easily disguised as normal operating decisions. In a survey of CFOs, the following paper finds that managers prefer to use REM.
See Graham, J., C. Harvey, and S. Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40, 3-73.
A well known paper by Sloan shows that accrual earnings management can predict future returns. Firms with more AEM to boost up earnings would subsequently outperform in stock prices. The main explanation is that investors do not fully understand the impact of accruals and blindly react to the announced earnings numbers (which is partly fudged). So if that is the case, Citi shareholders are likely to experience some relatively lower returns in comparison to stocks with similar risk/characteristics. This accrual characteristic has been used by buy-side money managers extensively in the last ten years.
See Sloan, R., 1996, Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315.
Similarly to Sloan 1996, I have a recent working paper in which I find that firms practicing more REM to increase earnings would suffer lower future stock returns. See my paper "Real earnings management and subsequent stock returns: at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679832. The paper has been presented at the annual meeting of Chicago Quantitative Alliance, a national organization of mostly buy-side researchers and portfolio managers this September. It has made every top ten downloaded list that fits its category. Part of the paper is likely to be in most every buy-side managers' toolkit in the future.
Sunday, October 17, 2010
401k track record from 4/2001-9/2010: 109%
I finally get the 401k statement for some other reason. I requested that they provide year by year return number so that I can show that there is probably no year with negative returns. However, it does not have a break down for each year (maybe I will ask them again, which will take a while). But it does have a total return over the whole period. The total return from 4/16/2001 to 10/1/2010 is 109% (so over about 10 (9.5) years). And it is restricted to only a short list of mutual funds (generally the choice is less than 10). So it is a very constrained investment opportunity set and I do not have full time to trade this that frequently (and it has restrictions against frequent trading).
The annualized return, if you put into excel, is about 8.1% per year. I hope this does not disappoint my readers given the simultaneous markets' performance. If 8% annualized a year in the last decade sounds boring, how about no or almost no negative returns in any of the last 10 years ;=). So the Sharpe ratio, or the ratio of return to volatility, is likely to be quite higher, because of the relatively little volatility in performance. I also get every trade executed in and out of the mutual funds from this statement. If you or you know any one who have a chunk of money and would be interested in this kind of performance (or better), I would happy to provide the service. I have my own company to take care of the administrative stuff. The investments will be in highly liquid securities (or pure mutual funds, like my 401k), and will have relatively low risk exposure and low correlation with market performance through my 'impressive' asset allocation.
The reason for little volatility or negative performance in my performance is because I had everything in cash in 2002 and 2008, the two big market down year. There is no long-term T-bond fund in the 401k account so there is no way to capture the upside in those down years. But zero return is still way... better than 30-50% downside, right?
Another thought, I wonder how many are educated enough to recognize, this kind of long-term performance would be quite attractive in any environment (either at the start of 2000, when bull markets are raging, or at the depth of the bear markets in 2008). These are equity like returns with bond like risks. That is close to heavenly investing. I hope I can repeat this performance for the years to come. The paranoid survives.
The annualized return, if you put into excel, is about 8.1% per year. I hope this does not disappoint my readers given the simultaneous markets' performance. If 8% annualized a year in the last decade sounds boring, how about no or almost no negative returns in any of the last 10 years ;=). So the Sharpe ratio, or the ratio of return to volatility, is likely to be quite higher, because of the relatively little volatility in performance. I also get every trade executed in and out of the mutual funds from this statement. If you or you know any one who have a chunk of money and would be interested in this kind of performance (or better), I would happy to provide the service. I have my own company to take care of the administrative stuff. The investments will be in highly liquid securities (or pure mutual funds, like my 401k), and will have relatively low risk exposure and low correlation with market performance through my 'impressive' asset allocation.
The reason for little volatility or negative performance in my performance is because I had everything in cash in 2002 and 2008, the two big market down year. There is no long-term T-bond fund in the 401k account so there is no way to capture the upside in those down years. But zero return is still way... better than 30-50% downside, right?
Another thought, I wonder how many are educated enough to recognize, this kind of long-term performance would be quite attractive in any environment (either at the start of 2000, when bull markets are raging, or at the depth of the bear markets in 2008). These are equity like returns with bond like risks. That is close to heavenly investing. I hope I can repeat this performance for the years to come. The paranoid survives.
Thursday, October 14, 2010
Confirmation about my predictions on US and Chinese trade balance
As I mentioned earlier, this will be the case for the quarters to come
http://xlpartners.blogspot.com/2010/08/preoccupation-on-nominal-exchange-rates.html
until we have some serious threat of trade war or maybe actual trade war. This is the single most important threat to the smooth rise of the emerging markets. This is confirmed again with the latest data
http://online.wsj.com/article/SB10001424052748704361504575551811511078860.html?mod=WSJ_hps_LEFTWhatsNews
"The U.S. trade deficit with China grew to $28.04 billion from $25.92 billion in July. Imports from China grew 6.1% to a record $35.29 billion. Meanwhile, exports fell $92 million to $7.25 billion."
http://xlpartners.blogspot.com/2010/08/preoccupation-on-nominal-exchange-rates.html
until we have some serious threat of trade war or maybe actual trade war. This is the single most important threat to the smooth rise of the emerging markets. This is confirmed again with the latest data
http://online.wsj.com/article/SB10001424052748704361504575551811511078860.html?mod=WSJ_hps_LEFTWhatsNews
"The U.S. trade deficit with China grew to $28.04 billion from $25.92 billion in July. Imports from China grew 6.1% to a record $35.29 billion. Meanwhile, exports fell $92 million to $7.25 billion."
Monday, October 11, 2010
If you want to see what it means by pyramid builders, look at this
"Four of Bank of America's top 10 shareholders have sold 10% or more of their holdings since March, and the bank's shares are down 34% since reaching a 52-week high of $19.86 in mid-April."
I did not check those holders specifically. Since a few top hedge funds earned an enormous profit from loading a huge amount of shares of BOA and other banks, it is likely that some of them are among those four.
http://online.wsj.com/article/SB10001424052748704127904575544161532372790.html?mod=WSJ_hps_LEFTWhatsNews
I did not check those holders specifically. Since a few top hedge funds earned an enormous profit from loading a huge amount of shares of BOA and other banks, it is likely that some of them are among those four.
http://online.wsj.com/article/SB10001424052748704127904575544161532372790.html?mod=WSJ_hps_LEFTWhatsNews
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