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Money management in equilibrium
The document discusses the concept of money management in equilibrium, focusing on mutual funds, their performance, and the relationship between fund size and expected returns. It critiques the rational competitive market theory and explores how net alpha is a better measure of manager quality than gross alpha due to their dependence on fund size. The findings indicate that while investors may struggle with predictability in net alpha, they appear to utilize risk models like CAPM in their decision-making.
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Money management in equilibrium
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- 2. MONEY MANAGEMENT INEQUILIBRIUM UNDERLYING RESEARCH ▸ Joint with Richard Green ▸ Mutual Fund Flows and Performance in Rational Markets ▸ Joint with Jules van Binsbergen ▸ Measuring Skill in the Mutual Fund Industry ▸ Assessing Asset Pricing Models using Revealed Preference ▸ Overview paper joint with Jules van Binsbergen ▸ Mutual Funds in Equilibrium
- 3. MONEY MANAGEMENT INEQUILIBRIUM RATIONAL, COMPETITIVE MARKETS (AKA, EFFICIENT MARKETS) ▸ Markets are so competitive that the quality of the company is reflected in the VALUE of the company ▸ Consequently, the expected return of the company is just a function of its risk, it tells you nothing about the quality of the company. ▸ This idea is so well accepted as an explanation of equity prices that it is acceptable as evidence in a court of law
- 4. MONEY MANAGEMENT INEQUILIBRIUM THE INCONSISTENCY ▸ Historically, the rational competitive market concept has been inconsistently applied to money management ▸ Equity The value (size) of a stock reflects its quality. The expected return reflects its risk ▸ Money Management The size (total AUM) of a fund is random. The quality of the fund (manager) is reflected in the fund’s expected return (alpha)
- 5. MONEY MANAGEMENT INEQUILIBRIUM NET ALPHA ▸ Using the Net Alpha to measure the quality of the manager is akin to using a stock’s return to measure the quality of the company ▸ Like a stock, the expected return of a fund is determined by its risk, so the net alpha of every fund is zero. ▸ Hard not to see the irony that Fama himself did not correctly apply his own “theory.” That should be a warning for us all. If we want to be a scientific based discipline we need to take the science seriously.
- 6. MONEY MANAGEMENT INEQUILIBRIUM HOW DOES THIS WORK? ▸ Like every industry in the economy, mutual funds face decreasing returns to scale ▸ Assume that there was a manager who provided his investors with a positive alpha. What would happen? ▸ The size of the fund adjusts to ensure that net alpha is zero.
- 7. MONEY MANAGEMENT INEQUILIBRIUM DYNAMICS ▸ Start with a mutual fund market in equilibrium so all net alphas are zero. ▸ Now new information arrives, say the manager outperforms his benchmark ▸ People update, if nothing else happened this manager would have a positive net alpha in equilibrium ▸ Result: Inflow of funds until the net alpha is again zero
- 8. MONEY MANAGEMENT INEQUILIBRIUM WHAT DO WE LEARN FROM NET ALPHA ▸ The same thing we learn when we study the net alpha of stocks ▸ Net alpha tells us about investors, not managers ▸ Positive: Markets are not fully competitive ▸ Negative: Some investors are irrational (too much money is being allocated to money management) ▸ Zero: Markets are competitive and investors rational
- 9. MONEY MANAGEMENT INEQUILIBRIUM GROSS ALPHA ▸ You cannot use the gross alpha either ▸ What you rather have, a 100% return on $1 or a 10% return on $1 Billion? ▸ Size matters in money management, you cannot use a measure that ignores it.
- 10. MONEY MANAGEMENT INEQUILIBRIUM IN FACT ... ▸ Gross alpha isn’t necessarily even positively correlated with skill if investors are rational and markets are competitive ▸ Why? Because in competitive, rational markets (aka, efficient markets) ▸ Net alpha is zero ▸ Gross alpha is just net alpha plus the percentage fee ▸ That is, gross alpha is equal to the fee, which is a choice variable! ▸ For gross alpha to even be positively correlated to skill requires additional assumptions
- 11. MONEY MANAGEMENT INEQUILIBRIUM FEES ARE IRRELEVANT ▸ Managers can charge a high fee and manage a small fund or a low fee and manage a large fund ▸ The fee only determines the size of the fund ▸ Either way, managers will always choose to actively manage the amount of capital that maximizes the value they add
- 12. MONEY MANAGEMENT INEQUILIBRIUM CORRECT MEASURE OF SKILL ▸ Value Added: the total amount of money the manager extracts from markets: q is AUM f is the percentage fee is the expected outperformance
- 13. MONEY MANAGEMENT INEQUILIBRIUM VALUE ADDED ESTIMATES (in Y2000 $ millions/month) About $2 million/year!
- 14. MONEY MANAGEMENT INEQUILIBRIUM PERSISTENCE ▸ We first sort stocks into deciles based on t-stat of value added up until time t ▸ We then measure performance over horizons of 3 to 10 years by recording the average value added in each decile in each month ▸ We repeat this procedure at the end of each horizon providing a single value added time series for each decile. We report the mean and s.e. of each series in each decile
- 15. MONEY MANAGEMENT INEQUILIBRIUM PERSISTENCE IN VALUE ADDED Vanguard Benchmark The 10th decile is always the highest decile and almost always is statistically positive
- 16. MONEY MANAGEMENT INEQUILIBRIUM PERSISTENCE IN VALUE ADDED FFC Risk Adjustment
- 17. MONEY MANAGEMENT INEQUILIBRIUM OUT OF SAMPLE PERFORMANCE OF THE TOP DECILE Note how much capital is concentrated in the 10th decile
- 18. MONEY MANAGEMENT INEQUILIBRIUM OUT OF SAMPLE COMPENSATION Vanguard is stronger than FF
- 19. MONEY MANAGEMENT INEQUILIBRIUM PREDICTABILITY IN VALUE ADDED USING COMPENSATION Vanguard Benchmark The predictability is stronger and more monotone than when we sorted on past value added!
- 20. MONEY MANAGEMENT INEQUILIBRIUM NET ALPHA ESTIMATES (in b.p./month)
- 21. MONEY MANAGEMENT INEQUILIBRIUM There is no obvious evidence of any predictability OUT OF SAMPLE NET ALPHA Vanguard Benchmark
- 22. MONEY MANAGEMENT INEQUILIBRIUM OUT OF SAMPLE NET ALPHA FFC Risk Adjustment
- 23. OUT-OF-SAMPLE NET-ALPHA OFTHE TOP DECILE A little evidence of predictabilityStrong evidence of predictability
- 24. MONEY MANAGEMENT INEQUILIBRIUM WHAT CAN WE LEARN FROM THE REMARKABLE OBSERVATIONS ABOUT COMPENSATION AND NET ALPHA? ▸ What we saw was that when we used Vanguard, compensation worked very well. It predicted performance but not net alpha ▸ It did not work well when we used FFC. In fact, net alpha (as defined by the FFC factor structure) was highly predictable ▸ There are two possible explanations ▸ Investors are happily leaving money on the table ▸ Investors don’t care about the FFC factors
- 25. MONEY MANAGEMENT INEQUILIBRIUM NEO-CLASSICAL ASSUMPTIONS THAT UNDERLIE ALL ASSET PRICING MODELS ▸ Investor compete fiercely with each other chasing positive NPV investment opportunities ▸ This competition eliminates all such opportunities ▸ Assets are priced to ensure that the expected return is solely a function of risk ▸ This causes the asset pricing relation to hold
- 26. MONEY MANAGEMENT INEQUILIBRIUM DYNAMICS ▸ What happens when new information arrives? ▸ Again, investor competition instantaneously eliminates any positive NPV opportunities that may exist at the old prices (with the new information) ▸ Again, this process implies that the asset pricing condition continues to hold ▸ This price adjustment process is part of all asset pricing models
- 27. MONEY MANAGEMENT INEQUILIBRIUM MUTUAL FUNDS ▸ New information is the return the manager earns. ▸ Only two ways to eliminate a positive NPV investment opportunity ▸ Investor flows ▸ Fee changes
- 28. MONEY MANAGEMENT INEQUILIBRIUM ADVANTAGE OF THIS TEST ▸ It is not subject to the epicycle bias ▸ Current factor models are designed to explain the data, so it is not surprising that they do a good job of that ▸ Merely explaining the data does not imply the models are right. Correct models explain must explain new regularities ▸ This test is not something the models were designed to explain
- 29. MONEY MANAGEMENT INEQUILIBRIUM METHODOLOGY ▸ We will just look at signs ▸ We compute the fraction of times we observe an inflow when the realized abnormal return is positive ▸ We compute the fraction of times we observe an outflow when the realized abnormal return is negative ▸ Our measure of model performance is the average of (1) and (2) ▸ We will rank models by this measure ▸ If flows and returns are unrelated the measure will equal 50%
- 30. MONEY MANAGEMENT INEQUILIBRIUM PRACTICAL ISSUES ▸ What time horizon do we measure flows and abnormal returns over? ▸ We should use the shortest horizon possible ▸ But what if investors don't react immediately ▸ We solve this problem by using horizons from 3 months to 4 years.
- 31. MONEY MANAGEMENT INEQUILIBRIUM 1977-2011
- 32. MONEY MANAGEMENT INEQUILIBRIUM Investors do use a risk model They are not risk neutral MODEL RANKING Investors do not use the factor models They adjust for risk using the CAPM beta!
- 33. MONEY MANAGEMENT INEQUILIBRIUM INVESTORS APPEAR TO BE USING THE CAPM ▸ CAPM does better than no model at all ▸ It does better than just adjusting by the market return ▸ Investors are using BETA. ▸ remember, this is theoretical prediction of investor behavior ▸ how often are economic models able to do this?
- 34. MONEY MANAGEMENT INEQUILIBRIUM TAKE AWAYS ▸ We were very surprised with the finding that people appear to be using the CAPM ▸ Implied puzzle: Why then does the CAPM not work in the cross section? ▸ There is also other stuff going on that the paradigm does not explain
- 35. MONEY MANAGEMENT INEQUILIBRIUM FACTOR MODELS ▸ Here there is no theory ▸ They appear to just be the result of overfitting to the data ▸ Finance equivalent of epicycles
- 36. MONEY MANAGEMENT INEQUILIBRIUM COST OF CAPITAL ▸ Ultimate goal of asset pricing ▸ Method for calculating the cost of capital ▸ What this paper says is the CAPM is still the best we have
- 37. MONEY MANAGEMENT INEQUILIBRIUM
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