October 2, 2015

An Efficient Edge

Over the years the differing opinions of stock portfolio management and predictive models overflowed to the world of academia owing its credibility to the massive endowments that were faced with the same issues as the average investor, namely, how to make money. But as the markets have recently shown their first price rebellion in four years memories are stimulated about the days when gross uncertainty made capital preservation a winning strategy. Today, I believe we are seeing a similar correction in today’s volatile markets. 

For many years individuals from prestigious academic institutions and other backgrounds have tried their collective hands at the management of assets. Most did so to no avail, as the markets proved too random to consistently outperform. So what did these individuals do? They gave up. Or rather they keenly decided that if all the available education and pedigree didn’t prepare them for success in asset management then what hope was there for the average investor. Hence the introduction of indexed mutual funds.

What this created was an investing environment that could be tracked on a basis that forgoes fundamental analysis and instead relies on the premise that all information that is available to influence market behavior (i.e. volatility) is available to everybody, making its efficiently distributed. This meant that if the stock market index went up a portfolio could be hedged with a bond index that could be counted on going down. Sounds simple enough, and the fancy name given to this characterization was The Efficient Frontier.

Flash forward and today those index funds are the mainstay of the ETF business. That means in short all of the characteristics of a mutual fund with the tradability of an individual stock. The product has been a gift to the speculating community, looking at a horizon no longer than an 8 hour trading day. But it hasn’t been that easy in the years since the aforementioned frontier strategies stumbled in the financial crisis and a new set of short term models based on thousands of pieces of data compiled over fundamental, technical and now behavioral analysis projecting more activity in the markets, including a near quadrupling of option volume since the introduction of ETF’s, and a clearing system, given the fancy name High Frequency Trading, can capitalize even without a spec of leverage.  And it can all happen in seconds, as we’ve all felt in the last few weeks.

In short, the chronic hyperbole, the computers, the chaotic global economies, all at the beckon of technology has served to move us further and further away from the discipline that indexing was meant to create for us. However, in its place it has heightened the need for true active asset management as the efficient means to offset the surrounding axis of volatility. It also doesn’t hurt to have a real person to talk to.