Empirical Facts

AgPa #83: How Much of the US Market is Passive?

The passive ownership share is double what you think it is (2024)
Alex Chinco (URL), Marco Sammon (URL)
Journal of Financial Economics, URL/SSRN

After my post on passive investing (see AgPa #77) and its consequences for active managers, I had a long and very interesting discussion with David Einhorn about the issue. David was very gracious with his time and we ended up agreeing on many things, but also agreed to disagree on a few others. Overall, I think it is fair to say that I am still somewhat more supportive for passive than he is.

So what I am going to do over the following weeks is to challenge my views further. For that purpose, I went back to the episode of the Rational Reminder podcast with Michael Green (URL) from Simplify Asset Management. Mike describes the potential problems of passive investing in great detail and brings a lot of arguments to the table. He also mentions some interesting research papers on the subject. This week’s AGNOSTIC Paper is the starting point and attempts to measure how much of the US equity market is actually passive. Spoiler: it is hard to say precisely, but probably much more than most people think…

  • Trading data suggest that 1/3 of the US market is passive
  • Index changes trigger massive trading volumes
  • Passive trading affects prices – but (usually) not on reconstitution day

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AgPa #82: Equity Risk Premiums and Interest Rates (2/2)

Expected Stock Returns When Interest Rates Are Low (2022)
David Blitz
The Journal of Portfolio Management 48(7), URL/SSRN

The second AGNOSTIC Paper on equity risk premiums when interest rates are high(er). This one was actually published before the last one, so David Blitz deserves credit for the original idea. He also examines a longer and more comprehensive dataset that serves as a nice out-of-sample test. So I think it makes sense to conclude the posts on equity risk premiums and interest rates with this more comprehensive paper.

  • Equity risk premiums were lower when interest rates are higher
  • Controlling for other factors doesn’t change the negative relation
  • EPS growth seems to explain the pattern

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AgPa #81: Equity Risk Premiums and Interest Rates (1/2)

Honey, the Fed Shrunk the Equity Premium: Asset Allocation in a Higher-Rate World (2024)
Thomas Maloney
The Journal of Portfolio Management 50(6), URL/AQR

Risk-free interest rates, the most fundamental anchor of asset prices, increased dramatically in 2022 and are still considerably higher than over the last 10+ years. At the same time, equity markets around the world posted strong performance in 2023 and 2024 (so far). Many investors thus wonder how this fits together. Why should we pay the same multiple for stocks when the risk-free alternative is much better than a few years ago? Or more technically, why should we accept such a low equity risk premium? This week’s AGNOSTIC Paper is the first of two that sheds some light on this (very important, but also very difficult) issue.

  • Equity returns and risk-premiums were lower in higher-rates environments
  • EPS growth, valuations, and interest rate changes explain the effect
  • Treasuries and absolute-return strategies historically benefitted from higher rates

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#4: Warren Buffett is not an Index Hugger

Two weeks ago, the Financial Times (FT) Unhedged Newsletter (URL) joined many others to write about Warren Buffett and Berkshire Hathaway (BRK) in the week of its famous annual general meeting in Omaha. The FT also published an outstanding series on the future of Berkshire Hathaway without the now 93 year-old legendary CEO and Chairman (URL).

I stumbled across some statements in the two Unhedged Newsletters “Warren Buffett: The world’s richest index-hugger” (URL) and “Berkshire’s next move” (URL) from May 6 and 7, respectively. I have nothing qualified to say about Buffett’s succession, but I do believe the statement that Warren Buffett is an index hugger deserves some more discussion.

  • Berkshire Hathaway’s returns over the last 21 years
  • Berkshire Hathaway’s “risk” over the last 21 years
  • What is risk?
  • Berkshire Hathaway in good and bad markets
  • Is Warren Buffett an index hugger?

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AgPa #77: Too Much Passive Investing?

The Rise of Passive Investing and Active Mutual Fund Skill (2023)
Da Huang
SSRN Working Paper, URL

This week’s AGNOSTIC Paper is a quite recent working paper that examines the impact of passive investing on the US stock market. The debate about a potential tipping point when too many assets go passive is ongoing and often quite emotional. Depending on who you ask, you hear everything from “fundamentally broken” markets to the idea that we only need very few skilled active managers who compete for all the alpha. This week’s paper provides some interesting theoretical and empirical results on that matter.

  • Passive investing in the US grew tremendously
  • Passive investing forces unskilled managers to quit
  • Surviving active managers have more skill, but take less risk
  • We are probably not yet at the point of too much passive

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AgPa #74: Peer-Reviewed Research is Not Helpful to Predict Returns – Really?

Does peer-reviewed theory help predict the cross-section of stock returns? (2023)
Andrew Y. Chen, Alejandro Lopez-Lira, Tom Zimmermann
Working Paper, URL

This week’s AGNOSTIC Paper examines the holy grail of empirical research and systematic investing. Is all the research from those smart academics and practitioners really helpful to predict stock returns? Or are we all victims of data mining? The paper if of course not the first one examining this issue, but the approach is in my opinion quite interesting and the authors derive some thought-provoking implications. Pure data mining matches the results from decades of peer-reviewed research surprisingly well. The practical implications, however, are in my opinion not as clear as the statistical ones.

Putting all of this together, the authors may be right that peer-reviewed research and theory are (statistically) not helpful to predict stock returns. I do believe, however, that theory and rigor research in the sense of understanding what you are attempting to do is helpful for real-world investing.

  • Return predictors decay out-of-sample – with and without theory
  • Data mining generates similar patterns like peer-reviewed research
  • Out-of-sample decays are similar for data mining and peer-reviewed research

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AgPa #71: Go Where the Earnings (per Share) Are

What Matters More for Emerging Markets Investors: Economic Growth or EPS Growth? (2022)
Jason Hsu, Jay Ritter, Phillip Wool, Harry Zhao
The Journal of Portfolio Management Emerging Markets 2022, 48 (8), URL/PDF

This week’s AGNOSTIC Paper is one from the myth-busting category and examines the relation between countries’ GDP growth and stock market returns. The idea and analyses are admittedly not new and the paper is basically an update of one of the authors previous work. Nonetheless, I think the question is very interesting and still very relevant for regional asset allocation.

  • GDP growth and stock returns are not correlated over the long-term
  • Theoretically, the missing relation is not surprising
  • Go Where the Earnings (per Share) Are

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AgPa #69: Rebalancing Luck

Fundamental Indexation: Rebalancing Assumptions and Performance (2010)
David Blitz, Bart van der Grient, Pim van Vliet
The Journal of Index Investing Fall 2010, 1(2), URL/SSRN

This week’s AGNOSTIC Paper is already more than 10 years old, but still carries a very important message. The core idea is very simple. If you design an investment strategy, you must make decisions about rebalancing. There are two aspects to consider. How much and when. This week’s authors examine the when at the example of fundamental indices. They show that choosing arbitrary rebalancing date(s) introduces substantial luck or bad luck to a strategy. Even more important, this luck or bad luck doesn’t seem to cancel out over time and thus permanently affects real-world returns. Fortunately, however, there are ways to make yourself less dependent from rebalancing luck…

  • Different rebalancing dates lead to different outcomes
  • Rebalancing luck (or bad luck) is relevant and persistent
  • There is a solution: stretch rebalancing over the year

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AgPa #61: Minivans versus Sports Cars

Sensation Seeking and Hedge Funds (2018)
Stephen Brown, Yan Lu, Sugata Ray, Melvyn Teo
The Journal of Finance 73(6), 2871-2914, URL/SSRN

Tell me about the car you drive and I tell you who you are. In the hope of not offending the car enthusiasts too much, this week’s AGNOSTIC Paper relates the performance and characteristics of hedge fund managers to the type of car they drive. As announced in last week’s article, this is a funny example for the important soft factors that investors should consider when selecting an asset manager.

  • Sports car drivers take more risk and deliver lower performance
  • Funds of sports car drivers come with more operational risk
  • Sports-car-driving investors want sports-car-driving fund managers

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AgPa #59: Why and When Institutional Investors Fire Asset Managers

Forbearance in Institutional Investment Management: Evidence from Survey Data (2023)
Amit Goyal, Ramon Tol, Sunil Wahal
Financial Analysts Journal 79(2), 7-20, URL

As we all know, extracting excess returns from (equity) markets is not so easy. Identifying and monitoring managers who can reliably do that is therefore at least as difficult, if not harder. In particular, deciding whether to continue working with a temporary underperforming manager is often difficult. This week‘s paper examines how institutional reports approach this problem in practice…

  • Institutional investors are more patient than thought
  • Tolerance for underperformance is surprisingly long
  • Sophistication and risk-appetite of investors do matter

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