Practical analysis for investment professionals
03 March 2016

Five Pieces of Conventional Wisdom That Make Smart Investors Look Dumb

Are investors neglecting more difficult dimensions and taking unwarranted shortcuts in order to try and make sense of information overload?

Take paper book sales: You might casually assume they are a lost cause in the age of e-books, yet the latest figures show they are surging. Or vinyl record sales: They are dramatically on the upswing amid a wave of retro-philia.

It seems that conventional wisdom is quite often wrong and misapprehensions can easily prevail, cemented perhaps by groupthink tendencies intrinsic to peer-influenced media.

1. Tech-Rapture Never Fails

For instance, consider almost any kind of optimism about the wonders of technology, an article of faith to most under-60s: According to Martin Wolf writing in Foreign Affairs, techo-optimists are just plain wrong. Recent advances are pitiful small fry compared to those of a 100 years ago. We could all benefit by cultivating some long-range perspective about what we can realistically expect from technology. According to another writer in the Harvard Business Review, “digitization” carries unfortunate costs as well as benefits. For example, it takes a skillful manager to keep staff up to date.

2. Wall Street Ethics to Blame Again

Can investors still attribute pretty much everything that goes wrong in the economy to questionable Wall Street ethics? Actually no, only anecdotally can the global financial crisis be blamed squarely on greed and selfishness among professionals in finance. One recent study in the Journal of Business Ethics summarized in CFA Digest reveals that professionals in finance are no less ethical than the general population.

3. Easy to Spot a Liar

More misapprehension revolves around the ease of identifying deceptive behavior, which newspaper headlines suggest is a common occurrence in the financial industry. A recent study in the Journal of Behavioral Finance abstracted in CFA Digest suggests financial professionals believe they can identify lies. Yet the survey detects an element of classic overconfidence among its participants. According to the survey, deceptive people are seen to be more nervous and fidgety and avoid eye contact compared to truth tellers, exactly as you might assume. But it seems no studies identify any definitive giveaway sign of deception.

4. Active Share Outs Closet Indexers

Surely, investors can at least rely on the latest techniques of “active share” and “smart beta” to help achieve their investing goals? Turns out that this too may be another comforting misapprehension. Evaluating performance using “active share,” a performance metric designed to measure the difference between a given portfolio and its benchmark, seems on first sight a great way to identify closet indexers and keep tabs on where managers lie on the passive-to-active spectrum. It has burgeoned in popularity among sophisticated retail and institutional investors.

But recent research by a trio from AQR Management and published in the Financial Analysts Journal suggests otherwise. The researchers took the same sample data that supported the original justification for “active share” and found that active share correlates with benchmark returns and is not informative in predicting fund returns. “Within individual benchmarks, it is as likely to correlate positively with performance as it is to correlate negatively,” the team conclude.

5. Smart Beta Is King

Then there is the popular adoption of smart beta strategies by asset allocators to solve many portfolio-formation problems: Smart beta strategies are transparent, rules-based, low-fee portfolios which mechanically track characteristics historically associated with excess risk-adjusted returns. Now part of a fast growing $300bn industry, smart beta strategies are related to passive vehicles but are still considered active since they require rebalancing to capture those chosen risk factors.

Yet if they are so smart, consider the queue of Nobel laureates telling us they are dumb. To name but two, Eugene Fama and William F. Sharpe condemn smart beta and its proponents at any and every opportunity, notably at CFA Institute conferences. Here is Sharpe in 2014:

“Are you telling me that this is good for everyone because you and your friends are really smart, the people who hold the market — the indexers — are dumb, and the people who underweight your favorite stocks are really dumb? If you and your friends are going to overweight value stocks and my friends and I are going to hold index funds, somebody somewhere is underweighting the value stocks. If you are smart and I am dumb, then the people on the other side of your positions must be really stupid. If your story is that you have found a way to exploit stupidity and if you’re right, I would suggest that before too long, the really dumb investors will begin to choose index funds or move in your direction, as may some of the index fund people. If so, your edge will diminish and eventually disappear.”

Of course an advocate of efficient markets would argue like that, but there are other technical problems with smart beta. A team from EDHEC-Risk Institute and ERI Scientific Beta recently evaluated the robustness of the outperformance of smart beta strategies. Their research, summarized in CFA Digest, evaluated the causes of a lack of robustness and suggested some useful fixes. Their conclusions reiterate the dangers of data mining and poor transparency.

Finally, if reading this article, the season of the year, the day of the week, the weather, your sports team’s performance, or anything else makes you especially happy today, consider this summary of a paper published recently in the Journal of Financial and Quantitative Analysis, “Do Happy People Make Optimistic Investors?” The researchers identify mood-related factors that potentially impact return and risk expectations among test subjects and discover that many such factors suggest a potential explanation.

Related readings, including recent CFA Digest summaries for interested readers to research, are summarized below:

  • Same as It Ever Was: Why Techno-Optimists Are Wrong: Leading economist and Financial Times columnist Martin Wolf notes that although technological progress undoubtedly influences how people live, both economically and socially current developments are more incremental compared with innovations in the 19th and 20th centuries. Nevertheless, they can still trigger significant changes — positive or negative — in society and in business conduct. Some measures can and should be taken to diminish adverse outcomes.
  • Digital Transformation Doesn’t Have to Leave Employees Behind: “Digitization” carries costs and benefits. Managers can help their conventional organization evolve into a digital one while ensuring that their employees are keeping pace.
  • The Global Financial Crisis and the Values of Professionals in Finance: An Empirical Analysis: Despite anecdotal wisdom attributing the global financial crisis to greed and selfishness among professionals in finance (PIFs), surveys on personal values compiled prior to the crisis show very little difference between PIFs and the general population. An environment of perverse incentives must then explain bad behavior by average people, and proper regulation offers a partial solution.
  • Robustness of Smart Beta Strategies: Investors are wary of the robustness of the outperformance of smart beta strategies. The authors address this concern by providing measures of relative and absolute robustness. They examine the causes of a lack of robustness and propose remedies for these problems. Their conclusions focus on the dangers of data mining and a lack of transparency.
  • Do Happy People Make Optimistic Investors? Various mood-related factors may influence individual investors’ expected month-ahead return forecasts and year-ahead risk forecasts. The authors test likely factors — such as general optimism, seasonality, day of the week, weather, and sports team performance — on risk and return forecasts and find that many factors show strong explanatory power.
  • Deactivating Active Share: The authors investigated “active share,” a measure meant to determine the level of active management in investment portfolios. Using the same sample that was used in the original research on this topic, they found that active share correlates with benchmark returns but does not predict actual fund returns; within individual benchmarks, it is as likely to correlate positively with performance as it is to correlate negatively. Their findings do not support an emphasis on active share as a manager selection tool or an appropriate guideline for institutional portfolios.
  • Detecting Lies in the Financial Industry: A Survey of Investment Professionals’ Beliefs: The authors address three issues relating to financial professionals’ beliefs about deceptive behavior. First, they find that financial professionals believe nonverbal cues are more useful in identifying deceptive behavior than verbal ones. Second, financial professionals view themselves as more likely to detect lies in their professional and personal lives when compared with other groups. Lastly, financial professionals place a high importance on learning how to better identify and handle deceptive behavior.
  • Past, Present, and Future Financial Thinking: At the 67th CFA Institute Annual Conference, held 4–7 May 2014 in Seattle, Robert Litterman interviewed Nobel laureate William F. Sharpe to elicit his perspective on a number of investment issues, including the capital asset pricing model, asset allocation, behavioral finance, and retirement income.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/CSA-Archive

About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, is director of journal publications at CFA Institute, where he supports a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

5 thoughts on “Five Pieces of Conventional Wisdom That Make Smart Investors Look Dumb”

  1. Eric Carlson says:

    I’ve been particularly interested in all of the active share research and have spent time speaking with Professor Cremer, one of the original authors of the first active share research, on multiple occasions. I think it is important to consider the motivations behind AQRs paper when making a conclusion as to the validity of their claims. While the same data was used to support AQR’s conclusions it was organized in a much different way. Both of the original authors have written responses to AQR which I think are worth considering before drawing your own personal conclusion.

    Here are links to the responses:

    http://www.petajisto.net/papers/petajisto%20response%20to%20AQR%20article.pdf

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2625214

    In addition, there has been more research done combining active share with measures of patience for active managers which result in more statistically relevant conclusions. Here is the link:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2498743

    Active share is obviously one tool of many used in evaluating mangers but as with everything else it is important to be as impartial as possible and evaluate as much information as you can find before determining whether you want to incorporate it into your own research.

  2. Dear Eric,

    thanks so much for generously sharing your thoughts about the lively debates around active share. This is developing into a contentious and fascinating area for academics and practitioners.

    I agree that it is always good practice for readers to carefully consider any vested interests or potential conflicts of interest in any research.

    I am looking forward to taking a closer read of some of your suggested papers.

    Best regards,

    Mark

  3. Dave Johnson says:

    Well, I have to comment on the ethics comparison (being that financial execs and people are no more unethical than the general population). I believe that and another belief springs to mind: Sure, but financial executives go to JAIL less than the general population. RAMPANT THEFT on Wall Street has led to just a handful of REAL punishment. JPM is a great example: the London Whale loses billions, Jamie Dimon offers up a “great performance” in one of those hard-hitting Congressional hearings, and NO ONE is punished but the share holders. THE COMPANY pays the Fines. This is the distinct difference and your missing this is quite honestly putting you in the middle of the road.

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