Evidence Based Finance

Initial thoughts for 2023:
The US market ended the year about -20%, pretty bad.
Looking historically though, how many negative back to back years has it had since 1928? Only 4.
Great news for us right? Maybe not:

The conditions in those years except for 1939-1941 were all pretty similar. In 1928, 1973, and 2000 the Fed hiked rates into a recession.
While not guaranteed, a recession is widely expected for 2023.

What to do? Stay the course, don’t change what you’re doing. Don’t try to predict the market. Don’t listen to experts because they don’t know either.

The Evidence Based Investor details 20 years of active management failure:

New study shows 20 years of failure for active managers | TEBI     By LARRY SWEDROE   Nobel Prize winner Eugene Fama is considered the father of the efficient market hypothesis (EMH), which asserts that financial markets are “informationally efficient” — the result of financial markets processing millions of trades, reflecting the viewpoint of investor...

Part 5: Diversification

Indexes do not always make for optimal portfolios, as they can have heavy weightings in certain sectors. More than half of the market capitalization of the S&P/TSX Composite Index, for example, is in just two sectors, energy and financial services. An actively managed portfolio can diversify away from such concentrations, and can include attractive sectors and securities that are not well represented in the index.

The first point is true, Canada’s market has large weightings in Energy and Financial Services. But do actively managed funds create increased value by diversifying into “attractive sectors and securities that are not well represented in the index”?

This assertion would be easy enough to prove, just provide long term fund returns in Canada.

Unfortunately, Canadian managers have underperformed their benchmarks 84-91% after fees, over the last 10 years. It seems they aren’t finding more attractive sectors and securities than the benchmark.

However, for the first time in their argument for active investing: Recent studies have shown that truly actively managed portfolios tend to outperform. A 2009 paper by Yale finance professors Martijn Cremers and Antti Petajisto concluded that the best-performing funds focus heavily on stock selection, and have high “active share,” a measure that identifies the portion of a portfolio that is different from the benchmark index.

The implication here is that most active managers are trying to just look like the benchmark, when you isolate for “active share” you find that they do tend be a predictor of outperformance.

Although the paper and its methods have been widely panned, Cliff Asness of AQR Capital effectively recreated the study in his own paper “Deactivating Active Share” and found that “for a given benchmark, we did not find reliable evidence that high-active-share funds earn higher returns than low-active-share fund”. While funds with more active share looked and behaved less like the benchmark, there was no ability to predict whether that performance was good or bad. He went on to conclude “that active share does not reliably predict performance and that investors who rely on it to identify skilled managers may reach erroneous conclusions.”

Deactivating Active Share The authors investigate Active Share, a measure meant to determine the level of active management in investment portfolios, and find it wanting.