Fruit Basket Paradox

Abstract

Investment management which is worth USD 70 trillion can be seen like a fruit basket. The job of the fund manager was to select the fruits from the market and sell it to the investor. Global pensions are a part of this pool. Despite the important role fund managers play, there is a lot of confusion regarding financial theories and lack of standardization between investment management practices. Investment solutions are primarily for a rising market. There are limited solutions for a falling market. The investment solutions are primarily equity focussed. There are no standardized metrics to look at all asset classes together i.e. equities, commodities, bonds, currencies, alternatives. Academic thinking is also very equity focussed. ‘Size’ the most important factor explaining stock market returns is not understood well. The lack of standardization, solutions for an up trended market, equity skew is the ‘Fruit Basket Paradox’, a term that explains the fragmented nature of financial theories and the circular argument that rots the investment management business today.

Fruit Basket

Investment Management is like a Fruit Basket. It is worth USD 70 trillion [1] today. Global Investors and your pension is a part of this pool. 1775, the first Mutual Fund [2] was formed and it was the fund manager aka the Fruit Basket Manager, who was in charge of 99.9% of these investments. His job was to select the fruits from the market and sell it to the investor. Fruit Basket Paradox is a term that explains the fragmented nature of financial theories and the circular argument that rots investment management today.

In 1885 came the rule based fruit basket. The S&P DJ Indices [3] created the fruit baskets of 30 and 500 stocks, the Beta. Then came the other rule-based managers [4], who manage your trillions of investments and pensions today. By 1970s the pie started shrinking for the fruit manager. The industry had started shifting to metrics and rules. By 1980s ETF [5] (Exchange Traded Funds) started and became the fastest growing financial instrument in the history of markets. The Fruit Managers were under attack.

In 2002 came another contender; the Smart Beta [6]. The fastest segment to raise USD 100 billion Assets Under Management. The Fruit Manager’s business shrank further. The estimates put the pie at 65% in the next 3 years [7]. The Fruit manager was first challenged by Beta. This was followed by Smart Beta, which flanked Beta and ate into the Fruit Basket Manager’s pie further.

Broken Basket

The rule-based investment industry is just focused on stocks. It ignores the rest of the basket which includes commodities, currencies, bonds and alternatives. There is no standard metric for all assets. The industry standard called the ’Style Box’ [8] classifies equity and fixed income differently. It makes no claims to understand commodities, currencies, alternatives or a combination of multiple assets. The ‘Style Box’ is broken [9].

The problem is rooted in the past. Just because Value was narrowly defined in 1920’s [10] fundamentally and Value was seen as a good way of selection, the industry clustered around Value investing and made it a buzzword. Of course, Value investing meant patience, longer duration, and low-risk entries, which was not for everyone. A section of market believed in Growth investing, running after the fundamental winners.

It will revert anyway

Now there is enough proof that it is not about one style over the other, both styles work. There are periods when Value beats Growth and vice versa. Moreover, the narrow fundamental definition of Value and Growth makes it tough to have an objective debate about the subject. The more confusing it is, the easier it is to convince the trillions following Bogle and Vanguard to stop worrying about Value or Growth and just follow the market. The problem is similar with technicians [11] who debate about momentum (trend following) or reversion (counter trend) systems [12]. A section of the market believes in momentum while the other patiently waits for reversion.

At the end of the day, just because we cannot explain Value over Growth does not make buying the market a default solution. We have a problem with our metrics. By the way, Bogle is a believer of Mean Reversion and he uses it against both Value and Growth. “Both the styles will revert so why to choose one over the other.” [13]

Ostrich Problem

But just because nobody wants to resolve the conflict between Value and Growth, Momentum and Reversion [14] does not mean that the Ostrich problem is going away.

It is my pension and I want to ask more than a few questions. Even if we assume the Fruit Manager beats the S&P500 [15], what would he do if the S&P500 tanks? We know what happens when markets tank. There is a limited hedge, correlated assets, and herding. If it all goes one way, what metrics and what rules does the Fruit Manager follow? Systems cannot just work in the US. They have to work also across geographies [16].

Beta and Smart Beta are designed for markets going up. The rules do not work for a market that is going down. Smart Beta’s claim to be smarter than the Beta cannot just be for an up trended market [17]. There should be a Smart Inverse that works on the way down [18]. How can rules work just on the way up but make no sense on the way down? Hedgers need better solutions.

The Paradox

The CAPM has little respect [19]. The Beta is dead [20]. The Nobel Prize winners driving the industry say “We don’t know why it works?” [21] Are markets efficient or inefficient? [22] If bubbles were always emotional, [23] how come behavioral finance funds failed to outperform [24]? Why are we seriously looking at “End of Behavioral Finance” [25]? The lack of standardization, solutions for an up trended market, equity skew is the ‘Fruit Basket Paradox’, a term that explains the fragmented nature of financial theories and the circular argument that rots the investment management business today. The investment management industry is estimated to reach USD 100 trillion in 2020 [26]. For over 100 years the physicists are struggling to explain why the rich get richer. [27] The industry ought to know more about the risk it is traversing.

What is the solution?

First; Money has to be managed like a basket. Wealth creation is about portfolio management. Jules Regnault’s law of ruin [28] from 1863 still holds. “The more you will trade, the more you will ruin yourself”. Second; Metrics have to work across assets, across regions, across preferences; the style box has to be one for all asset classes; Third; What works on the way up, should also be mathematically invertible on the way down. If your rule box can beat S&P500 on the way up, it should also beat it on the way down. For every Smart Beta, there has to be a Smart Inverse. Fourth; Academically, one should be able to explain why Size [29] and Value premium [30] works? Why are markets efficient and inefficient? [31] If an architecture can explain and deliver outperformance, we have resolved the ‘Fruit Basket Paradox’ [32]. Until then the Fruit Manager is going to see his pie shrinking as rule-based systems complete for assets under management.

Bibliography

[1] PWC – Asset Management 2020 a brave new world
[2] Smart Beta Trends, Tralio Blog, Pal, 2016
[3] S&P DJ Indices – Indexing Company
[4] Invesco – PowerShares, FTSE Russell, MSCI
[5] ETFs making mutual funds extinct, Business Insider, 2016
[6] The rise of smart beta, Economist, Jun 6, 2013
[7] PWC – Asset Management 2020 a brave new world
[8] Style Box, Morning Star
[9] Is the Style Box broken or fixed? Pal, 2015
[10] What is Value?, SSRN, Pal, 2014
[11] Market Technicians, New York
[12] Gamblers of New York, Pal, 2013
[13] The Stock Market Universe—Stars, Comets, and the Sun, John Bogle, 2001
[14] Momentum and Reversion, Pal, 2015
[15] Why hasn’t Active investing outperformed Passive investing in recent years?, CFA Institute, 2015
[16] Do Behavioral Biases Adversely Affect the Macro-Economy?, Korniotis, Kumar, 2010
[17] Is Smart Beta dumb?, Pal, 2015
[18] The Short Index, Pal, 2014
[19] CAPM is CRAP, Montier, 2013
[20] Is Beta dead or alive? Lakonishok, 1993
[21] Two Pillars of Asset Pricing – Nobel Prize Lecture, Fama, 2013
[22] What is Value?, SSRN, Pal, 2014
[23] Irrational Exuberance, Shiller, 2000
[24] Did Behavioral Mutual Funds Exploit Market Inefficiencies During or after the Financial Crisis?, SSRN, Philippas, 2015
[25] End of Behavioral Finance?, SSRN, Pal, 2013
[26] PWC – Asset Management 2020 a brave new world
[27] Network Science, The Barbási – Albert model, 2014
[28] Calcul des Chances et Philosophie de la Bourse, Regnault, 1863
[29] The Cross-Section of Expected Stock Returns, The Journal of Finance, Fama & French, 1992
[30] Common risk factors in the returns on stocks and bonds, Journal of Financial Economics, Fama & French, 1993
[31] What is Value?, SSRN, Pal, 2014
[32] Fruit Basket Paradox – A term coined by the author to explain the fragmented nature of financial theories.