Is The Stock Market 'Overgrazed'? | Seeking Alpha
Summary
A new paper by Claude Erb notes that over time the beta, size and value premiums have all declined.
The paper questions whether or not the trades are too crowded with investors demanding too much from a limited supply.
Erb notes that there is no way to know if markets have been “overgrazed” — though declining trends at least raise the suspicion that they have been.
There’s an interesting new paper by Claude Erb, “Has the Stock Market Been Overgrazed?” He begins with noting that over time (since the 1920s), the beta, size and value premiums have all declined. He then asks: “What if too many investors are demanding too much from a possibly limited supply of opportunities?” Said another way, are the “trades” too crowded? If that’s the case, investors need to “find untrammeled parts of the investment ‘commons’ by developing new investment strategies seeking above average returns.” As Erb goes on to note: “A challenge arises though if these new strategies seeking above average returns end up recycling the underlying overgrazed building blocks of equity returns.”
Erb then presents the evidence showing how the size of the premiums have fallen over time, and are now at much lower levels than their historical averages. He also provides an explanation for the phenomenon: “Empirical research over the last fifty years has produced much awareness of past asset returns.” He added: “Empirical academic research breeds familiarity with previously successful investment opportunities” and “familiarity breeds investment.”
The May 2013 study, “Does Academic Research Destroy Stock ReturnPredictablity“, by R. David McLean and Jeffrey Pontiff provides support to Erb’s thesis. The authors found that post publication, the “average characteristic’s return decays by about 35 percent.” They also found that “characteristic portfolios that consist more of stocks that are costly to arbitrage decline less post-publication. This is consistent with the idea that arbitrage costs limit arbitrage and protect mispricing.”
Erb notes that the one exception to the problem of shrinkage is that the small value premium hasn’t shrunk over time, at least not yet. Erb also notes that it’s hard to access the small value premium because small value stocks make up only about 2 percent of the market.
Erb also raises questions about the likelihood of other premiums being sustained now that they are well known and investors/funds are now “chasing them” – specifically the momentum and profitability premiums. As Erb himself notes, there really is no way to know if markets have been “overgrazed” – though declining trends at least raise the suspicion that they have been.
What’s the implication for investors? If a trade/strategy is going to get crowded, you want to be there before that happens, as you will benefit from investors driving prices in your favor. But there’s a reason that there’s an adage among investment professionals that you don’t want to be a member of a crowd. It refers to the fact that when an investment strategy gets “crowded” (due to large inflows from investors chasing returns), it’s time to exit. Think of the recent bubble in residential real estate, the 1990s tech bubble, and all the other bubbles that occurred, such as the “tronics” bubble of the 1960s.
William Bernstein, author of the mini-book “Skating Where the Puck Was”, demonstrated the wisdom of this adage when he examined the return of hedge funds. Applying a three-factor analysis (exposure to the risks of the stock market, small stocks and value stocks) to HFR’s (Hedge Fund Research) Global Returns series covering the period 1998-2012, Bernstein found that while hedge funds did produce large alphas in the first third of the period, as investor assets chased those returns, that alpha shrank and then turned negative. From 1998 through 2002, hedge funds produced an incredible alpha of 9.0 percent. However, from 2003 through 2007, their alphas went to -0.7 percent. And from 2008 through 2012, the alpha became -4.5 percent.
Why did that happen? David S. Hsieh, Professor of Finance at Duke’s Fuqua School of Business, provided a simple explanation – alpha is a finite resource. Hsieh, who has been doing ongoing research on the hedge fund industry, presented his findings at the CFA Institute’s February 2006 hedge fund conference in Philadelphia. He told the audience that he was comfortable determining that for the entire hedge fund industry, there was a finite amount of available alpha – roughly $30 billion each year. The implication is that as more money enters the industry, there is less and less alpha to go around per hedge fund. This wasn’t good news for hedge fund investors, because dollars had been flowing in at a rapid pace.
While we have no way of knowing how Professor Hsieh determined the $30 billion figure, let’s assume that his estimate was correct. With simple math, we can now determine what that means for hedge fund investors. Hsieh estimated that at the time the industry had about $1 trillion under management. Thirty billion dollars of alpha spread over $1 trillion of assets is 3 percent alpha for the industry. (Of course that’s gross alpha, and 3 percent doesn’t go very far when you are charging 2 and 20 for it.)
It is also worthwhile to consider the following. Again, assume that Hsieh is correct that there is a finite amount of alpha, and it’s $30 billion. Let’s go back in time to when the hedge fund industry had just $300 billion under management. Then the industry-average alpha would have been 10 percent – close to the 9 percent alpha Bernstein calculated during the 1998-2002 period. Investors would have received above-benchmark returns, and then poured more money into hedge funds. As a result, the available alpha became diluted. Despite their poor performance since 2002, total hedge fund assets under management continue to grow. Today, the industry has assets of over $2.6 trillion. And the news gets worse as the very act of exploiting market mispricings makes them disappear, shrinking the available alpha over time as anomalies are uncovered and exploited. The result is that we have more dollars chasing fewer opportunities to generate alpha. Not a good prescription for investors, at least those chasing alpha.
The lesson you should take is that whenever an investment strategy that’s supposedly exploiting some market mispricing has become popular, it’s probably already too late to join the party. Even worse, as Bill Bernstein pointed out, when a strategy becomes popular, not only will it have low expected returns due to the crowding, but the investors are now “weak hands,” which tend to panic at the first sign of trouble. That leads to the worst returns occurring at the worst times, when the correlations of all risky assets move toward one.
Source:
Is The Stock Market ‘Overgrazed’?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More…)
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Is The Stock Market 'Overgrazed'? | Seeking Alpha
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