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Posts Tagged ‘Lakonishok Shleifer and Vishny’

Yesterday’s post on LSV Asset Management’s performance reminded me of the practical difficulties of implementing many theoretically well-performed investment strategies. LSV Asset Management is an outgrowth of the research conducted by Josef Lakonishok, Andrei Shleifer, and Robert Vishny. They are perhaps best known for the Contrarian Investment, Extrapolation, and Risk paper, which, among other things, analyzed low price-to-book value stocks in deciles (an approach possibly suggested by Roger Ibbotson’s study Decile Portfolios of the New York Stock Exchange, 1967 – 1984). They found that low price-to-book value stocks out perform, and in rank order (the cheapest decile outperforms the next cheapest decile and so on). The problem with the approach is that the lowest price-to-book value deciles – that is, the cheapest and therefore best performed deciles – are uninvestable.

In an earlier post, Walking the talk: Applying back-tested investment strategies in practice, I noted that Aswath Damodaran, a Professor of Finance at the Stern School of Business, has a thesis that “transaction costs” – broadly defined to include brokerage commissions, spread and the “price impact” of trading – foil in the real world investment strategies that beat the market in back-tests. Damodaran made the point that even well-researched, back-tested, market-beating strategies underperform in practice:

Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver “excess returns”. Ergo, a money making strategy is born.. books are written.. mutual funds are created.

The average active portfolio manager, who I assume is the primary user of these can’t-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to “bad” portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year…

Damodaran’s solution for why some market-beating strategies that work on paper fail in the real world is transaction costs. But it’s not the only reason. Some strategies are simply impossible to implement, and LSV’s low decile price-to-book value strategy is one such strategy.

James P. O’Shaughnessy’s What works on Wall Street is one of my favorite books on investing. In the book, O’Shaughnessy suggests another problem with the real-world application of LSV’s decile approach:

Most academic studies of market capitalization sort stocks by deciles (10 percent) and review how an investment in each fares over time. The studies are nearly unanimous in their findings that small stocks (those in the lowest four deciles) do significantly better than large ones. We too have found tremendous returns from tiny stocks.

So far so good. So what’s the problem?

The glaring problem with this method, when used with the Compustat database, is that it’s virtually impossible to buy the stocks that account for the performance advantage of small capitalization strategies. Table 4-9 illustrates the problem. On December 31, 2003, approximately 8,178 stocks in the active Compustat database had both year-end prices and a number for common shares outstanding. If we sorted the database by decile, each decile would be made up of 818 stocks. As Table 4-9 shows, market capitalization doesn’t get past $150 million until you get to decile 6. The top market capitalization in the fourth decile is $61 million, a number far too small to allow widespread buying of those stocks.

A market capitalization of $2 million – the cheapest and best-performed decile – is uninvestable. This leads O’Shaughnessy to make the point that “micro-cap stock returns are an illusion”:

The only way to achieve these stellar returns is to invest only a few million dollars in over 2,000 stocks. Precious few investors can do that. The stocks are far too small for a mutual fund to buy and far too numerous for an individual to tackle. So there they sit, tantalizingly out of reach of nearly everyone. What’s more, even if you could spread $2,000,000 over 2,000 names, the bid–ask spread would eat you alive.

Even a small investor will struggle to buy enough stock in the 3rd or 4th deciles, which encompass stocks with market capitalizations below $26 million and $61 million respectively. These are not, therefore, institutional-grade strategies. Says O’Shaughnessy:

This presents an interesting paradox: Small-cap mutual funds justify their investments using academic research that shows small stocks outperforming large ones, yet the funds themselves cannot buy the stocks that provide the lion’s share of performance because of a lack of trading liquidity.

A review of the Morningstar Mutual Fund database proves this. On December 31, 2003, the median market capitalization of the 1,215 mutual funds in Morningstar’s all equity, small-cap category was $967 million. That’s right between decile 7 and 8 from the Compustat universe—hardly small.

The good news is, there are other strategies that do work.

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Insider Monkey has a great analysis of LSV Asset Management’s Value Equity Fund returns and alpha (LSVEX). LSV Asset Management is a quantitative value shop founded by Josef Lakonishok, Andrei Schleifer, and Robert Vishny, authors of the landmark 1994 Contrarian Investment, Extrapolation, and Risk paper, which is a favorite topic of mine (for more, see the archives on LSV and quantitative investment). Insider Monkey’s conclusions are not particularly positive for LSV:

LSV’s Value Equity Fund (LSVEX) uses quantitative methods to pick out-of-favor value stocks and does not employ any market timing strategies. LSV describes its investment process as follows:

A proprietary investment model is used to rank a universe of stocks based on a variety of factors we believe to be predictive of future stock returns. The process is continuously refined and enhanced by our investment team although the basic philosophy has never changed – a combination of value and momentum factors. We then overlay strict risk controls that limit the over- or under-exposure of the portfolio to industry and sector concentrations.We also limit exposures in individual securities to ensure the portfolios are broadly diversified, further controlling risk.

The competitive strength of this strategy is that it avoids introducing the process to any judgmental biases and behavioral weaknesses that often influence investment decisions.

Portfolio turnover is approximately 30% for each strategy.

LSVEX

Insider Monkey downloaded LSV Value Equity Fund’s returns from Yahoo to calculate their alpha by using Carhart’s four factor model:

The LSV Value Equity Fund has $1.7 Billion under management, but the strategy is actually used to manage $22.2 billion in assets in various LSV funds. The fund’s objective is to achieve 200 basis points in excess returns before expenses. Considering that the LSV Value Equity Fund has an expense ratio of 0.65%, its alpha should not be less than 1.35%. The minimum investment is set at $100,000, so this fund is really not for small investors.

We calculated LSVEX’s alpha for the Oct 1999-Jun 2010 period. Though they call themselves a value fund, the LSV Value Equity Fund isn’t one. It had a slight value tilt in the first five years of the fund, but now it has a growth tilt. Neither of these are statistically significant though. Also during the first five years, the fund was investing in smaller companies. LSVEX had a monthly alpha of 31 basis points after expenses. This is exceptional for a mutual fund; usually mutual funds don’t have any alpha after expenses. But as assets grew, LSVEX was naturally tilted towards the large cap space. It doesn’t follow a momentum strategy. Unfortunately, the LSV Value Equity Fund’s alpha dropped to 10 basis points as assets grew, between 2005 and Jun, 2010. This level of alpha is actually 15 basis points below their goal of 1.35% annual alpha.

The top holdings of LSV funds are Chevron (CVX), Pfizer (PFE), AT&T (T), Conoco Philips (COP), Bank of America (BAC), and JP Morgan (JPM). Notice a theme here? This is the fundamental problem with talented mutual fund managers- they siphon most of their alpha into their pockets by inflating assets under management, because it pays to have large AUM but it doesn’t pay to have a large alpha. LSV could opt to manage a $3 Billion hedge fund and maintain a respectable 10% alpha. Instead of doing this, LSV added another $20 Billion of assets that follow the index funds and got a 1% alpha. Then they charged a 0.65% management for managing a $20 Billion index fund. That 0.65% fee from that $20 Billion is not much different from what could be collected from managing a hedge fund. LSV’s alpha is around $300-350 Million per year. They take $100-$150 Million from that in performance fees and leave the rest for their mutual fund investors.

See the article from Insider Monkey.

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