Monday, February 15, 2010

Transactions Costs and Beating the Market

One of my books, Investment Fables, is directed at answering one of the most puzzling questions in investments: How is that there seem to be so many ways to beat the market on paper but that so few money managers seem to do it in practice? A key reason, in my view, is that transactions costs have a much greater impact on returns than we realize.

Let's start with the good news. Both academics and practitioners have found dozens of ways to beat the market. To see the academic list of market inefficiencies, try this link:
And here is a link to sure fire money makers from practitioners:
Wow! Hundred ways to beat the market! Each new finding in academia seems to offer fresh opportunities for the "smart, informed" investor. The latest wave of schemes build off the behavioral finance literature. In fact, two prominent behavioral finance economists have set up their own money management firm (showing you that academics are not immune from greed):

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.

Now let's look at the bad news. 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...

So, why do portfolios that perform so well in back testing not deliver results in real time? The biggest culprit, in my view, is transactions costs, defined to include not only the commission and brokerage costs but two more significant costs - the spread between the bid price and the ask price and the price impact you have when you trade. The strategies that seem to do best on paper also expose you the most to these costs. Consider one simple example: Stocks that have lost the most of the previous year seem to generate much better returns over the following five years than stocks have done the best. This "loser" stock strategy was first listed in the academic literature in the mid-1980s and greeted as vindication by contrarians. Later analysis showed, though, that almost all of the excess returns from this strategy come from stocks that have dropped to below a dollar (the biggest losing stocks are often susceptible to this problem). The bid-ask spread on these stocks, as a percentage of the stock price, is huge (20-25%) and the illiquidity can also cause large price changes on trading - you push the price up as you buy and the price down as you sell. Removing these stocks from your portfolio eliminated almost all of the excess returns.

In perhaps the most telling example of slips between the cup and lip, Value Line, the data and investment services firm, got great press when Fischer Black, noted academic and believer in efficient markets, did a study where he indicated that buying stocks ranked 1 in the Value Line timeliness indicator would beat the market. Value Line, believing its own hype, decided to start mutual funds that would invest in its best ranking stocks. During the years that the funds have been in existence, the actual funds have underperformed the Value Line hypothetical fund (which is what it uses for its graphs) significantly.

In closing, I am not trying to dissuade you from being an active investor; I am one. My point is that you should be careful about taking the claims by anyone - academic on practitioner - about market-beating strategies. The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes. Talking about making money is easy.. actually making money is far more difficult.


AJ said...

So much finance is based on the rational markets assumption ... when everybody (almost) knows its not true ... u take that assumption out and there goes ure finance textbooks out of the window.

Roberto Ushisima said...

I don't know about Fuller and Thaler, but the average behavorial mutual fund is unable to provide abnormal returns.

Mahesh Sethuraman said...

Wow...So what do you think we should Mr.AJ? Throw out finance textbooks? or start them with the assumption that markets are irrational? If Markets are not rational and therefore not worthy, do we go back to barter system then?

"The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes."

This is exactly the point about rationality. If you are smarter than all the investors of the world to understand that markets are irrational, who's stopping you from making money betting on the irrationality of the market?

Fabian said...

Dear Professor

I absolutely agree with you. I would like to add two other aspects for lower real returns: First, backtesting strategies is subject to many problems; like the survivorship bias, look ahead bias etc. Second, defining an appropriate sample is not that easy (linked to an index? linked to a country? etc.).
I tested the "magic formula" from Joel Greenblatt for european companies (MSCI Europe as sample) -the result was: no significant return difference between the magic formula und a simple value strategy.
However, Greenblatt founded a company which offers everyone the possibility to invest according to the Magic Formula...

Aswath Damodaran said...

The usual straw man surfaces. Whenever there is talk about the failures of active money management, the response you get is that markets are not rational. But where in my original post did I even posit that markets were rational? In fact, I will accept your proposition that markets are irrational and investors are crazy. So, how do you explain the gap between promised returns and actual performance?

AT said...

Investment Fables was the first book of yours I read; then Investment Philosophies; and now I've started Investment Valuation. I'm starting to go down the behavioral route a la James Montier, but I do appreciate your scholarship and blog.

Guru said...

Its precisely because markets are irrational that one needs to go back to basics time and again especially when the majority is proved wrong.

Lets face it. Abnormal returns are an aberration and most often not the rule.

The choice of the money manager is between normal returns on the strength of fundamental financials on one hand and abnormal temporary returns relying on a highly irrational market.

Ankit said...

Dear Sir .

In total agreement with you on the point . I believe what makes it even tougher to stand by any strategy is the confidence of fund managers in there own strategy and they tend to sway away from it .

Alexander said...

"...slip between the cup and the lip..." Love the aphorism!

Fabian said...

Markets are irrational, at least temporary (otherwise nobody would do the necessary analysis!). We all agree. But how to explain the performance difference of backtested strategies and real returns with irrationality? In my opinion these are two differenct aspects.
As i mentioned before backtesting is always subject to different problems (various bias, transaction costs etc.), which I see as the most important explanation of the performance gap.

Rod said...

Does your blog have an RSS feed?

twilexia said...

Hi Professor,
I agree with you that whatever the latest "hot" stock-buying strategy is always too good to be true. Even if it did work, people would catch on so quick and use it so much that the strategy would ultimately backfire on itself.

However, just because a stock-buying strategy does not work for one time period doesn't mean that it is completely worthless. Finance is a constantly evolving field, and sometimes the errors are just as valuable as the "eureka!" moments. I feel that, as a community, the more errors we come up with that end up not working, the closer we can get to something that will work. (very optimistic viewpoint, I know)

Ing. Juan Ignacio Zamora M, MSc. said...

Hi professor,
Thanks for your posts, I learn a lot from them.
I´m very new to this financial themes, but I think that there are ways that can help in order to get covered when investing (principally in order to avoid loss from the spread in bid ask), like using hedge funds or working with options, futures or even making some currency arbitrage.

Joshua said...

Have you seen the following paper?

"Best Ideas"

"We find that the stock that active managers display the most conviction towards ex-ante, outperforms the market, as well as the other stocks in those managers' portfolios, by approximately one to four percent per quarter depending on the benchmark employed. The results for managers' other high-conviction investments (e.g. top five stocks) are also strong. The other stocks managers hold do not exhibit significant outperformance. This leads us to two conclusions. First, the U.S. stock market does not appear to be efficiently priced, since even the typical active mutual fund manager is able to identify stocks that outperform by economically and statistically large amounts. Second, consistent with the view of Berk and Green (2004), the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers. We argue that investors would benefit if managers held more concentrated portfolios."


I'd say that while transaction costs are definitely a factor, the real culprit is a combination of closet indexing and window dressing. Not to mention that ignoring the incentives for mutual fund managers to gather assets and how they gain those assets (hint: marketing) and then comparing their performance against the market is a straw-man argument. Plus, I thought the annual underperformance of mutual funds was pretty close to the average fee. What about the before-fee & after-fee performance of hedge funds? Would your argument still hold?

Doug said...

Hah! We've been beating the market and showing this on the internet for the past nine years. We follow every stock recommendation with a buy and sell point. We even deduct 1% for transaction costs. Our average annual return for the past nine years is a whopping 27.0% vs. 2.2% for the S & P 500. For more info go to Even though we have demonstrated this for nine years, few people know about us. We're not professionals. It's also possible that if we became more well-known the system might not work since it depends on buying microcaps.

Aditya said...

But surely the findings such as high dividend yield stocks, and low pe or ev/ebitda stocks will not fully lose out-performance over index wholly if you replicate as best as you can, and wait for a long period? That is, some of those papers did a cross-section of size as well (so ranked deciles of size) and there was still some out-performance over the index even in the top 4 size deciles. I think a Wesley Gray study did this, will have to look it up.

Also, greenblatt is heavily promoting weighting indices by price-book or ev-ebitda. Is this also flawed?

Anonymous said...

This is why we have index funds.

Evan said...

Another core reason is investor bias/irrationality. Often when a "formula" or "system" works, no matter what system it is, investors have a way of mucking it up by doing things that go against the strategy. They horde cash when they shouldn't, they fail to sell when they should, etc etc. Since a lot of strategies produce such a small amount of excess return, it's easy for a lot of investors to erode pretty much all of the excess return.

You comments on stocks below $1 and large bid-ask spreads are more a concern for large money managers than small retail investors, though. I routinely buy & sell stocks below $1 that have a 25% bid-ask spread using limit orders and am able to buy for the quoted price on Google Finance. It's really a non-issue for small portfolios.