For those interested in the theories behind how markets work, Dimensional's Weston Wellington has posted his latest commentary piece looking at the topic of the efficient markets.  Weston focuses on the writings of Justin Fox who criticises the theory.  Unfortunately Fox cannot identify where investors are exploiting this lack of market efficiency.  His conclusion is that investors are best served by employing a buy and hold strategy.  Weston's full commentary is set out below.

Regards,
Scott Keefer

Over six years ago, Fortune writer Justin Fox wrote an article titled, "Is the Market Rational?" Much of the article focused on the intellectual rivalry between two Chicago professors?Eugene Fama and Richard Thaler?and Fox made no secret which of the two he found more persuasive. The next generation of finance professors, he said, were "ripping Fama's teachings to shreds," and market efficiency as an organizing principle was being shouldered aside by something called "behavioral finance." In this view, irrational investors make systematic judgment errors that produce predictable patterns in stock prices. Fox noted approvingly that the Nobel Prize in economics had been awarded the previous month to a Princeton psychology professor in recognition of his work on behavioral biases and suggested it was possible for investors with sufficient "contrarian gumption" to outperform the market by exploiting such biases. But he doubted most of his readers would be successful in this effort, due to their own propensity to make mistakes. His conclusion for investors? "That's easy," he wrote. "Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control?costs?and keep them as low as possible."

Fox has been hard at work since that time; the article has mushroomed into a 328-page book and the title is no longer a question but an assertion: The Myth of the Rational Market. The book has much to recommend it?a wide-ranging survey of the battle of ideas among financial economists over the last century, with an enormous cast of characters. Readers of Peter Bernstein's Capital Ideas will find themselves covering familiar ground, but there is enough new material to make it worthwhile. Fox's breezy style is effective in distilling complicated ideas into digestible portions, and his colorful sketches help maintain our interest in a dry, statistics-laden topic. Social critic Thorstein Veblen, for example, is a "crotchety philanderer." Yale economist Irving Fisher is a prohibitionist and health-food advocate. Milton Friedman finds the early research on efficient portfolio design similar to his work during World War II on the statistical properties of artillery shell fragmentation.

Financial economics as a distinct field of inquiry has grown from humble beginnings in the 1950s to a major field of study, and Fox takes the reader on a long journey in his effort to find a comprehensive explanation for the mystery of markets and rational behavior. Perhaps too long. One knotty problem leads to another; and even with greatly condensed versions of all the various issues, the progress is slow. Only those with considerable intellectual curiosity are likely to make it all the way through the discussions of random walks, asset pricing puzzles, expected utility theory, fractals, futures contracts, game theory, organizational behavior, corporate governance, central bank policy, derivatives, behavioral biases, and on and on.

There is so much ground to cover that some intriguing questions are left barely explored. After pointing out the flaws of the efficient market hypothesis using the CAPM model of expected returns, Fox quickly dismisses the alternative Fama/French multifactor approach as "clunky" and moves on. The value premium, in his view, is attributable primarily to investor irrationality. This is certainly one interpretation, but a more nuanced view deserves attention as well. Chicago Ph.D. and hedge fund manager Cliff Asness has pointed out that despite the extensive literature on the issue, an explanation for the value premium remains a "gigantic, subtle, and still unsettled academic debate."

For those hoping to find some concrete suggestions for improving their investment results, the book is apt to be disappointing. Fox finds little evidence of success among professional money managers in exploiting the inefficiencies he believes are so clearly evident. He has some kind words for academics who have set up money management firms to apply research on behavioral biases to generate superior returns, but he cites no evidence of their success, perhaps because their results are generally well explained by the standard asset pricing models he is so quick to condemn.

Fox appears frustrated that the evidence of market irrationality appears so clear but the evidence of investor success in exploiting these mistakes is so thin. His brief message to investors toward the end of the book carries an air of resignation?all the effort devoted to identifying flaws in the rational market model doesn't appear to offer hope of a superior approach. Almost as an afterthought, his practical advice to investors includes the following suggestions:

• "If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you are. You don't have to stop there. But if you do come up with an idea for beating the market, you need a model that explains why everybody else isn't already doing the same thing you are."
• "If you're picking somebody else to manage your money, the chances of finding a market-beating path are even harder."

Bottom line: Ideal way to bone up on financial economics if you want to sound like a know-it-all. But it's unlikely to change anyone's mind with regard to the optimal investment strategy.

Asness, Clifford. "The Value of Fundamental Indexing." Institutional Investor, October 19, 2006.
Bernstein, Peter. Capital Ideas: The Improbable Origins of Modern Wall Street. Hoboken, NJ: Wiley, 2005.
Fox, Justin. "Is the Market Rational?" Fortune, December 3, 2002.
Fox, Justin. The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. New York: HarperBusiness, 2009.

The latest video uploaded to the Fama & French Forum looks at the issue of identifying superior managers.  This is what the big financial companies are telling us every day through their advertising - that they have the expertise to set the course for your financial assets.  As Ken French explains, there may actually be superior investment managers out there, the trouble is how do we identify them before not after their period of out-performance?

The conclusion is that if you want to be certain that you will achieve better than average returns you need to employ an index based approach where the fees, transaction costs and capital gains implications are lower.  I encourage you to take a look at the video - Identifying superior managers.

Regards,
Scott Keefer

Users of our website, through our User Voice feedback forum, have requested that we regularly update the graphs outlining the performance of the Dimensional trusts that we use in building portfolios for clients.  In response to this feedback we have updated these graphs to reflect performance up to the end of May 2009.

Commentary:

The graphs show strong monthly returns over the month for most of the asset classes especially in the Australian Small Company and Emerging Markets allocations.  Global Small Companies and the MSCI World ex Australia indexes were relatively flat for the month.

Over the long run, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist:

Australian Share Trusts - 7 Year returns

International Share Trusts - 7 Year returns

NB - These premiums are higher than what we would expect going forward.

Please click on the following link to be taken to the graphs - Dimensional Fund Performance Graphs.

For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research.  Take a look at our Building Portfolios and Our Research Based Approach pages for more details.  In our view, this research compels us to use the three factor model developed by Fama and French.  In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dimensional.com.au).  We do not receive any form of commission or payment from Dimensional for using their trusts.  We use them because they provide the returns clients are entitled to from share markets.

However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research.  Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.

Please let us know if you have any feedback regarding these graphs by using the Request for More Information form to the right or via our User Voice feedback forum.

Regards,

Scott Keefer

Professors Fama & French published academic research in 1992 which forms the core of this firm's philosophy towards investing. The details of their paper can be found on our website - The Three Factor Model.

Earlier this year, in conjunction with Dimensional Fund Advisors, the professors started an online forum through which they could discuss a range of important and interesting investment topics.

This month they have included a series of items looking at the problems with an active investment approach.  The first two are video pieces for those who prefer to take in information visually.

More sellers than buyers? - Ken French discusses why share prices fall and links it to expectations about future cash flows and the expected return on an investment including changes in perceived risk with investing in a particular investment or the market as a whole.

Is this a good time for active investing? - Ken French is interviewed about whether now is a good time to take an active management approach.  His response is that it comes down to a mathematical exercise regarding fees.  At every instant in time the average active investor will underperform an index based approach because they are paying more fees to do so.

Why active investing is a negative sum gain - In a written piece Eugene Fama & Ken French look at the arithmetic of active management as set out by William Sharpe in 1991 setting out the same argument as raised by Ken French in the previous video.

All are well worth a look.  If you would like more information about what we see as the aacademic research that underpins a sound approach to investing please take a look at our Research Based Approach pages on our site.

Regards,

Scott Keefer

Over the past few days i have noticed a couple of articles suggesting that some major Industry super funds are moving to passive investment approaches and managers to look after core components of their investments.  Yesterday is was Local Government Super, today AustralianSuper - AustralianSuper Saves $4m.

A quick reminder, passive investing is opposite to the predominant active investment approach taken by most fund managers and individual investors.  Rather than picking which company or industry sector is going to outperform going forward, passive investors invest in the entire market usually value weighted.  i.e. larger companies like BHP on the ASX200 index making up a larger proportion.  Basically the market is telling the investor in what to invest and what is a fair price.

Why are industry super funds doing this?

As the linked article points out, a primary reason is to limit costs.  With a passive investment approach you do not need to spend huge amounts of money researching companies, rather you let the market do the research for you.  You are also buying and selling much less often thus reducing trading costs.  Thirdly, because you are trading less, you are realising capital gains less often and therefore you are receiving more cost effective returns.

So if industry super funds are using a passive strategy, should you?

This firm's investment philosophy and approach answers most definitely.  The decision is not only about reducing costs.  The end goal is to get the best possible return from a particular asset class.  I will leave our Building Portfolios page of our website to set these out why passive investing makes sense.

Regards,
Scott Keefer