II - The Wall Street Math Hustle

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swaption
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II - The Wall Street Math Hustle

Post by swaption » Tue Nov 06, 2018 11:23 am

Have my views on this, interested in others.

https://www.institutionalinvestor.com/a ... ath-hustle
Last edited by swaption on Tue Nov 06, 2018 2:30 pm, edited 1 time in total.

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Re: II - The Wall Street Math Hustle

Post by Fallible » Tue Nov 06, 2018 11:45 am

swaption wrote:
Tue Nov 06, 2018 11:23 am
Have my views on this, interested in others.

https://www.institutionalinvestor.com/a ... h%20Hustle.
I liked this part:
Real math is painfully precise. (Watch the movie Hidden Figures if you didn’t already know that.) Investment finance math is sales math. It doesn’t matter that you don’t need it or that everybody interprets it in their own way. You’re using it to impress clients.
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Re: II - The Wall Street Math Hustle

Post by hdas » Tue Nov 06, 2018 12:01 pm

I don't think the dataset was adjusted for survivorship bias. H

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Re: II - The Wall Street Math Hustle

Post by nisiprius » Tue Nov 06, 2018 12:30 pm

As best I can tell in a quick skim, I think it's right, and a good article.

I quit believing in Wall Street math some years ago, when I noticed that nobody was even trying to explain or justify the use of parametric statistics like "T-stats", when nonparametric tests have been available for decades... other, of course, than the venal justification that parametric tests are more likely to show "statistical significance."
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Re: II - The Wall Street Math Hustle

Post by garlandwhizzer » Tue Nov 06, 2018 12:41 pm

I enjoyed reading this article and have finally encountered someone who is more skeptical about Wall Street than I am.
For many years, alpha was the Holy Grail of investment and almost all money managers claimed they could produce it. Then, under a Jupiter-sized weight of evidence that no investment manager — not mutual funds, not hedge funds — could reliably produce alpha, investment managers stopped laying outright claims to it.

Now, for many, there is a new Holy Grail: diversification.

Unable as a group to show that they can get returns, the industry changed the subject by shifting the focus of investing from return to risk.
I think it's important to hear both sides of complex investing questions like factors versus cap weight, how to achieve return efficient diversification, etc.. Wiggins and Edesess present a counter argument to complex strategies to achieve investment goals. They suggest that the theories on which these strategies are based tend to mistake random market noise for true signal in mathematical backtesting. I'm not sure who's right on this point but it's worth a read.

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Re: II - The Wall Street Math Hustle

Post by PVW » Tue Nov 06, 2018 1:49 pm

swaption wrote:
Tue Nov 06, 2018 11:23 am
Have my views on this, interested in others.

[...]
Your link contains UTM tracking codes that tell Google and other web trackers where you got the link (https://en.wikipedia.org/wiki/UTM_parameters). You should edit your link to remove the tracking info. Here is the direct link: https://www.institutionalinvestor.com/a ... ath-hustle .

As to the article, I believe that telling people what to invest in will always be significantly influenced by marketing. Using fundamental math is useless against the forces of marketing. As a Boglehead, I just give up trying to understand the mathematics behind what I should be investing in and I'll just be satisfied with average returns.

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Re: II - The Wall Street Math Hustle

Post by triceratop » Tue Nov 06, 2018 2:01 pm

...indeed, the requirement — today is for firms to use scientific language and notation to nourish the idea that they’ve proved mathematically that there’s a way to systematically beat the market.
Hahaha :oops: . As someone who actually uses math and reads/understands/disbelieves/occasionally writes proofs the idea that what the financial industry does is anywhere close to the level of mathematical proof or rigor expected in actual math is just hilarious.
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Re: II - The Wall Street Math Hustle

Post by Tycoon » Tue Nov 06, 2018 2:38 pm

triceratop wrote:
Tue Nov 06, 2018 2:01 pm
...indeed, the requirement — today is for firms to use scientific language and notation to nourish the idea that they’ve proved mathematically that there’s a way to systematically beat the market.
Hahaha :oops: . As someone who actually uses math and reads/understands/disbelieves/occasionally writes proofs the idea that what the financial industry does is anywhere close to the level of mathematical proof or rigor expected in actual math is just hilarious.
Pure math (math without numbers) is difficult. :shock:
Last edited by Tycoon on Wed Nov 07, 2018 1:59 pm, edited 2 times in total.
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Re: II - The Wall Street Math Hustle

Post by swaption » Tue Nov 06, 2018 2:48 pm

Original poster here. In my opinion, a bunch of garbled, barely coherent BS. Sure, there are a couple of ok ideas. But he uses his math quite selectively, throwing neat statistics around, and in some case throwing nothing around. Take the following passage:
If it were that easy, active managers would be beating their indexes year after year because by now we’re sure they’ve gotten the memo about Rolf Banz’s 30-year-old paper “proving” that small-cap stocks beat large caps, which, by the way, isn’t true: He forgot to transform monthly holding-period returns to log returns before running his regression.
This is rationalization masquerading as real analysis. Managers can only be as smart as the money that comes to their funds, so perhaps systemically many essentially chase the money that chases the returns. Not saying this is right or wrong, but the simplistic answer of "the "managers would have gotten it by now" is just ridiculous. Sure, if this were a world where managers could be myopically focused on long term returns, immune to the economic realities of attracting capital, then maybe he'd have a point. But there are agency and behavioral factors at work here, while maybe open to debate, they can't be completely dismissed.

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Re: II - The Wall Street Math Hustle

Post by nisiprius » Tue Nov 06, 2018 5:52 pm

Is Wiggins the same person who pointed out that Fama and French use a seemingly arbitrary classification system, in which size gets a two-category classification but value gets three--and the fact that the two factors are treated differently is never mentioned, let alone justified?
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Re: II - The Wall Street Math Hustle

Post by JoMoney » Tue Nov 06, 2018 6:36 pm

Thank for sharing, I agree with most everything in the article...
A statistic I found interesting (but not surprising a la Pareto distributions):
... According to Hendrik Bessembinder, a finance professor at Arizona State University, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing 4 percent of listed companies, and the cap-weighted indexes captured all of it because they don’t rebalance.
Loved this bit:
... To the extent that this difference is large, an investor has put together securities that are intrinsically different from each other — but it doesn’t necessarily mean it’s more diversified than the market-cap-weighted portfolio. Betting on both red and black at the same time in roulette delivers a mammoth diversification ratio. It’s also stupid.

Maximum diversification has a name and story so fat that, like yelling “Hey Kool-Aid!” investors come crashing through the wall. What they’re leaving out of the sales pitch is that the maximum diversification portfolio is always more concentrated relative to the market-cap-weighted portfolio in terms of risk contribution.
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Re: II - The Wall Street Math Hustle

Post by swaption » Tue Nov 06, 2018 7:31 pm

JoMoney wrote:
Tue Nov 06, 2018 6:36 pm
Thank for sharing, I agree with most everything in the article...
A statistic I found interesting (but not surprising a la Pareto distributions):
... According to Hendrik Bessembinder, a finance professor at Arizona State University, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing 4 percent of listed companies, and the cap-weighted indexes captured all of it because they don’t rebalance.
Loved this bit:
... To the extent that this difference is large, an investor has put together securities that are intrinsically different from each other — but it doesn’t necessarily mean it’s more diversified than the market-cap-weighted portfolio. Betting on both red and black at the same time in roulette delivers a mammoth diversification ratio. It’s also stupid.

Maximum diversification has a name and story so fat that, like yelling “Hey Kool-Aid!” investors come crashing through the wall. What they’re leaving out of the sales pitch is that the maximum diversification portfolio is always more concentrated relative to the market-cap-weighted portfolio in terms of risk contribution.
So in other words, small and value premiums may entail additional risk. Just seems like a bunch of bloviated stuff saying just that.

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90-year study: Large-caps vs. Small-caps.

Post by Taylor Larimore » Tue Nov 06, 2018 8:22 pm

Bogleheads:

I wonder how many small-cap advocates will read this:
According to a 90-year study by Bessembinder, when buy-and-hold portfolios of stocks are sorted by beginning market cap and held for a decade, large-cap portfolio returns are higher (153 percent) than the mean returns for small-cap portfolios (97 percent)
Best wishes.
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Re: II - The Wall Street Math Hustle

Post by danieljquirk » Wed Nov 07, 2018 1:44 pm

I thought it was good, and is a reminder of what has been proven and stated many times: markets are efficient. The best, simplest and most mathematically pure way to invest is market-cap based indexing. Despite Wall Street's continued marketing ponzi schemes, the amount of success they've had in attracting assets to things like smart beta or equal weight index funds has been marginal compared to market cap weighted index funds.

But the mathematical and practical beauty of market-cap based indexing is a message that needs to be consistently repeated, so I applaud the article, and I really like its concluding paragraph. :sharebeer

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Re: 90-year study: Large-caps vs. Small-caps.

Post by triceratop » Wed Nov 07, 2018 2:18 pm

Taylor Larimore wrote:
Tue Nov 06, 2018 8:22 pm
Bogleheads:

I wonder how many small-cap advocates will read this:
According to a 90-year study by Bessembinder, when buy-and-hold portfolios of stocks are sorted by beginning market cap and held for a decade, large-cap portfolio returns are higher (153 percent) than the mean returns for small-cap portfolios (97 percent)
Best wishes.
Taylor
The word "portfolio" is doing a lot of work in that sentence. The original article, and you, are misreading (or not reading) the original research study by Bessembinder which finds in Do Stocks Outperform Treasury Bills?:
Bessembinder wrote:Despite the fact that small firms deliver higher mean monthly returns as compared to large, the data reported on Table 3A show a distinct pattern by which small stocks display more return skewness and a higher frequency of underperformance relative to benchmarks.
I very much think that the study doesn't show what you think it is showing. Skewness in individual stock returns is not the same as returns in market cap portfolios targeting a given decile.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

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Re: II - The Wall Street Math Hustle

Post by alpine_boglehead » Wed Nov 07, 2018 2:32 pm

swaption wrote:
Tue Nov 06, 2018 2:48 pm
Original poster here. In my opinion, a bunch of garbled, barely coherent BS. Sure, there are a couple of ok ideas. But he uses his math quite selectively, throwing neat statistics around, and in some case throwing nothing around. Take the following passage:
If it were that easy, active managers would be beating their indexes year after year because by now we’re sure they’ve gotten the memo about Rolf Banz’s 30-year-old paper “proving” that small-cap stocks beat large caps, which, by the way, isn’t true: He forgot to transform monthly holding-period returns to log returns before running his regression.
This is rationalization masquerading as real analysis. Managers can only be as smart as the money that comes to their funds, so perhaps systemically many essentially chase the money that chases the returns. Not saying this is right or wrong, but the simplistic answer of "the "managers would have gotten it by now" is just ridiculous. Sure, if this were a world where managers could be myopically focused on long term returns, immune to the economic realities of attracting capital, then maybe he'd have a point. But there are agency and behavioral factors at work here, while maybe open to debate, they can't be completely dismissed.
It's a bit lengthy to read and yes, it's a wild mix of ideas, but there's quite some gems already pointed out by the other posters.

Your point that managers just cater to the taste of investors may be right in some situations. On the other side there's banks, brokers and advisers pushing overpriced investments on to clueless (retail) investors. And the article is right that the tune of the sales pitches has become more sophisticated.

Just saw an ad of a local bank that now provides "diversified investments via ETFs". They created a fund that holds ETFs, put the "diversification" marketing tag on it and charge 1.35% expense ratio. Buyer beware.

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Re: II - The Wall Street Math Hustle

Post by edgeagg » Wed Nov 07, 2018 3:07 pm

There is one small problem with the paper, as far as I can tell. The two curves shown in the paper in the figure entitled "Slippery Correlation Ramp"- which I recreated using R in the code below don't have a negative correlation at all. In fact they are strongly positively correlated. I am mostly in agreement with the overall thesis, however.

This chart shows two negatively correlated portfolios, correlation coefficient is -1

Image

This chart shows two positively correlated portfolios - Correlation coefficient is 0.98

Image

R code is here

Code: Select all

test.sine <- function(slope, shift, x){
    sin(x+shift)  + slope*x
}

x <- seq(0,8*pi,0.001)

jpeg(filename="corplot1.jpg")
# Draw the curves with zero slope. 
matplot(x, cbind(test.sine(slope=0,shift=0,x), test.sine(slope=0,shift=pi,x)), main='Two negatively correlated portfolios')
dev.off()
# Now add a common slope as in the paper.
jpeg(filename="corplot2.jpg")
matplot(x, cbind(test.sine(slope=-1,shift=0,x), test.sine(slope=-1,shift=pi,x)), main='Slope induces positive correlation')
dev.off()
# Compute the correlation if slope is zero.
cor(test.sine(slope=0, shift=0,x),test.sine(slope=0,shift=pi,x))
# Correlation will be -1
cor(test.sine(slope=-1, shift=0,x), test.sine(slope=-1,shift=pi,x))
# Correlation is 0.9818

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Re: II - The Wall Street Math Hustle

Post by edgeagg » Wed Nov 07, 2018 4:43 pm

alpine_boglehead wrote:
Wed Nov 07, 2018 2:32 pm
Just saw an ad of a local bank that now provides "diversified investments via ETFs". They created a fund that holds ETFs, put the "diversification" marketing tag on it and charge 1.35% expense ratio. Buyer beware.
Wow! Holy c**p! Their prospectus should make for interesting reading. You could set up as an investment advisor in Austria and undercut them at 1% by buying facebook ads!!!

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Re: II - The Wall Street Math Hustle

Post by alpine_boglehead » Thu Nov 08, 2018 1:21 pm

edgeagg wrote:
Wed Nov 07, 2018 4:43 pm
alpine_boglehead wrote:
Wed Nov 07, 2018 2:32 pm
Just saw an ad of a local bank that now provides "diversified investments via ETFs". They created a fund that holds ETFs, put the "diversification" marketing tag on it and charge 1.35% expense ratio. Buyer beware.
Wow! Holy c**p! Their prospectus should make for interesting reading. You could set up as an investment advisor in Austria and undercut them at 1% by buying facebook ads!!!
Would be an idea - this "ETF fund" already has 15 million AUM, so a similar scheme with 1% ER less 0.2% ETF fees would make you 120k per year. A look at the prospectus shows 32% in S&P 500 ETFs, 14% MSCI Europe ETF, and so on ... they're fleecing investors who could just hold a total stock and total bond ETF.

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Re: II - The Wall Street Math Hustle

Post by edgeagg » Thu Nov 08, 2018 1:25 pm

alpine_boglehead wrote:
Thu Nov 08, 2018 1:21 pm
Would be an idea - this "ETF fund" already has 15 million AUM, so a similar scheme with 1% ER less 0.2% ETF fees would make you 120k per year. A look at the prospectus shows 32% in S&P 500 ETFs, 14% MSCI Europe ETF, and so on ... they're fleecing investors who could just hold a total stock and total bond ETF.
Amazing!! Time to set up the Alpine Boglehead Fund!!! Facebook ads aren't that expensive. You recall that WealthFront was doing something similar until their latest pivot to smart beta.....

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