Efficiently Inefficient How Smart Money Invests and Market Prices Are Determined by Lasse Heje Peder

This preview shows page 1 out of 369 pages.

Unformatted text preview: EFFICIENTLY INEFFICIENT EFFICIENTLY INEFFICIENT How Smart Money Invests and Market Prices Are Determined LASSE HEJE PEDERSEN PRINCETON UNIVERSITY PRESS PRINCETON AND OXFORD Copyright © 2015 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW press.princeton.edu Jacket art © akindo/Getty Images All Rights Reserved Library of Congress Cataloging-Â�in-Â�Publication Data Pedersen, Lasse Heje. Efficiently inefficient : how smart money invests and market prices are determined / Lasse Heje Pedersen. pages cm Includes bibliographical references and index. ISBN 978-Â�0-Â�691-Â�16619-Â�3 (hardcover : alk. paper)╇ 1. Investment analysis.╇ 2. Investments. 3.╯Portfolio management.╇ 4. Capital market.╇ 5. Securities—Prices.╇ 6. Liquidity (Economics) I. Title. HG4529.P425 2015 332.6—dc23 2014037791 British Library Cataloging-Â�in-Â�Publication Data is available This book has been composed in Sabon Next LT Pro and DINPro Printed on acid-Â�free paper. ∞ Printed in the United States of America 10╇9╇8╇7╇6╇5╇4╇3╇2╇1 Contents The Main Themes in Three Simple Tables vii Prefacexi Who Should Read the Book? xiv Acknowledgmentsxv About the Author xvii Introduction1 i. Efficiently Inefficient Markets 3 ii. Global Trading Strategies: Overview of the Book 7 iii. Investment Styles and Factor Investing 14 Part Iâ•… Active Investment17 Chapter 1â•… Understanding Hedge Funds and Other Smart Money Chapter 2â•… Evaluating Trading Strategies: Performance Measures Chapter 3â•…Finding and Backtesting Strategies: Profiting in Efficiently Inefficient Markets Chapter 4â•… Portfolio Construction and Risk Management Chapter 5â•…Trading and Financing a Strategy: Market and Funding Liquidity 19 27 39 54 63 Part IIâ•… Equity Strategies85 Chapter 6â•… Introduction to Equity Valuation and Investing 87 Chapter 7â•…Discretionary Equity Investing 95 Interview with Lee S. Ainslie III of Maverick Capital 108 Chapter 8â•… Dedicated Short Bias 115 Interview with James Chanos of Kynikos Associates 127 Chapter 9â•… Quantitative Equity Investing 133 Interview with Cliff Asness of AQR Capital Management158 viâ•…•â•…Contents Part IIIâ•… Asset Allocation and Macro Strategies165 Chapter 10â•…Introduction to Asset Allocation: The Returns to the Major Asset Classes 167 Chapter 11â•… Global Macro Investing 184 ╇Interview with George Soros of Soros Fund Management204 Chapter 12â•… Managed Futures: Trend-Â�Following Investing 208 ╇Interview with David Harding of Winton Capital Management 225 Part IVâ•… Arbitrage Strategies231 Chapter 13â•… Introduction to Arbitrage Pricing and Trading 233 Chapter 14â•… Fixed-Â�Income Arbitrage 241 ╇ Interview with Nobel Laureate Myron Scholes 262 Chapter 15â•… Convertible Bond Arbitrage 269 ╇ Interview with Ken Griffin of Citadel 286 Chapter 16â•… Event-Â�Driven Investments 291 ╇ Interview with John A. Paulson of Paulson & Co. 313 References323 Index331 The Main Themes in Three Simple Tables OVERVIEW TABLE I. EFFICIENTLY INEFFICIENT MARKETS Market Efficiency Investment Implications Efficient Market Hypothesis: The idea that all prices reflect all relevant information at all times. Passive investing: If prices reflect all information, efforts to beat the market are in vain. Investors paying fees for active management can expect to underperform by the amount of the fee. However, if no one tried to beat the market, who would make the market efficient? Inefficient Market: The idea that market prices are significantly influenced by investor irrationality and behavioral biases. Active investing: If prices bounce around with little relation to fundamentals due to investors being naïve, beating the market would be easy. However, markets are very competitive, and most investment professionals do not beat the market. Efficiently Inefficient Markets: The idea that markets are inefficient but to an efficient extent. Competition among professional investors makes markets almost efficient, but the market remains so inefficient that they are compensated for their costs and risks. Active investment by those with a comparative advantage: A limited amount of capital can be invested with active managers who can beat the market using a few economically motivated investment styles. This idea underlying the book provides a framework for understanding why certain strategies work and how securities are priced. viiiâ•… •â•… The Main Themes in Three Simple Tables OVERVIEW TABLE II. HEDGE FUND STRATEGIES AND GURUS Classic Hedge Fund Strategies The profit sources for active investment Gurus Interviewed in This Book Who personify the classic strategies Discretionary Equity Investing: Stock picking through fundamental analysis of each company’s business. Lee Ainslie III: Star “Tiger Cub” and stock selector. Dedicated Short Bias: Uncovering companies with overstated earnings or flawed business plans. James Chanos: Legendary financial detective who shorted Enron before its collapse. Quantitative Equity: Using scientific methods and Â�computer models to buy and sell thousands of securities. Cliff Asness: Quant luminary and a pioneer in the discovery of momentum investing. Global Macro Investing: Betting on the macro developments in global bond, currency, credit, and equity markets. George Soros: The macro philosopher who “broke the Bank of England.” Managed Futures Strategies: Trend-Â�following trades across global futures and forwards. David Harding: Devised a systematic trend-Â�detection system. Fixed-Â�Income Arbitrage: Relative value trades across similar securities such as bonds, bond futures, and swaps. Myron Scholes: Traded on his seminal academic ideas that won the Nobel Prize. Convertible Bond Arbitrage: Buying cheap illiquid convertible bonds and hedging with stocks. Ken Griffin: Boy king who started trading from his Harvard dorm room and built a big business. Event-Â�Driven Arbitrage: Trading on specific events such as mergers, spin-Â�offs, or financial distress. John A. Paulson: Event master with the subprime “greatest trade ever.” The Main Themes in Three Simple Tables â•… •â•… ix OVERVIEW TABLE III. INVESTMENT STYLES AND THEIR RETURN DRIVERS Investment Styles Ubiquitous methods used across trading strategies Return Drivers Why these methods work in efficiently inefficient markets Value Investing: Buying cheap securities with a low ratio of price to fundamental value—e.g., stocks with a low price to book or price-Â�earnings ratio—while possibly shorting expensive ones. Risk premiums and overreaction: A security that has a high risk premium or is out of favor becomes cheap, especially when investors overreact to several years of bad news. Trend-Â�Following Investing: Buying securities that have been rising while shorting those that are falling, i.e., momentum and time series momentum. Initial underreaction and delayed overreaction: Behavioral biases, herding, and capital flows can lead to trends as prices initially underreact to news, catch up over time, and eventually overshoot. Liquidity Provision: Buying securities with high liquidity risk or securities being sold by other investors who demand liquidity. Liquidity risk premium: Investors naturally prefer to own securities with lower transaction costs and liquidity risk, so illiquid securities must offer a return premium. Carry Trading: Buying securities with high “carry,” i.e., securities that will have a high return if market conditions stay the same (i.e., if prices do not change). Risk premiums and frictions: Carry is a timely and observable measure of expected returns as risk premiums are likely to be reflected in the carry. Low-Â�Risk Investing: Buying safe securities with leverage while shorting risky ones, also called betting against beta. Leverage constraints: Low-Â�risk investing profits from a leverage risk premium as other investors demand high-Â�risk “lottery” assets to avoid using leverage. Quality Investing: Buying high-Â�quality securities—profitable, stable, growing, and well-Â� managed companies—while shorting low-Â�quality securities. Slow adjustment: Securities with strong quality characteristics should have high prices, but if markets adjust slowly, then these securities will have high returns. Preface My first experience as a hedge fund manager was seeing hundreds of millions of dollars being lost. The losses came with remarkable consistency. Looking at the blinking screen with live P&L (profits and losses), I saw new million-Â�dollar losses every 10 minutes for a couple of days—a clear pattern that defied the random walk theory of efficient markets and, ironically, showed remarkable likeness to my own theories. Let me explain, but let’s start from the beginning. My career as a finance guy started in 2001 when I graduated with a Ph.D. from Stanford Graduate School of Business and joined the finance faculty at the New York University Stern School of Business. My dissertation research studied how prices are determined in markets plagued by liquidity risk, and I hoped that being at a great university in the midst of things in New York City would help me find out what was going on both inside and outside the Ivory Tower. I continued my research on how investors demand a higher return for securities with more liquidity risk, that is, securities that suffer in liquidity crises. Digging a layer deeper, my research showed how liquidity spirals can arise when leveraged investors run into funding problems and everyone runs for the exit, leading to a self-Â�reinforcing drop and rebound in prices. I tried my best to do relevant research and, whenever I had the chance, I talked to investment bankers and hedge fund traders about the institutional details of the real markets. I also presented my research at central banks and tried to understand their perspective. However, when I really wanted to understand the details of how trade execution or margin requirements actually work, I often hit a roadblock. As an academic outside the trading floors, it was very difficult to get to the bottom of how markets actually work. At the same time, traders who knew the details of the market did not have the time and perspective to do research on how it all fits together. I wanted to combine real-Â�world insight with rigorous academic modeling. In 2006, I was contacted by AQR, a global asset manager operating hedge funds and long-Â�only investments using scientific methods. I was excited and started consulting shortly after. Working with AQR opened a new world to me. I became an insider in the asset management world and finally had access to people who knew how securities are traded, how leverage is financed, and how xiiâ•…•â•…Preface trading strategies are executed, both my colleagues at AQR and, through them, the rest of Wall Street. Most excitingly, my own research was being put into practice. After a year, AQR convinced me to take a leave of absence from NYU to join them full time starting on July 1, 2007. Moving from Greenwich Village to Greenwich, CT, the first big shock was how dark and quiet it was at night compared to the constant buzz of Manhattan, but a bigger shock was around the corner. My job was to develop new systematic trading strategies as a member of the Global Asset Allocation team, focusing on global equity indices, bonds, commodities, and currencies, and I also had opportunities to contribute to the research going on in the Global Stock Selection and arbitrage teams. However, my start as a full-Â�time practitioner happened to coincide with the beginning of the subprime credit crisis. As I began working in July 2007, AQR was actually profiting from some bets against the subprime market but was starting to experience a puzzling behavior of the equity markets. As a ripple effect of the subprime crisis, other quantitative equity investors had started liquidating some of their long and short equity positions, which affected equity prices in a subtle way. It made cheap stocks cheaper, expensive stocks more expensive, while leaving overall equity prices relatively unchanged. The effect was invisible to an observer of the overall market or someone studying just a few stocks, but became more and more clearly visible through the lens of diversified long–short quant portfolios. In early August, a number of quant equity investors started running for the exit and things escalated in the week of Monday, August 6. All my long-Â�term research was put aside as I was staring at the P&L screen, wondering what to do about it. The P&L updated every few seconds, and I saw the losses constantly mounting. Here was a real-Â�life liquidity spiral, all too similar to that in my theoretical model. It is difficult to explain the emotional reaction to seeing many millions being lost, but it hurts. It hurt even though the strategies that I had worked on were actually unaffected and even though I had a tenured lifetime appointment at NYU to return to. It has been said that you cannot explain what it is like to be in a war unless you experience bullets flying over your head, and I think something similar holds for being in the midst of a trading crisis. I understand why most of the successful managers whom I interviewed for this book emphasize the importance of self-Â�discipline. The question that kept going through my head was “what should we do?” Should we start selling part of the portfolio to reduce risk but then contribute to the sell-Â�off and reduce the potential gains from prices turning around? Or should we stay the course? Or add to our positions to increase the profit from a future snapback of prices? Or rotate the portfolio to our more secret and idiosyncratic Prefaceâ•…•â•…xiii factors that were not affected by the event? Although I was engaged in these important deliberations as an academic with models of exactly this type of liquidity spirals, let me be clear that I wasn’t exactly running the operation. I suspect that there was a sense that I was still too much an academic and not enough a practitioner, akin to Robert Duvall’s character in The Godfather, Tom Hagen, who was too much lawyer and not enough Sicilian to be “wartime consigliere.” To answer these questions, we first needed to know whether we were facing a liquidity spiral or an unlucky step in the random walk of an efficient market. The efficient market theory says that, going forward, prices should fluctuate randomly, whereas the liquidity spiral theory says that when prices are depressed by forced selling, prices will likely bounce back later. These theories clearly had different implications for how to position our portfolio. On Monday, we became completely convinced that we were facing a liquidity event. All market dynamics pointed clearly in the direction of liquidity and defied the random walk theory (which implies that losing every 10 minutes for several days in a row is next to impossible). Knowing that you are facing a liquidity event and that prices will eventually snap back is one thing; knowing when this will happen and what to do about it is another. The answer is complex and, though this book will go into the details of the quant event and the general principles of risk management in an efficiently inefficient market, let me briefly tell you how it ended. In the funds with limited leverage, we managed to stay the course and made back most of the losses when the snapback finally started on Friday morning. In the more highly leveraged hedge funds, we reduced positions to limit the risk of a forced sale, but we started putting back the positions close to the bottom just before the market turned around. When the profits started, they arrived at an even wilder pace than the losses had. I returned to my “peacetime” efforts of developing new trading strategies and other long-Â�term research. I set out to understand each of the different types of trading strategies and their return drivers through careful research. I had the fortune of working with lots of great people across investment teams and helped develop new funds with elements of all the eight strategies discussed in this book, long–short equities, short-Â�selling, quantitative equities, global macro, managed futures, fixed-Â�income arbitrage, convertible bond arbitrage, and event-Â�driven investment. As I love the combination of theory and practice, I decided to straddle both worlds between AQR and academia, first at NYU and now also at Copenhagen Business School as I moved back to my home country, Denmark, after 14 years in the United States. I have been teaching a new course on hedge fund strategies that I developed based on my research and experience and the insights of my colleagues, interviewees, and guest-Â�lecturing hedge fund managers. The lecture notes for this course slowly developed into this book. xivâ•…•â•…Preface WHO SHOULD READ THE BOOK? Anyone interested in financial markets can read it. The book can be read at different levels, both by those who want to delve into the details and those who prefer to skip the equations and focus on the intuitive explanations and interviews. It is meant both as a resource for finance practitioners and as a textbook for students. First, I hope that the book is useful for finance practitioners working in hedge funds, pension funds, endowments, mutual funds, insurance companies, banks, central banks, or really anyone interested in how smart money invests and how market prices are determined. Second, the book can be used as a textbook. I have used the material to teach courses on investments and hedge fund strategies to MBA students at New York University and master’s students at Copenhagen Business School. The book can be used for a broad set of courses, either as the main textbook (as in my course) or as supplementary reading. The book can be read by students ranging from advanced undergraduates to Ph.D. students, several of whom have gotten research ideas from thinking about efficiently inefficient markets. My website contains problem sets for each chapter and other teaching resources: . Acknowledgments I am deeply grateful for countless ideas for this book from my colleagues at AQR Capital Management, New York University, Copenhagen Business School, and beyond. At AQR, I would in particular like to thank John Liew for teaching me a lot about asset management when I knew next to nothing about real-Â�world trading; Cliff Asness for always sharing his brilliant insights (often masked as jokes) when I bust into his office; David Kabiller for his thoughtful visions about how to build a business (and for trying to make me a businessman); Andrea Frazzini, the fastest quant backtester around, for his great collaboration; Toby Moskowitz for sharing both the experience of going from academia to AQR and, initially, an office—you’re a great office mate; Yao Hua Ooi for tremendous teamwork on many projects; and all the others at AQR who provided helpful comments on early drafts of the book, including Aaron Brown, Brian Hurst, Ari Levine, Mike Mendelson, Scott Metchick, Mark Mitchell, Lars Nielsen, Todd Pulvino, Scott Richardson, Mark Stein, Rodney Sullivan, and, especially, Antti Ilmanen and Ronen Israel who provided many insights for the book. I am also extremely grateful to my colleagues and students at New York University Stern School of Business and at Copenhagen Business School. This book has really benefited from my inspiring discussions with colleagues at NYU, such as Viral Acharya, Yakov Amihud, Xavier Gabaix, Thomas Philippon, Matt Richardson, William Silber, Marti Subrahmanyam, Stijn Van Nieuwerburgh, Jeff Wurgler, and my colleagues at Copenhagen Business School, including David Lando (who first got me interested in finance when I was an undergrad), Søren Hvidkjær, Niklas Kohl, Jesper Lund, and Kristi...
View Full Document

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture