Crappy financial journalism

A couple of news stories today piqued my interest with unsourced statements

about financial markets which didn’t make a lot of sense to me. First of all

there was a column by Ed Dravo

in Slate, which said that

When an asset manager begins to beat his peers by a large margin, pension

trustees actually withdraw money from the hot-performing manager.

Individual investors, by contrast, pour their money into those same asset

managers. History shows today’s high-performing funds are tomorrow’s laggards,

so individual investors are choosing investments that are likely to disappoint.

I agree that individual investors tend to put their money into hot-performing

funds, but that’s about all I agree with. Is there any evidence at all that

if pension trustees are lucky or smart enough to find an asset manager who starts

doing really well, they then take their money away from him? I can just about

imagine a situation where no one manager is allowed more than a certain percentage

of total assets, and that if he’s doing really well, he might start exceeding

that percentage and triggering withdrawals. But I can’t imagine that trustees,

having found a successful manager, will then give up on him just as he starts


Furthermore, I really don’t think that "history shows today’s high-performing

funds are tomorrow’s laggards". When a rather obnoxious man at Citibank

tried to sell me some mutual funds once, based on their outperformance, I actually

spent quite a bit of time researching this issue. Companies like Morningstar

generally group funds into quintiles: the top 20%, the next 20%, and so on.

And there is in fact a certain amount of correlation between past performance

and future performance. Not a lot, but a little. Funds in the bottom quintile

will tend to underperform in the future, funds in the fourth quintile will underperform

but not quite as badly, and funds in the top three quintiles are all roughly

equally likely to outperform in the future.

This is actually the opposite of what Dravo is implying, which is that funds

in the top quintile are the most likely to underperform in future – and

I certainly found no evidence of that. I know there’s a lot of sleaziness among

financial advisors, but I don’t think that so many of them would push funds

based on their Morningstar ratings if past performance was actually negatively

correlated to future performance.

If you were to be charitable, you might say that financial markets are cyclical,

and if one asset class has done well for a while (technology stocks, say, or

emerging-market bonds, or small-cap manufacturers) then it stands to reason

that it might slow down in future and some other asset class – invested

in by some other mutual fund – will be the new place to be. But that’s

not what Dravo was saying, and in any case you’re just as likely to move from

today’s high-performing asset class to tomorrow’s low-performing asset class

as you are to make the perfect leap from outperformer to outperformer just as

the former has stopped rising and the latter has just started. Rather than try

to execute that kind of acrobatic act, better you just stick with what’s working,

I think – even Dravo, later on, points out that people who trade more,

lose more.

Meanwhile, the BBC picks up on the

story of Google’s IPO:

Dutch auctions and other supposedly open IPO forms are blamed for the extraordinary

price swings seen in the early days after some high-profile flotations.

Some analysts say they also tend to underprice shares, leading to insufficient

returns for the issuer.

This is the point at which Jon Stewart, of The Daily Show, would rub his eyes

in a comical manner and do one of his patented "wha????" expressions.

Dutch auctions, of course, are designed precisely to avoid extraordinary

price swings in the aftermarket – people pay exactly what they want to

pay, without investment banks second-guessing them or trying to underprice the

shares so that there are lots of juicy immediate profits for their favoured


And while some Wall Street types do have an argument that Dutch auctions overprice

shares (see the quote from the FT on this

blog), I have yet to see any reason why they should underprice

them. After all, the stock market is essentially one big continuous Dutch auction:

sellers sell their stock to the person who will pay them the highest price.

And the stock market seems to work a lot more efficiently than IPOs normally


Think about it for a minute: if institutional investors are willing to pay

more than retail investors, then the institutions will end up owning most of

the shares, at a reasonable market price. If, on the other hand, retail investors

are willing to pay more than institutional investors, then most of the Google

shares will end up in individual hands, and when those people come to sell,

they might have to take a loss in the secondary market. In other words, the

IPO would have been overpriced, not underpriced. It really is hard to imagine

how a Dutch auction could underprice shares – or even to think of what

kind of "analyst" would ever say such a thing.

Now I’m willing to admit that I might be wrong here – would anybody like

to come to the defense either of Mr Dravo or of the BBC?

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8 Responses to Crappy financial journalism

  1. Matthew says:

    BBC is right. In typical IPO, investment bank sets a low price, issues few shares–mostly to best friends–and watches as price soars in early days as all that pent-up demand is met. With a Dutch Auction, the clearing price can end up being rather high, possibly even over-valuing the company. That leads to lots of early selling and little buying until the price falls, hence, volatility. Also, a Dutch Auction does two other things: It satisfies a whole lot more regular investor demand than traditional IPOs so you don’t get those early price spikes. It also discourages institutional buyers, who tend not to flip for quick profits.

    From the prospectus (if you don’t believe me):

    “The auction process for our initial public offering may result in a phenomenon known as the ÏwinnerÌs curse.Ó At the conclusion of the auction, bidders that receive allocations of shares in this offering (successful bidders) may infer that there is little incremental demand for our shares above or equal to the initial public offering price. As a result, successful bidders may conclude that they paid too much for our shares and could seek to immediately sell their shares to limit their losses should our stock price decline. In this situation, other investors that did not submit successful bids may wait for this selling to be completed, resulting in reduced demand for our Class A common stock in the public market and a significant decline in our stock price. Therefore, we caution investors that submitting successful bids and receiving allocations may be followed by a significant decline in the value of their investment in our Class A common stock shortly after our offering.

    To the extent our auction process results in a lower level of participation by professional long-term investors and a higher level of participation by retail investors than is normal for initial public offerings, our stock price may decrease from the initial public offering price and be more volatile.”

  2. Matthew says:

    OK. Half right. Didn’t read it too carefully. Now I have. Not sure what they could mean by underpricing, unless it’s a sloppy way of referring to downward swings after the first day or so of trading. More important question: why are you relying on the BBC to help you navigate this particular topic? Would be like asking Stefan for advice on sexual technique.

  3. Felix says:

    By “half right”, Matthew, do you mean “wrong”? After all, the “underprice” bit is clearly wrong, and the “extraordinary price swings seen in the early days after some high-profile flotations” can’t refer to Dutch auctions, since all high-profile flotations have used the traditional IPO method.

  4. Stefan Geens says:

    My sexual technique does not lead to the downward spiraling of anything, and I definitely provide sufficient returns.

  5. Jame says:

    Depending on the mandate, it may be common for institutional investors such as a corporate pension fund to withdraw money from a manager that is doing too well. Managers are selected to invest in a certain asset class using a particular style. If their tracking error from the underlying benchmark exceeds the client’s parameters, there is a chance that the fund manager is not complying with risk controls. Pension funds have learned the hard way that such managers are usually dangerous in the long run. The US capital markets are efficient enough that gross outperformance of a benchmark like the S&P500 is pretty hard to do unless you make concentrated but risky bets.

    The prudent ones will sit down with the fund manager to understand why performance strayed so far from the benchmark. If the portfolio remains within the outlined parameters (i.e. someone hired to manage a value-oriented equities fund is still doing so; limits on owning a particular stock or sector are being respected; etc) then the pension fund will allow the manager to carry on.

  6. Matthew says:

    I think there have been some high-profile IPOs a using Dutch auction. They were mentioned in the WSJ piece the day after the IPO was announced and I’m too lazy to look it up. Maybe. Anyway, accept it as an article of faith (or at least CW) that Dutch-auctioned IPOs tend to be more volatile in early trading days than the regular sort, which tend to just go up.

  7. simian says:

    Actually the academic evidence points primarily to a random walk when it comes to mutual fund performance. Morningstar ratings – which are currently based on risk-adjusted, peer-relative trailing returns for various horizons (1 year, 3 year, 5 year, etc) – have generally been shown to be non-persistent (Blake & Morley). So prior good performance does not suggest that future performance will be particularly good or bad; it’s merely noninformative. The studies which did find some, albeit not very strong, persistence (Warshawsky) suggested that economies of scale played a role. In other words, if a fund did well, assets poured into it, and a large fund is better able to control and allocate costs, to a degree which overcomes the increased market impact of its trades.

    The opposite has been shown to be true of hedge funds, the relatively sophisticated investors in which also tend to chase returns: high-returning hedge funds collect assets more quickly, but their returns tend to drop off afterwards. This is presumably because hedge funds can be successful by being nimble and identifying arbitrage opportunities with limited capacities; after this capacity is exceeded, the hedge fund manager finds him or herself without investment opportunities, and performance wanes.

    Of course, given that risk-adjusted mutual fund returns are generally below those of their benchmarks, and hedge fund returns are generally above those of their benchmarks (to the extent that such benchmarks can be identified), this just means that you are slightly less badly off investing in a mutual fund which has done well instead of in an index fund; and that you are slightly worse off investing in a hedge fund which has done well instead of investing in a benchmark like the risk free rate; but either way, hedge funds tend to make you money and mutual funds tend to lose you money, further suggesting that you generally get what you pay for!


  8. Jame says:

    Institutional investors may invest in mutual funds but they are more likely to mandate external managers to run a customized portfolio. Institutions also don’t pay the high fees that retail investors do. Furthermore, institutions and consultants have resources to identify external managers that are likely to consistently outperform a peer group.

    Finally, picking the fund manager is a minor decision compared with figuring out your starting asset allocation; get the right asset class mix and you’re 80% of the way there. Therefore active fund management continues to flourish.

    For your retail client, I agree with Simian that indexed funds for equities make sense. But this is not a good option for fixed income; particularly older investors are still dependent upon an active mutual fund manager.

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