Thursday, January 26, 2006

Investment Risk & Indexing

I have scoured IFA's website for the past week and I repeat my prior claim that this is one of the better index investing sites in existence. Much like Swensen, their focus is on convincing us that index investing your best bet.

One of the more interesting tidbits I discovered was their discussion of investment risk and return (which is step 8 of their 12 step active management recovery program), including research findings from French and Fama.

One of modern finance's key pillars is the CAPM model -- CAPM says that your investment return should be the risk free rate plus some percentage of the return of the market based on your exposure to the market. Sharpe created a ratio that purports to measure how well a portfolio performs as compared to what the CAPM model predicts. If the Sharpe ratio is less than 1, you would claim that the portfolio's return does not justify the risk. If the Sharp ratio exceeds 1, you would conclude that the portfolio manager 'beat the market'.

If you believe in efficient markets, Sharp ratios exceeding 1 should not exist. Well, they do exist and many proponents of actively managed investing point to this fact to sell there stock picking services.

French and Fama discovered that the CAPM model only 'predicts' 70% of a given portfolio's return. The active traders believe the remaining 30% is manager skill - French and Fama show it was simply model error. Their research expanded the CAPM model to include additional factors in addition to market risk. They added a factor for the weighted market capitalization of a given portfolio and for the growth/value tilt of the portfolio. This new, expanded model predicts 95% of a given portfolio's return - an 83% reduction in tracking error.

French and Fama both work/consult for an index mutual fund company called DFA. DFA manages $84 billion in index mutual funds for private and institutional investors. Their funds take advantage of all three risk factors that French and Fama discovered and they have some truly unique offerings. IFA's model portfolios are based on DFA's funds. In fact, I've taken their risk survey and I've identified the portfolio I want to model my holdings after. There's just one catch - DFA funds are only available through selected financial advisers. Although there are advisers who will grant you access to the funds for relatively small fees (20 basis points), I plan to try to construct my portfolio based on freely available mutual funds and EFTs.

I'll let you know how it turns out.


At 9:04 AM, Blogger franky said...

Is that the multi-factor arbitrage model? Trying to recall if I learned about that or not.

At 10:43 AM, Blogger Early Riser said...

not sure... it sounds impresssive though

At 1:38 PM, Blogger The Unknown Professor said...

IFA is a good site, and Fama and French are two of the smartest guys around. However, the existence of high sharpe ratios in the past doesn't necessarily mean that the CAPM and/or efficient market theory is wrong.

It could result from chance. Even if stock returns are totally unpredictable, some people will end up beating the market even for years at a time.

It's like flipping a coin 100 times and counting the number of heads. If you do it enough times, you'll get some series where there are 80 or even 90 heads out of a hundred. Efficient market theory just says you can't use the good performers in the past to predict the good ones in the future.

They could be good, or they could be lucky - you just can't tell which.

Having said that, F&F's weork is without a doubt extremely cool.

At 4:49 AM, Blogger J.Klein said...

As a personal investing strategy, F&F is no good. It works only for large or very large investors, investing in large corporations. That criterion severily limits the universe you are in and restricts the possibility of earning a better reward.

At 11:12 PM, Blogger piadv said...

J Klein, I think you are mistaken. DFA's strategies allow one to invest in virtually one of every security including small, small value and small foreign better than any others.


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