There is a famous story about an economist walking down the street with his wife. They come upon a $50 bill laying on the sidewalk. The economist’s wife goes to pick up the bill when the economist stops her and says, “don’t bother - if it was a real $50 bill, someone would have picked it up already.” While this story is likely fictional, and I hope a little - even to my economist friends - funny, it serves as a fairly accurate portrayal of the logic behind the efficient market hypothesis (EMH.) This hypothesis, developed in the 1960’s, states that share prices in public markets reflect all available information and are priced correctly. In short, the market is so efficient that security prices reflect solely the intrinsic value of the company and no opportunities for outsized returns exist. Over the last 15 years this theory has gained popularity, with now over 14% of all U.S. equities held in passive index ETFs alone. Anyone that has spent time on a trading floor, however, will likely disagree with EMH and be able to point to numerous examples of when markets did not work efficiently, myself included. These last few months have been unique in that a few apparent security mispricing have garnered substantial media attention. Let’s take look:
A new social media site called Clubhouse has gained popularity. New user growth has rocketed higher, with celebrities such as Elon Musk, Oprah, and Kevin Hart interacting with the now nearly 10 million users. Hoping to own a part of this promising growth, investors have erroneously driven up the share price (chart above) of Clubhouse Media Group, a pink sheet traded company with one employee and no relations to the social media site.
On January 6th, Signal Advance Inc’s share price (above) went from $0.60 to $13.54 after Elon Musk tweeted “use signal,” in reference to a completely different company. The share price has subsequently retreated after he clarified that he was not referencing Signal Advance Inc.
And most famously, GameStop. Investors on reddit have collectively come together to “stick it to the suits,” or hedge funds, by driving up the share price (above) of GME. As much has already been written about this I will not go into greater detail. However, if you are unfamiliar with the story, an interesting summary can be found on the Wall Street Journal.
While these securities are obviously mispriced, they are not necessarily in violation of EMH. To capitalize on these mispriced securities, an investor must either find shares to borrow to then subsequently sell or use derivatives that benefit from a decline in share price. Implied volatility, a component of derivative pricing, and the borrow rate, the fee charged to borrow shares, are currently so high that profiting from the discrepancy would entail substantial risk that would rise with time. In layman terms, we have found a $50 dollar bill on the ground, but we would need to rent a jackhammer that cost $40 an hour to get the bill free.
However, these examples highlight the major flaw of EMH; investors are not completely rational. A rational investor would have taken the time to research Clubhouse Media Group and learnt that it was a separate entity from the social media app. The reddit community buying GME are not profit seeking rational investors but a community that has found an opportunity to hurt “Wall Street”, even if that means losing money. And the investors that purchased shares in Signal Advance Inc after Elon Musk’s tweet likely were driven by greed and behavioral biases, not logic.
While we will not be looking to profit from the above examples and are not anxiously sitting by for Musk’s next tweet, there are opportunities to generate above market returns sustainably and consistently. Like everything we do or say, this is substantiated by evidence and research. Let's look at some of the evidence and our roadmap to generate above market returns:
The greatest example of persistent irrationality by investors lies in factor premiums. Companies that exhibit certain characteristics - such as a low price to book multiple, high ROE, strong recent price performance etc. - have been shown to outperform the market over time. Recent research traces this phenomenon back to imperfect reasoning and rationality by investors. For example, companies that have a low price to earnings ratio - how much an investor is willing to pay for $1 of earnings - over time tend to outperform companies with high earnings ratios. In the field of behavioral finance, this is explained by investors “giving up” on companies whose performance has been weak, and “falling in love” with companies who have done well, moving the valuations beyond what is warranted by company fundamentals. As time passes, the behavioral impact on share price should ultimately subside, creating a mean reverting opportunity for outsized returns.
By tilting exposures to companies that exhibit the example factor (value) and others, evidence shows that investors can expect to earn an additional 2% return annually over a passive index portfolio (1). My old boss and a thought leader in factor investing always liked to say, “we will outperform the market, not every time, but over time” in reference to factor investing, as there may be periods where these factors underperform the market. The below chart, courtesy of MSCI’s Index applied research team, shows the frequency of a given factor outperforming the market over various rolling period's of time.
Evident by the chart is the value of being a long-term orientated investor. The longer the investment period, the more likely portfolio returns will be aided by tilting portfolios to companies that exhibit the characteristics of a given factor. Furthermore, by combing different factor exposures to portfolios, portfolios are more likely to outperform over shorter investment periods. This can be seen by the far-right column “Balanced Mix.”
Much has been written about the death of security selection, or active management, in which investors identify mispriced securities and profit from them. It is a relatively easy argument to make as active managers have consistently underperformed their benchmarks. For example, active large cap managers have underperformed the S&P 500 by 1.7% per calendar year since 1990. What is missed in this argument, however, is how active managers' highest conviction ideas have performed. On average these securities represent an average annual excess return of 3.67% gross of fees per year. Academics attribute this paradox of sorts to a concept called “beta drag,” where the top ideas and biggest position exceed market returns but the rest of the portfolio substantially “drags” performance down.
In layman, and $50 bill on the street terms; evidence shows that when active managers find a $50 bill on the street, they know it and can generate substantial profits from finding it. However, the lower conviction investment ideas that comprise the rest of the portfolio substantially lower returns. As such evidence supports only making active overweight decisions on securities that investors have unique insights, informational advantages, and strong conviction in.
The little things
The little things are not glamorous. You likely won’t see an investor walk into a bar on Wall Street and proclaim “my tax strategies generated an excess 2% after-tax return for clients this year. Drinks on me!” Like you would if an investor had succeeded on a pre-tax basis. Yet, a 2% after tax outperformance is as valuable – actually, more valuable accounting for tax drag - as a 2% pre-tax outperformance. Even more puzzling as to why after-tax is not celebrated is that the strategies that investors can employ to achieve an excess 2% after-tax return are repeatable and controllable. By harvesting tax losses, and using individual shares investors can add between 1% and 3.16% - depending on their tax rate -in after tax returns annually with minimal impact on pre-tax performance (2) in taxable accounts.
Our only ambition is to help clients achieve their financial goals which are paid for in after tax dollars. As such that is the basis that we evaluate our own performance on - from initial investment to the spendable value after fees, expenses, and taxes have all been paid. To further aid in our pursuit of after tax outperformance beyond our tax harvesting strategies, we believe in having robust charitable giving and estate plans, locating assets in the most efficient account type (for that asset), and following potential tax law changes closely.
There are countless other minute details of portfolio construction that we believe will add value over time. This minutia is by design. While we have established that the market is not perfectly efficient, going against the crowd and history should only be done when supported by thorough research, and evidence. We liken ourselves to a baker cooking a very important loaf of bread. The baker can improve a recipe by choosing the highest quality ingredients, kneading the dough by hand, meticulously studying other bakers, learning from past loafs, and baking it in special convection oven. However, too large of a deviation from the recipe and without supporting evidence, you run the risk that the dough will not rise.
See Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” The Journal of Finance (June 1992); and Asness, Moskowitz, & Pedersen, “Value and Momentum Everywhere,” Chicago Booth Research Paper No. 12-53 Fama-Miller Working paper (November 2012).
Chaudhuri, Burnham, & Lo; An Empirical Evaluation of Tax-Loss Harvesting Alpha, January 2020
Sutherland Integrated Investment Management Group, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.