It’s time, once again for the Monday Message Board. As usual, civilised discussion and absolutely no coarse language, please.
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John Quiggin 
Australia’s first step into Asia as a football nation was disastrous.
Playing minnows Laos and Indonesia we didn’t even get through the qualifying stage.
This obviously reflects on the coach who must go.
however we desperately need a high quality technical director of coaching.
BBMB – to be fair that was the joeys. In addition, the coah at this level isn’t necessarily the problem; rather it is the entire techncial coaching system that is at fault.
The AFF need to appoint a technical director NOW; and given the person’s experience and skill level, we should be seeing the fruits of that work in a generation or two. It will take that long.
Agree but a decent coach wouldn’t let an Aussie team draw with Laos.
A good coach can lift a bad team.
The sooner we have a technical director the better
BBDR, the coach can’t play on the park.
no he can’t but as aussie Guus has shown he can make a hell of a difference.
No Aussie team should ever not be able to beat Laos!
Serves them right for playing Soccer. An Aussie AFL team would have flogged both of those countries.
I have a question to pose to anyone who has some knowledge of finance. A lot of mutual funds now invest in stock markets in proportion to the market capitalisation of firms. Thus they don’t try to ‘stock pick’ on technical or fundamentalist basis because they believe in efficient markets theory.
What happens as the market becomes dominated by such traders? Does it become unstable given that most people are not making choices on the basis of underlying values? Does there evolve a role for smart investors in such a market that takes advantage of the stupidity of the funds? In short does widespread belief in efficient markets theory make markets inefficient? Maybe this is just the well-known sort of instability that you get in asset markerts under rational expectations.
HC, I have often thought of these issues as a time scale thing. It’s like saying “the sea is flat”; you can make that rough generalisation for cedrtain purposes, but it is quite clear that it is instantaneously very uneven. So you can make the working assumption of market efficiency if your timescale is long enough, but on shorter time scales you are bound to see a certain choppiness that is evidence of the very processes that work to smooth out “unflatness”.
So, for funds that are supposed to be responding, there could easily develop some form of Pilot Induced Oscillation (PIO) by the very fact that they are assuming the very thing that only conscious participation would work to bring about. But for funds or individuals who have no capacity to monitor and adjust their holdings that quickly, there should be no problem (apart from the opportunity cost of not being so nippy) – provided that they aren’t dominating the market, i.e. that they truly are following some larger dominating activity on smaller time scales.
I’ve tried to present that for illustration rather than as proof. It corresponds to mathematical intuition that should be fairly easy to formalise so that one could highlight whether or not the assumptions about shorter time scales corresponded to any real mechanisms. I imagine that some form of renormalising and looking for invariants (and/or their equivalent symmetries) would help.
Can you any believe this alp renewal rubbish? One union hack replacing an ex union hack. Shorten, Marles and Paluka – evidence of a very small gene pool
Harry, firstly a little bit of terminology – these types of investors aren’t traders – they are investors. Secondly, what you are talking about are Index Managers. Their mantra is that it is not timing the market but time in the market. They need to keep their costs low as possible to be able to stay as close as possible to the Index they choose to track. They will never be able to 100% reflect an Index because of cash flows in and out of the fund and the inability to quickly re-weight.
I don’t believe that the Fund managers believe in the Strong form of the Efficient Market Hypothesis. It is more an issue of avoiding being a poor stock picker and getting punished for under-performance.
Yes, it does create opportunities that can be exploited (I try to do it when I can). Basically it works on the fact that the funds try to reflect an Index. Indices regularly drop stocks and pick up new ones over time. If you can identify a stock that is going to be included in an Index that you are pretty sure the Index funds are going to be under-weight in, then you buy early with the expectation that in the period around inclusion time the stock price will rise on demand from the funds.
The question though, is is this an inefficiency? And if so, what form of inefficiency are you interested in? From memory there were three types of efficiency, but I can only remember two – Weak Form and Strong Form.
Hope that helps.
Thanks for that Razor but my quip about believing in efficient markets was really irrelevant to my argument. All I wanted to suppose that people bought stocks in a way that was proportional to their aggregate market values. I read recently that in the US the bulk of investment occurs in this way. Active trading is dead. With information about the prospects of companies changing through time it is easy to see that such rules could produce outcomes that are out of wack with market realities – bubbles and so on.
I understand your point about guessing changes in the composition of indices but can’t the market as a whole get seriosly out of wack when this type of naivete dominates?
Harry, as Razor says, there are issues created at the margins, where it becomes profitable to buy shares that you think are likely to enter the index, and sell those you think are likely to exit. And, as Razor also says, no-one believes in the strong EMH.
Let’s take it to the extreme, where all of the investors in the market were index tracking funds. It’s not unstable. There would be no trades at all, there would be no reason for any of the funds to buy or sell anything.
If we introduce one independent trader, say you, that would introduce instability. Any time you wanted to sell something, say a single CBA share, you’d have to reduce your price far enough to tempt one of the index managers to break ranks, and buy at $0.40, causing the others to think “OMG! Index weighting of CBA has dropped by 99%! Sell! Sell! Sell!” At which point you could buy up all of the outstanding shares of CBA for about fifty bucks.
That’s an unstable equilibrium.
The more interesting question is what happens to markets that become dominated by investors with unchangeable investment criteria, e.g. superannuation fundswith 100% into Australian shares (or any other fixed criterion like 50% bonds, 30% Australian shares, 20% US shares), regardless of the future prospects for those investments.
After reading back through what I just posted, I realise that I need to clarify.
If Harry’s question is confined to just this:
Then the answer is yes, it becomes unstable.
Which in both theory and practice prevents the posited domination.
I must say that if active trading is dead then news of its’ death is rather premature.
John,
Just a quick note to say the RSS feeds do indeed seem to be working. Thanks for fixing that up.
Oddly enough, I couldn’t add this comment to the post titled “RSS” as firefox refused to render it and only gave me the xml source.
Can I take up this issue of Index trading and instability again? Suppose most market participants are index traders and a stock gets some good news which increases its value among the fundamentalist minority. Will not any induced price rise make index traders drive up the price of the stock which in turn will cumulatively lead to more investment and so on? OK some of the fundamentalists may sell out but if there is any stickiness here in their behaviour you could get cumulative price gains. So my question is, can a minority of fundamentalists create instability in a market where many participants invest on the basis of inflexible rules unrelated to market fundamentals? Also can those trying to manipulate stock prices by issuing false information achieve their objectives better whenm you have lots of index traders? Buy a bit, watch the price rise and the institutions pile in, then sell out.
I think we need to get clearer about what we mean by the word unstable. In one sence the price is almost always unstable, which is why it keeps on moving. That does not mean that the market is unstable (it is not about to stop being a market).
Harry seems to be asking if the actions of a few can be magnified by the following of many. In most of human history it has been thus. The thinkers lead and the followers follow and we all pay.
Harry,
I would suggest you have a good read about theories of market efficiency. The usual spot (wikipedia) is improving in this area, and the article on market efficiency is a good place to start. The arguments on the validity of the hypothesis is an interesting section.
Andrew, Wiki does not answer the question I askedl. I am not an expert but I know the basics of EMH. I am just curoius what people as the macro-market implications of being index traders. May not be much at all but I remain curious.
Harry, I think this was a short term response by institutional investors to the Dot.Com bubble where the real capital backing vanished in cash burns without income streams and the intellectualised value vanished with the firms. So investing on market capitalisation is now a defacto standard of risk minimisation, quite rational, perhaps.
If you look at Robert Schillers work on the actual decision making of stock investors (big and small) you find that it is more than illuminating on these questions. The means by which a lot of people make investment decisions on the basis of faulty information or emotional bias (mates rates), is quite extraordinary. In summary, market has no rationality other than that it has at the time, Smith’s invisible hand is not necessarily intelligent or prudent.
Harry,
Provided the way that the index trackers track indices is known and there are some out there seeking arbitrage opportunities then it should not matter (too much). A good way to get a handle on this is by looking at what happens prior to a stock joining one of the major indicies and what happens just after they drop out. If the trackers were having a major effect on prices then there should be an appreciable increase just after a stock joins an index and a drop just after they fall out.
There is normally a price movement around this time, but whether this relates to the liquidity premium or another effect is the subject of a number of learned papers. Intuitively, though, if it were easy to make a profit from it then you could make a decent living out of forcasting entries into and exits from an index and trading on the results. Unfortunately, the quantum of the movement is normally below the bid-ask spread of the market, so no real short-term arbitrage normally opportunity exists.
Harry, I’ll have another go at explaining it. My earlier off-the-top-of-my-head answer was wrong.
The main effect is a reduction in liquidity. An index fund manager only needs to buy or sell shares when there’s a change in index composition, or when there’s a net inflow or outflow of money to/from the fund.
This can make it difficult, or perhaps even impossible, for other people to buy or sell their shares. If I own 10% of the shares in XYZ corp, and index fund managers own the other 90%, it’s going to be difficult for me to unload my shares without significantly dropping the share price, because the main participants in the market – the index funds – don’t want them at any price. Conversely, if I want to increase my shareholding, I’m totally screwed because the funds don’t want to sell at any price.
The less liquidity in a market, the more likely it is that any attempt to buy or sell will shift the price.
The market doesn’t become unstable, but it will require a liquidity discount, i.e., a fall in prices to compensate the extra risk that’s been introduced.
Thanks Mike, Andrew and SJ.
Mike I thought blindly investing in daft dotcoms without any earnings or without any clear business plans is silly. Why is it risk-minimisation (or are you being ironic)? The he only way you can rationally understand it is in terms of ‘greater fools’ theory. But I think, in the end, you are agreeing with me that, with a predominance of ad hoc rules driving investment, the market need not make much sense.
Andrew I’ll think about this but don’t see clearly any implied arbitrage opportunity. I am more interested in how bubbles and market over-corrections come about. Can you supply the references you refer to?
I like your line SJ and it sounds right. Dullard index fund managers once they are ‘in’ will stabilise the market by restricting the suopply of equity. But I still think that means the non-index fund minority can exert a very strong inflence on prices. Indeed if this minority is fundamentalist the market will be stable.
Harry Clarke says:“Dullard index fund managers once they are ‘in’ will stabilise the market by restricting the [supply] of equity.”
No, that’s not stabilisation at all. It’s a reduction in liquidity.
I just read through the Wikipedia entry on liquidity, and it’s not bad. Take Andrew Reynold’s advice: have a read.
“But I still think that means the non-index fund minority can exert a very strong inflence on prices.”
Yes, that’s what illiquidity means.
“Indeed if this minority is fundamentalist the market will be stable.”
That does not follow. There’s no requirement for the other market players to follow any particular stock valuation method.
To reduce ambiguity, I should have said:
That does not follow. There’s no requirement for the other market players to use any particular stock valuation method.
SJ, Yes, OK less liquidity – we are saying the same thing I think. And the other bit I agree with also. But the last sentence I can’t see. If the dullards are more or less stuck with their holdings, the motives of the minorities will matter won’t they? And that’s the basis for my presumption that you will get unstable market outcomes if most asset holders are Index Funds.
Harry,
This is one of those places where greed truly is good. The only condition to achieve stability in such a market is that there is liquidity and profit seeking behavior from sufficient participants with sufficient liquidity. Provided the “dullards” do not make up 100% of the market they will be price takers. The price makers will be the rest of the participants. Profit seeking behavior by the price makers wil result in at the very least weak form efficiency, and (I would contend) probably semi-strong form efficiency.
The key question is whether the amount of shares left for the price makers is sufficient to allow decent liquidity in the market. If there are a lot of shares around, even a 1% free float may be enough, but this is unlikely to be the case for small, less traded offerings. The US analysis indicates that, for most market activity, around 24% is free float (see here), and this should be more than enough.
Perhaps another way to look at it is that if the ‘dullard’ investors come to dominate the market the scope for arbitrage will grow enormously, as the reaction of the ‘dullards’ to price changes will be known. The scope for an active investor to make super-normal profits consistently will appear, so the incentive will be for investors to switch out of trackers and into active investors. This will reduce the tracker’s weight and increase the active weight, removing the problem.
Andrew, Looking at the hyperlink you cite I see the issue I raise was analysed 26 years ago by Grossman & Stiglitz in 1980. The paper you cite is also a goodie on the empirical issue of the extent to which stock-picking has declined and I’ll go through it too. Its a nice question.
1. I agree with those who say that a definition of a concept of ‘stability’ is required before the conditions under which ‘stablity’ exists can be investigated.
2. I don’t agree with those who talk about ‘strong form’, ‘semi-strong-form’ and ‘weak-form’ market efficiency ala Fama et all. The empirical tests of the ‘semi-strong-form’ efficiency hypothesis (lots of papers, lots of publications) aren’t tests of what they say they are. They merely provide an measure of the average response of share prices to public announcements. This conclusion was reached independently by Frank Milne and by E. Gross in the mid 1980s. Neither paper was published. But after the 1987 stock exchange crashes, some U.S. academics toured the world and conceded.
3. I dont’ agree with those who suggest that ‘greed is good’ unconditionally. Consider leveraged investments and Oliver Hart’s 1970s article on the existence of equilibrium in securities markets (I’ve given a reference in an earlier post).
4. SIRCA is doing some interesting empirical work on securities markets.
Ernestine,
If the market is inefficient then there would be plenty of scope for arbitrage opportunities. If you find some, please let me know and we could both make a fortune without risk.
Please let me know – I
needwant the money.I’ve been listening to the RU-486 debates in the Senate and the House.
It’s striking that the fact that this is a conscience vote has resulted in a much more polite and more carefully argued debate than the norm.
It sounds liek peopel are actually attempting to explain their views and possible even convince others to change their own view rather than simply shouting down and belittling ‘the other lot”.
Still I’m sure it’ll all return to normal as soon as these bills are dealt with.
Ian,
When you have a conscience vote they all get to leave the tribe behind for a while. Hence less tribalism.
Regards,
Terje.
Andrew,
Tests of SSF EMH do not allow the researcher to distinguish between
a) ‘fully reflected’
b) ‘partially reflected’
c) ‘not taken into account at all’
Theoretical result: An equilibrium of type A implies ‘no arbitrage profits’
But the absence of arbitrage profits does not necessarily imply equilibrium type A.
If the EFM would be ‘true’ then HIH (and others ‘disasters’) would not have happened, would it?
There is at least one contributor to this blog site who has practical experience in financial markets. Perhaps he or she could provide examples of arbitrage trading profits.
??dullards??
To test whether the word ‘dullard’ is appropriate, may I suggest real time trading information is bought for each ‘small investor’ and each ‘small investor’ is compensated for the differential transactions costs, arising from the differences in the size of the transactions, and for losses due to automated trading systems (eg CBC’s derivative trading system). I believe this would be helpful to exclude the possibility of some of the brightest people being empirically classified as ‘dullards’ only because they are control relatively small portfolios.
Correction: “only because they are control relatively small portfolios” should read: “only because they control relatively small portfolios”
When my wife and I looked into trading a while back my wife ran some mechanical models that on historical data typically returned over 25% per annum (which is brilliant!!). However for a float size of less than $100,000 and with the number of trades involved, the returns disappeared entirely once you included transaction costs.
So I agree with the point being made by Ernestine.
Ernestine,
I do have some practical knowledge of markets of this sort.
On the question of HIH, I suggest you look at the definition of either weak or semi-strong efficiency – it is only public information that is included in the price. Where fraud or deliberate mis-information is priced in then the market is not going to be accurate. A market also cannot be strong form efficient where the information priced in is wrong.
The ‘dullards’ that are being referred to above are the index trackers. Re-read the thread on this basis and I think you will find it makes better sence – although you may still disagree.
.
Terje,
I agree on that as well, but Ernestine mis-understood my repeating of the use made by Harry Clarke of the word ‘dullard’.
Andrew,
You are in perfect agreement with me regarding HIH (I referred to EMH and not SSF EMH).
If you insist, I’ll go through the trouble and find some asymmetry (relative to the basic theoretical model) which will become the foundation of new proposal for a ‘dullard test’.
The point about HIH raises nevertheless a question about ‘market discipline’ – or rather ‘inefficient market discipline’ with respect to the timing.
I used to have a colleague in a Finance department who drove a heavy Merc etc, etc. He was great fun to have particularly during the time when all these SSF EMH papers were published. In response to the question, how do you make money, he smiled and said: “You buy cheap and sell expensive”.
Cheers
Ernestine,
If you asked him how to lose money, would he have said “Buy expensive and sell cheap or churn and get caught”.
Driving a heavy Merc does not mean you are a successful trader, just one with high volumes and/or lots of clients and/or the need to advertise. The true measure whether he beat the market, range traded or got beaten would be to look at his trading results, not the car he drove.
Andrew thanks for your response to my question. I tried to deal with it here. Basically Grossman-Stiglitz dealt with the issue I posed yonks ago and the paoer you send provided empirical implications of ;stick picker’ trends and minimum levels of stock picking.,
.
Andrew, I don’t think anybody drew a conclusion from the anectode I mentioned – it was just light entertainment on the discourse between academics and practitioners.
Just whant to say HI! I love this place!