The Evidence-Based Investor

Tag Archive: joachim klement

1. Practitioners still pay too little attention to academia

   September 16, 2020 4:42 pm Comments Off on Practitioners still pay too little attention to academia

    

   By JOACHIM KLEMENT

    

   I recently read a paper that claimed that practitioner research has become increasingly more reliant on academic research and less on non-academic and unpublished research (e.g. from brokerage firms). As someone who intensively uses academic research in his work, I was encouraged by this claim — until I read how the study was done.

   The study by Jerry Parwada at UNSW Business School in Sydney, Australia, looked at the articles published in practitioner journals like the Financial Analysts Journal or the Journal of Portfolio Management and what papers were cited by both academics and practitioners. Then they showed that academics tend to cite academic papers and very rarely cite non-academic work. Meanwhile, practitioners tend to cite non-academic work much more often than academic work. This has broadly stayed the same over time, but there is a slight tendency for practitioner articles to cite more academic research since 2008.

    

   Quality of practitioner articles has improved

   However, as someone who has published a dozen or two articles in practitioner journals my impression is that practitioners have become more academically minded. Instead, the requirements and standards of practitioner journals have significantly increased over the last decade.

   Today, some of the practitioner articles published a decade or two ago would be rejected outright as insufficiently sourced and researched. And that is good because only high-quality material should be published in a journal, whether it is academic or practitioner-oriented.

    

   Nice charts, shame about the “research”

   It is bad enough that so many brokers can publish “research” that is obviously nonsense and simply a case of wishful thinking to justify whatever view the analyst or the firm has. When I was working on the buy side, I tried to stay away as far as possible from these analysts who just came up with a few nice charts without any evidence that whatever “correlation” they showed over the last couple of years would hold in the future.

   I am still surprised how many followers people can have on Twitter by just posting a bunch of charts every day that seem to show some correlation or another. As someone who is a professional, I so often find myself shaking my head at these charts because I know that if the timeframe would have been extended just a little bit, the “correlation” would break down altogether. But, apparently, people love to pin their hopes on these charts instead of checking the data for themselves.

    

   The gold standard

   Instead, in my work, I gravitate to people who are able to support their views with good research that is grounded in academic results (which remain the gold standard of finance, no matter its flaws and failures). And this is also why I tend to write on academic research a great deal. I form my opinions based on sound research, not based on some tables with past performance numbers or common market knowledge.

   Using academic research as the starting point of your own research doesn’t mean you are always going to be right. But it means you are practising evidence-based research that has as a starting point empirical observations that have been checked and checked again by some of the brightest people on the planet. And that reduces your chances of losing money and increases your chances of being on the right side of the trade.

   Thank goodness, I do see more and more of that in practitioner journals. Unfortunately, though, I don’t perceive a rise in evidence-based investing in the practitioner community as a whole — which is why it can still be an advantage for those who practise it.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

   Joachim is a regular contributor to TEBI. Here are some of his most recent articles: 

   No more room at the factor zoo

   Boohoo teaches ESG investors a lesson

   Stop admiring your successful trades

   Is there a link between intelligence and performance?

   Wall and Main are two different streets

   Is book-to-market still the best measure of value?

    

   What are you going to read next? Here are some suggestions:

   Investing shouldn’t be a gamble

   Are you still playing by the old rules?

   The names are never the same

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   Let’s make EBI fun, Part 1

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   Truth tellers versus salesmen

    

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2. No more room at the factor zoo

   August 11, 2020 6:30 am Comments Off on No more room at the factor zoo

    

   It was apparently Professor John Cochrane of the University of Chicago who coined the term “zoo of factors” in his 2011 presidential address to the American Finance Association. Since then, the factor zoo has grown considerably. Several hundred risk factors have been identified which, it’s been claimed, have beaten the broader stock market over time.

   But very few risk factors have outperformed with any degree of consistency. For JOACHIM KLEMENT, it would be wrong to abandon factor investing altogether. But, he says, investors would be wise not to get their hopes up whenever a new factor emerges.

    

    

   Factor investing, or smart beta investing, as some people call it, has become all the rage. Admittedly it’s more popular in the United States than in the UK and Europe, but it’s been growing in popularity outside the US too.

   In their efforts to reduce costs while still generating above-market returns, many pension funds have shifted their assets into smart beta ETFs that try to mimic one factor or another.

   Meanwhile, the factor zoo has grown bigger and bigger and by now encompasses several hundred anomalies that promise significant outperformance. At least within the sample of the publication exploring the anomaly.

    

   The quest for publication

   The typical procedure for research is to describe the anomaly, and then measure the performance of a long/short-portfolio that is long the 20% best stocks (with regards to the anomaly) and short the 20% worst stocks. You win a prize (i.e. being published in a journal or launching a fund) if the performance of that long/short-portfolio has strong performance.

   Andrew Chen from the Federal Reserve Board and Mihail Velikov from Penn State recently examined 120 factors that are described in the academic literature. On average, the annual return of the long/short-portfolios formed on a factor had an annual return of almost 8%. That is impressive, but unfortunately, most studies don’t take transaction costs into account. So Chen and Velikov did it for them.

   Assuming that investors have to pay the typical bid-ask spread for the stocks they trade (the authors make sure to use historical transaction data where available instead of quoted prices that may have a narrower spread than investors pay in real life) the authors conclude that the average annual performance of the long/short-portfolio is lower, but a still-respectable 4.6% per year.

    

   The replication crisis

   But investors today are very much aware of the replication crisis (and if you aren’t, read about it here). Thus, most investors expect the performance of the factor to decline after publication for a number of reasons. And that is what the Chen and Velikov observe as well. After an anomaly has been published, its average performance net of trading costs drops to 1.6% per year.

   Ugh. It’s starting to look ugly.

   But wait, there is more.

   Stock market trading has changed dramatically in the 21st century. The rise of algorithmic trading and high-frequency trading has changed the dynamics of share prices and made it much easier for hedge funds to exploit market anomalies.

   When Chen and Velikov looked at the performance of factors net of trading costs and after publication but restricted their sample to data from 2005 onwards, all that was left of the performance of the average long/short-portfolio was a meagre 1% per year or 8bps per month.

    

   

    

   Two important caveats

   But before you abandon factor investing altogether, let me stress two important caveats:

   — The chart above shows the average performance of 120 factor portfolios. Some factors continue to have much better performance than others and indeed, Chen and Velikov show that the two factors that appear in one study after another as the most reliable factors, momentum and value, still have better than average returns after 2005 (despite the underperformance of value in the last decade).

   — There is an increasing amount of studies that show that combining different factors in a portfolio can significantly enhance performance.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

   Joachim is a regular contributor to TEBI. Here are some of his most recent articles: 

   Boohoo teaches ESG investors a lesson

   Stop admiring your successful trades

   Is there a link between intelligence and performance?

   Wall and Main are two different streets

   Is book-to-market still the best measure of value?

   Are we heading for another financial crisis?

    

   Here are some other posts on factor investing which we think you’ll find interesting:

   Have we seen the death of value?

   How inflation affects growth versus value

   How different risk factors performed in Q1

   What the latest research tells us about the value premium

   Is market-cap indexing a for of momentum investing?

   Is factor investing worth it?

    

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   Picture: Nikolay Tchaouchev via Unsplash

    

    

3. Boohoo teaches ESG investors a lesson

   August 3, 2020 5:39 pm Comments Off on Boohoo teaches ESG investors a lesson

    

   It’s been a month to forget for the UK online fashion company Boohoo. The company has seen a huge increase in sales during the lockdown. But a report in the Sunday Times it’s been hit by claims that workers at a Leicester factory that supplies some of its clothes were paid just £3.50 an hour. Boohoo also failed to offer them protection against coronavirus. The company has said it’s launching an investigation, but experts say its reputation has been severely damaged.

   Yet the stock had been popular with ESG funds. Just a few weeks before the story broke, MSCI gave the retailer a clean bill of health. The rating and index provider reiterated Boohoo’s AA rating, while highlighting how it scored far above the industry average on supply-chain labour standards. 

   JOACHIM KLEMENT says the episode has taught ESG investors an important lesson.

    

    

   The accusations of modern-day slavery against fast-fashion retailer Boohoo have not only dented its share price but also sent shockwaves through the ESG investing world. There were several ESG funds that were invested in the stock and one fund that claimed to pay particular attention to labour conditions even had Boohoo as largest holding in its fund.

   How can something like that happen?

    

   In terms of ESG ratings, it was a reasonable investment

   Well, if you look at the average ESG rating of Boohoo versus its closest peers ASOS and Zalando, then it seemed as if Boohoo wasn’t such a bad investment. Measured against a universe of more than 19,000 stocks worldwide, Boohoo was better than 71% of them. Both its peers were slightly better, but essentially all three stocks were in the top third in terms of ESG ratings.

    

   

    

   No unified standard of disclosure

   Investors who only looked at the ratings or the ESG data the companies disclosed could easily believe that Boohoo was a pretty good investment from an ESG perspective. But that overlooks a major problem with ESG investing. Because there is no unified standard of disclosure, every company is free to choose which metric it wants to publish.

   ESG disclosure is costly for companies (it takes both time and money to collect, analyse and publish the data) and in particular smaller companies often don’t have the resources to disclose as much information as their larger peers. ESG investors and ESG rating agencies obviously want as much information as they can get, but they have to make do with what companies are willing to publish. And, in order not to unfairly penalise smaller companies, they often calculate their ratings or make their investment decisions based on the available data and simply ignore the missing data.

    

   Gaming the system

   But that opens up the possibility for companies to game the system. If you have something to hide, you can simply choose to disclose only favourable information about your company. This way, you look much better to ESG investors and it may be even possible to look better than companies that are following better practices overall but disclose more information about their business.

   In other words, there is important information for investors is the lack of information. The Fashion Transparency Index engages with more than 200 fashion brands around the world and checks how much they disclose. Note that they don’t judge if a company has good or bad practices, they only judge how transparent a company is. And if we compare Boohoo to ASOS and Zalando it is obvious that it disclosed much less information than its peers in every category that the Fashion Transparency Index uses.

    

   Traceability was red flag

   A particularly important red flag is that in the area of traceability, Boohoo scored zero points. They provided absolutely no information to investors and consumers on where they buy their clothes or source their raw materials. And of course, that is exactly where the scandal was.

    

   

    

   Now, I am not claiming that Boohoo’s management knowingly covered up the scandal and systematically withheld vital information about the working conditions in its suppliers’ factories. That is for the ongoing investigations to determine.

    

   Pay more attention to disclosures

   What is clear, though, is that Boohoo could have been flagged as a potentially risky investment from an ESG perspective by looking at how much the company disclosed. It is high time that ESG investors pay more attention to disclosures than they did in the past. Otherwise, they will continue to fall into the same trap.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

   Joachim is a regular contributor to TEBI. Here are some of his most recent articles: 

   Stop admiring your successful trades

   Is there a link between intelligence and performance?

   Wall and Main are two different streets

   Is book-to-market still the best measure of value?

   Are we heading for another financial crisis?

   Knowledge can be dangerous for stock pickers

    

   Want something else to read? Here are some more articles we think you’ll find interesting:

   The legacy share class scandal

   Is Vanguard the Tom Hanks of asset management?

   Market timers are fooling themselves

   Leave alpha to the daredevils

   Stop admiring your successful trades

   Three truths about ESG investing

   Hedge fund fees are much worse than you thought

   Should you invest with Baillie Gifford?

   Is there such a thing as a “normal” stock market?