ETFs Lean on Academic Stars

Putting professors out front.

October 4, 2010

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592163_chalkTrying to apply academic insights to portfolios is not new. Dimensional Fund Advisors has long built on the work of Eugene Fama and Kenneth French. James O’Shaughnessy has sought to integrate “What Works On Wall Street” into his portfolios.

But there has been a new breed of academic, tempted to put their own analysis into practice to build ETFs. Random walker Burton Malkiel is one of them, and he advises an overweight position on China compared to a market-capitalization index. But he is only the latest financial luminary to front an ETF.

That’s a far cry from the day when prominent finance professors (as well as U.S. Fed chairman Alan Greenspan) seemed mostly to favour T-bills. (Of course, they do have university/government pensions to rely on, but still …)

And when it comes to stocks, finance professors are not necessarily armed with the latest theoretical insight, according to a 2007 study by James Doran and Colbrin Wright.

“Our sample of 642 useable responses indicates that over two-thirds of the sample are passive investors, and not because they don’t have the time to invest. The responses for all investors indicates that the traditional valuation techniques (specifically, the dividend-based valuation models) and the traditional asset-pricing models (namely the CAPM, APT, and Fama and French and Carhart models) are all unimportant in the decision of whether to buy or sell a specific stock. Instead, finance professors, particularly finance professors who trade stocks at least monthly and who admit they are trying to “beat the market” with their investment dollars, believe that firm characteristics (especially, a firm’s PE ratio and market capitalization), along with momentum related information (a firm’s returns over the past six months and year and a firm’s 52-week low and high) are most important when considering a stock sale and purchase. We also show that finance professors have less investing experience than one might expect, especially in the areas of margin trading, short selling, and derivatives.”

Well never mind that. What happens when theory meets practice in a full-blown ETF asks The Wall Street Journal? Erm,um, ahem: mixed success.

“When little-known SummerHaven Investment Management LLC launched its first commodity exchange-traded fund last month, it relied heavily on Yale University’s Geert Rouwenhorst, one of the academics best known for popularizing commodity futures as a long-term investment alongside stocks and bonds. Prof. Rouwenhorst, whose scholarship serves as the basis of SummerHaven’s trading strategy, isn’t alone.

“A parade of prominent economists, including stock guru Jeremy Siegel and housing expert Robert Shiller, have tapped the fast-growing ETF business in hopes of translating their academic theories into investment results.”

So far so good. As the Nike folks would say, “Just do it.” Or, on second thought, perhaps not, the WSJ suggests.

“But while market research by these scholars has helped shape how firms design hundreds or thousands of portfolios, the particular investments created by the academics themselves haven’t always performed well.”

Last word to Rouwenhorst: “It’s a competitive world,” Prof. Rouwenhorst says of the ETF marketplace. “There’s going to be winners and losers.”

In a real marketplace, of course. There’s always asymmetries of information – and other pesky behavioural factors: overconfidence, anchoring, herding …

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