Inefficient markets and wealth generation
High frequency trading, trading algorithms, big data analytics are all buzz words flowing around Wall Street. We have seen a technology boom in the last decade which has changed the face of the financial markets. With Hedge Funds and Bulge Bracket Banks in a technological arms race could they be leaving out an entire subset of the market? Thousands of new college graduates are constantly flowing into these institutions to help develop new intelligence tools, improve algorithms and execution platforms to identify small “Alpha’s” within our markets. However, students lack experience in our financial markets and rarely have studied their history. Could this lead to a majority of the industry overlooking entire subsectors of the market that may still hold large exploitable alphas? I believe the answer is yes, and all we have to do is look at how we define basic financial theory.
In financial theory, we define a risk reward relationship that holds true for all investors. The most well-known outcome of this idea is a model called the CAPM or Capital Asset Pricing Model. CAPM defines the risk in our markets as beta, or the simply the correlation of an asset to the market, which is usually an index like the S&P 500. For simplicity, we will define only two assets and assume a linear risk/reward relationship holds true between them. Our two assets are the 10 Year US Treasury, which will be considered as a risk-free asset (a beta of 0), and the S&P 500, which we will define to be our optimal market portfolio. Our return on the risk-free asset over the long run is 2%, so that will be our return. Our return on the market over the long run is 8%. Thus, connecting the two points on the graph we derive an equation to explain given any level of risk we will require an optimal amount of return. The equation is E[R stock] = [R risk-free] + Beta*[ E[R market] – [R risk-free] ]. If I invest in a security that has a beta of 2, twice as risky as the market my required level of return should be 14%. This theorem was derived through analysis of the stock market and the belief that investors are rational. Remarkably this theorem makes a broad assumption that alpha, a risk-free return parity developed and explained in detail by William Sharpe, should be extremely scarce and not reoccurring.
With the introduction of technology to the financial markets we have seen most investments be extremely reactive to news that could affect the future streams of cash that a company generates. We have also noticed that the time it takes to price in new information is getting remarkably quick. In instances where an arbitrage opportunity, a form of alpha, presents itself algorithms and trading systems will quickly correct the mispricing resulting in a risk-free return (free money.) Therefore, we have established a key idea behind how the technological boom has been able to flourish, they trade in highly liquid securities and instantaneously trade on any alpha opportunities available. However, if a security is illiquid, meaning it’s market is under established then we see less of these institutions trading these securities. Since these firms do not bother trading such securities, alpha opportunities may present themselves on a regular basis but since they are illiquid they may not be realized, allowing them to compound overtime. This combined with other fundamental drivers of value may cause a security to become underpriced, in which an equity research institution will often file a report or issue a statement to their institutional investors about such an opportunity. However, if these securities are not covered by those institutions then they will not be brought to the attention of investors. This could define a completely inefficient type of market, however our ways of fundamentally identifying values for securities still exist. It is the same way we may value a private company or a home. Interestingly over long periods of time these types of extremely low beta securities may have outsized returns due to a well-run business and great return on equity which is compounded over time. These are not extremely difficult to find however are not often brought into the spotlight of an investors attention without some help. Therefore, it is possible to identify subsets of the markets that are severely underpriced, and could be facing let’s say a consolidation trend. For example, a profitable bank with a market cap of $60 million may be trading at 15x P/E and .9x P/TBV, but since we have increased the amount of regulations on such institutions and face a low interest rate environment the management team may deem it best to combine their institution with a larger institution to achieve efficiencies of scale. When a deal is announced, the bank will be featured in top news stories and circulated around the media for a brief period. This will attract the attention of larger institutions like hedge funds and markets makers that will wish to profit in the proceeding volatility and merger arbitrage plays. This allows the security to transfer from an inefficient market to a semi-efficient market. Almost immediately we could see gains of 40-50% easily due to the current valuations of such deals within the banking sector. This all the sudden recognizes the compounded value within the company, which interestingly enough was there before hand. If you can identify industries or subsectors of the markets that cause shifts of profitable companies from inefficient markets to semi-efficient markets, then you can identify reoccurring alphas. Then it would make sense that those who have studied the markets for an ample period of time would be able to recognize such trends. When doing an analysis of the average age of an investor in the regional banking sector they tend to be significantly older than investors in the broader market. Thus, could this finally be a market that the technological arms race hasn’t had a significant impact on. My conclusion is that I strongly believe while technology has made the broader market much more efficient subsectors like the one described above are still largely inefficient and therefore significantly large alpha opportunities may still exist.
In summary, we noted that in these inefficient pockets of the market the investors tend to be older, and that may indicate more experience with investing. Using the argument that the markets impose a kind of natural selection we would conclude that the reason behind why the average age is higher is due to natural selection. Older investors may not want to be in volatile and highly liquid markets and only receive a small amount of return in compensation for their risk. Therefore. they will shift to the parts of the markets which still present alpha opportunities, which they will be able to identify with their unique experience investing. Thus, the average investor in these illiquid securities will tend to accumulate large pockets of wealth over long periods of time. In examining the types of holders of these illiquid securities that tend to show these inefficient to semi-efficient market movements tend to be institutional investors who rapidly build large pockets of wealth over time. Great examples of unheard of institutions may be hedge funds like PL Capital, The Banc Funds LLC, and the Wellington Management Group. They tend to be highly invested in these inefficient to semi-efficient movements and thus have a large corresponding return. In conclusion, while we may perceive our markets to have little or no alpha opportunities left I agree that in the broader market this is likely true, but in the inefficient markets I believe we may still be able to identify significant alpha opportunities.
Resources for returns of the stated hedge funds:
https://whalewisdom.com/filer/banc-funds-co-llc
https://whalewisdom.com/filer/pl-capital-advisors-llc
https://whalewisdom.com/filer/wellington-management-co-llp