Tuesday, April 26, 2011

The Segmented Market by Ari Paul

In this issue:
1) The Retail Investor
2) Long Equity Managers
3) Fundamental Hedge Funds
4) Short-term Equity Traders
5) Quants

For a PDF version of this newsletter, please look here:
http://www.scribd.com/doc/53945184/SegmentedMarketROR
Dear Friends, Colleagues, and Investors,

From the “Invisible Hand” to the “Rational Actor”, the “Electronic Herd”, or just the monolithic “Market”, we tend to think of asset prices as being driven by a uniform force. In reality, there are many different types of investors and traders who push and pull prices in myriad ways. The battle between these actors creates inefficiencies and profitable opportunities. I’ll discuss the most important market players and how their actions create distinct waves in asset prices. A rough estimate of the relative trading volumes:


1) The Retail Investor
The backbone of the stock market is the passive retail investor. Many people buy stock every year without giving much thought to valuation. Through the employer’s 401k, pension fund, or by consistent mutual fund purchases, these investors provide a relatively steady tailwind to the market. When the economy is doing well and they are optimistic, they invest more. During severe recessions they may produce net withdrawals. Even when their money is professionally managed by someone with great discretion, it tends to be invested in a way that is 100% long the market, and very diversified.

When these investors pour money into the market, the result is an indiscriminate rally that will lead to the overvaluation of some weak companies that are simply getting swept along. This causes the market truism, “a rising tide lifts all boats.” Over a 5+year horizon, their contributions will be influenced by the public attitude towards stocks and bonds in general. For example, for 20 years after the great depression, the American Public believed that stocks were inherently risky and unsuitable for most investors. Over a 10+ year horizon, contributions are also greatly influenced by demographics. As more Americans near retirement age, net investment into the stock market as a percentage of income will decrease. It’s also worth noting that passive investors are still relatively geographically isolated; American investors drive American stock market prices, and German investors drive German prices.

Over the long term, the valuation of a large country’s stock market is primarily determined by passive investors. To take advantage of opportunities created by the passive investor, we want to identify when they make poor choices. The simplest example is the passive investor’s exaggerated response to crisis. During a major war, recession, or natural disaster, public sentiment is likely to become extremely pessimistic. If the market has already sold off by as much as you think appropriate for the actual risks, it’s time to prepare for a contrarian trade. Similarly, we know that a young country with a growing economy will have a tremendous tailwind from a continuous flow of new earnings into the equity market. In the absence of a crisis, stock prices are likely to continue to rise regardless of valuation. As long as valuations are not obviously too high, we can ride the tailwind.

2) Long Equity Managers
These professionals consist of mutual fund managers and some pension and hedge fund managers. They focus on picking sectors that will outperform the market and individual companies that will outperform the sector. These managers usually have a 6 to 18 month investing horizon and they dominate the market in that time frame. They are driven by “ideas.” For example, a well respected analyst might put out a research report arguing that solar energy stocks are dramatically undervalued for various reasons. As this idea percolates through the market, fund managers overweight solar stocks in their portfolio. They tend to look for “pure plays”, stocks that are most directly tied to the investment thesis. They follow the dictum that it's better to fail conventionally than to succeed unconventionally, so they avoid “ugly” stocks, like those of companies embroiled in lawsuits.

It’s relatively easy to take advantage of these investors because their motivations are so clear. It’s sometimes possible to jump on a popular investment thesis near the beginning, but at the very least, you can avoid sectors that have already been pushed to bubble valuations. Because the fund managers look for “pure plays”, simple stocks are usually overvalued relative to more complex conglomerates. Conglomerates take more time to analyze and have less exposure to the trend, but frequently provide better value. Finally, these investors avoid “ugly” stocks because they don’t want to have to explain to their investors why they lost money on an obviously bad company. Ugly companies frequently provide the very best value investments for this reason. To borrow an example from the bond world, after Enron went bust in 2004, Seth Klarman of Baupost Group studied the company intensely and bought up a large portion of its bonds for 15 cents on the dollar. At the time he believed they were worth about 35 cents on the dollar and they paid off closer to 50. Most money managers didn’t want to risk losing money connected to one of the greatest stock scandal stories of all time; they were afraid to look stupid.

3) Fundamental Hedge Funds
The next economic actor at bat is the hedge fund that trades equities with a 1 month to 1 year time frame. Various hedge funds focus on long-short equity portfolios, predicting and trading around earnings announcements, medium-term technical analysis, and business cycle investing. The key feature of these funds is the timeframe, because they vary greatly in methodology and psychology. They are generally pretty efficient and rational in their investing process, but occasionally they fail spectacularly in ways that can be exploited.

In October of 2008, shares of the car maker Volkswagen soared 286%, making it briefly the largest company in the world. Many hedge funds had sold Volkswagen shares short because the company seemed generally weak and its stock overvalued. It was widely known that Porsche owned over 40% of Volkswagen shares, but Porsche had vehemently claimed they had no interest in acquiring more. Suddenly Porsche revealed they had secretly gained control of about 75% of Volkswagen, which meant that some shortsellers would be unable to find shares to cover their shorts. There was a stampede for the exits and as shortseller after shortseller bought back the stock, the price rose to the stratosphere. At that point, even hedge fund managers who wanted to remain short could not, because they were margin called and forced to buy Volkswagen shares. While equity hedge funds with a medium-term outlook are generally rational, extraordinary events can force them to create wildly mispriced valuations that we can trade against.

4) Short-term Equity Traders
Over a 1 minute to 1 month time frame, we have short-term equity traders. These traders are responsible for creating what we think of as the “efficient market.” They trade equities immediately after public announcements, natural disasters, economic releases, and even weather updates. When rumors float that a large hedge fund is getting margin called, these equity traders will fly like vultures over its corpse and take advantage of the resulting mispricing. Short-term equity traders try to anticipate the actions of the longer term equity managers and hop on “idea” trends at the very start. They ride the ebb and flow of bigger players’ orders.
These traders don’t frequently make “mistakes” that we can exploit as investors, but we have the advantage of a longer time frame. While they are rational at what they do, their disinterest in holding positions longer term means they leave a lot of money on the table. For example, after a subtle but strongly bullish announcement from a company, these traders will immediately buy a company’s stock, but if the stock price stalls, they may sell the stock out in an hour or a day. We can buy the stock from them and enjoy the gains over the next few months or years.

5) Quants
The last player in the equity game are “black box” hedges funds or “quants", and they represent about 70% of the trading volume. These traders program computer algorithms to trade in a time frame measured in microseconds to minutes. They immediately exploit simple arbitrages and use complex models to try to predict the actions of other market participants and jump ahead of them. For example, a computer program will notice that every 5 seconds, there is a purchase of 1000 shares of Microsoft stock. The program will purchase 10,000 shares and then sell the shares to the original purchaser every 5 seconds at a higher price. The quants make many basic mistakes. They overweight simple historical data and frequently fail to consider changing circumstances. For example, their programmers will estimate the impact of a good GDP number on stocks by looking at the impact of GDP reports over the last 10 years. However, they will likely fail to consider more subtle variables like current valuation levels, market sentiment, open stock option interest etc. Every once in a while, quants make eggregious, even comical errors. For example, during the “flash crash” of May 6th, 2010, quants sold the stocks of several large companies at $0.01.

It’s difficult to exploit quants unless you have access to similar technology. Even when the quants make eggregious mistakes, they are generally protected by the exchanges; the NYSE cancelled the trades in which the quants sold stock at $0.01. We can at least be mindful of their market impact. While quants are frequently thought of as “liquidity providers” in that they are constantly making markets and trade great volume, they become “liquidity takers” when the market is strongly trending. This means that a market with a high volume of quant trading is much more likely to experience a “flash crash.”

1 comment:

  1. What a good blog you have here. Please update it more often. This topic is very interesting. Thank you.
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