Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined

369 Pages·2015·1.8 MB·English

by  Lasse Heje Pedersen

EFFICIENTLY INEFFICIENT

EFFICIENTLY
INEFFICIENT
How Smart Money Invests and
Market Prices Are Determined
LASSE HEJE PEDERSEN
PRINCETON UNIVERSITY PRESS
PRINCETON AND OXFORD
Copyright © 2015 by Princeton University Press
Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540
In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire
OX20 1TW
press.princeton.edu
Jacket art © akindo/Getty Images
All Rights Reserved
Library of Congress Cataloging-i n-P ublication Data
Pedersen, Lasse Heje.
Efficiently inefficient : how smart money invests and market prices are determined / Lasse Heje
Pedersen.
pages cm
Includes bibliographical references and index.
ISBN 978- 0- 691-1 6619- 3 (hardcover : alk. paper) 1. Investment analysis. 2. Investments.
3. Portfolio management. 4. Capital market. 5. Securities—Prices. 6. Liquidity (Economics) I.
Title.
HG4529.P425 2015
332.6—dc23
2014037791
British Library Cataloging- in- Publication Data is available
This book has been composed in Sabon Next LT Pro and DINPro
Printed on acid-f ree paper. ∞
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
Contents
The Main Themes in Three Simple Tables vii
Preface xi
Who Should Read the Book? xiv
Acknowledgments xv
About the Author xvii
Introduction 1
i. Efficiently Inefficient Markets 3
ii. Global Trading Strategies: Overview of the Book 7
iii. Investment Styles and Factor Investing 14
Part I Active Investment 17
Chapter 1 Understanding Hedge Funds and Other Smart Money 19
Chapter 2 Evaluating Trading Strategies: Performance Measures 27
Chapter 3 Finding and Backtesting Strategies: Profiting in
Efficiently Inefficient Markets 39
Chapter 4 Portfolio Construction and Risk Management 54
Chapter 5 T rading and Financing a Strategy: Market and
Funding Liquidity 63
Part II Equity Strategies 85
Chapter 6 Introduction to Equity Valuation and Investing 87
Chapter 7 Discretionary Equity Investing 95
Interview with Lee S. Ainslie III of Maverick Capital 108
Chapter 8 Dedicated Short Bias 115
Interview with James Chanos of Kynikos Associates 127
Chapter 9 Quantitative Equity Investing 133
Interview with Cliff Asness of AQR Capital
Management 158
vi • Contents
Part III Asset Allocation and Macro Strategies 165
Chapter 10 I ntroduction to Asset Allocation: The Returns to
the Major Asset Classes 167
Chapter 11 Global Macro Investing 184
I nterview with George Soros of Soros Fund
Management 204
Chapter 12 Managed Futures: Trend-F ollowing Investing 208
I nterview with David Harding of Winton
Capital Management 225
Part IV Arbitrage Strategies 231
Chapter 13 Introduction to Arbitrage Pricing and Trading 233
Chapter 14 Fixed- Income Arbitrage 241
Interview with Nobel Laureate Myron Scholes 262
Chapter 15 Convertible Bond Arbitrage 269
Interview with Ken Griffin of Citadel 286
Chapter 16 Event- Driven Investments 291
Interview with John A. Paulson of Paulson & Co. 313
References 323
Index 331
The Main Themes in
Three Simple Tables
OVERVIEW TABLE I. EFFICIENTLY INEFFICIENT MARKETS
Market Efficiency Investment Implications
Efficient Market Hypothesis: Passive investing:
The idea that all prices reflect all If prices reflect all information,
relevant information at all times. efforts to beat the market are in vain.
Investors paying fees for active man-
agement can expect to underperform
by the amount of the fee.
However, if no one tried to beat the
market, who would make the market
efficient?
Inefficient Market: Active investing:
The idea that market prices are If prices bounce around with little
significantly influenced by investor relation to fundamentals due to inves-
irrationality and behavioral biases. tors being naïve, beating the market
would be easy.
However, markets are very competitive,
and most investment professionals do not
beat the market.
Efficiently Inefficient Markets: Active investment by those with a
The idea that markets are inefficient comparative advantage:
but to an efficient extent. Competition A limited amount of capital can be in-
among professional investors makes vested with active managers who can
markets almost efficient, but the mar- beat the market using a few economi-
ket remains so inefficient that they are cally motivated investment styles.
compensated for their costs and risks.
This idea underlying the book provides a
framework for understanding why certain
strategies work and how securities are
priced.
viii • The Main Themes in Three Simple Tables
OVERVIEW TABLE II. HEDGE FUND STRATEGIES
AND GURUS
Classic Hedge Fund Strategies Gurus Interviewed in This Book
The profit sources for active investment Who personify the classic strategies
Discretionary Equity Investing: Lee Ainslie III:
Stock picking through fundamental Star “Tiger Cub” and stock selector.
analysis of each company’s business.
Dedicated Short Bias: James Chanos:
Uncovering companies with over- Legendary financial detective who
stated earnings or flawed business shorted Enron before its collapse.
plans.
Quantitative Equity: Cliff Asness:
Using scientific methods and Quant luminary and a pioneer in the
computer models to buy and sell discovery of momentum investing.
thousands of securities.
Global Macro Investing: George Soros:
Betting on the macro developments The macro philosopher who “broke
in global bond, currency, credit, and the Bank of England.”
equity markets.
Managed Futures Strategies: David Harding:
Trend- following trades across global Devised a systematic trend-d etection
futures and forwards. system.
Fixed- Income Arbitrage: Myron Scholes:
Relative value trades across similar Traded on his seminal academic ideas
securities such as bonds, bond futures, that won the Nobel Prize.
and swaps.
Convertible Bond Arbitrage: Ken Griffin:
Buying cheap illiquid convertible Boy king who started trading from his
bonds and hedging with stocks. Harvard dorm room and built a big
business.
Event- Driven Arbitrage: John A. Paulson:
Trading on specific events such Event master with the subprime
as mergers, spin- offs, or financial “greatest trade ever.”
distress.
The Main Themes in Three Simple Tables • ix
OVERVIEW TABLE III. INVESTMENT STYLES AND THEIR
RETURN DRIVERS
Investment Styles Return Drivers
Ubiquitous methods used across trading Why these methods work in efficiently
strategies inefficient markets
Value Investing: Risk premiums and overreaction:
Buying cheap securities with a low A security that has a high risk
ratio of price to fundamental val- premium or is out of favor becomes
ue—e.g., stocks with a low price to cheap, especially when investors
book or price- earnings ratio—while overreact to several years of bad
possibly shorting expensive ones. news.
Trend- Following Investing: Initial underreaction and delayed
Buying securities that have been overreaction:
rising while shorting those that are Behavioral biases, herding, and cap-
falling, i.e., momentum and time ital flows can lead to trends as prices
series momentum. initially underreact to news, catch up
over time, and eventually overshoot.
Liquidity Provision: Liquidity risk premium:
Buying securities with high liquidity Investors naturally prefer to own
risk or securities being sold by other securities with lower transaction costs
investors who demand liquidity. and liquidity risk, so illiquid securi-
ties must offer a return premium.
Carry Trading: Risk premiums and frictions:
Buying securities with high “carry,” Carry is a timely and observable
i.e., securities that will have a high measure of expected returns as risk
return if market conditions stay the premiums are likely to be reflected in
same (i.e., if prices do not change). the carry.
Low- Risk Investing: Leverage constraints:
Buying safe securities with leverage Low- risk investing profits from a
while shorting risky ones, also called leverage risk premium as other inves-
betting against beta. tors demand high- risk “lottery” assets
to avoid using leverage.
Quality Investing: Slow adjustment:
Buying high- quality securities—prof- Securities with strong quality charac-
itable, stable, growing, and well- teristics should have high prices, but
managed companies—while shorting if markets adjust slowly, then these
low- quality securities. securities will have high returns.