November 01, 2013

Nobel laureates, market timers and pension funds in Chile

A quick riddle: which of the following quotes corresponds to a strong believer on market efficiency, someone who thinks asset prices are always right (and if they were not, who are you to tell). – Or, if you will, which one comes from an efficiency skeptic, one who found that price volatility cannot be explained by fundamentals alone and bubbles are around the corner.
“It’s not easy to make a lot of money fast, and that you can go for years losing money, even if you’re a very smart person”
“If they know – (how bad the market is in setting absolute prices) - they should be rich men. What better way to make money than to know exactly about the absolute level of prices”.
“The problem is that, almost surely, expected returns vary through time because of risk aversion, wealth, everything else varies through time. But measuring that requires that you have a good variable for tracking (risk aversion) or good models for tracking it. We don’t have that”.
If understandably, you have not figured out yet, the additional quote would give you the answer:
 “Well, Gene and I have a lot in common, more than you might think”.
Indeed, Eugene Fama and Robert Shiller may disagree on the need for the authorities to monitor asset valuations and regulate aggregate risk exposures. - However, they share a common view: regardless of how efficient the market is, nobody can systematically beat it, especially in the short run. So, no room for gurus within the bounds of licit information rules and practices. Just a tiny room for, both hard working and lucky, alpha seekers.

The case for active management is the main casualty of the above mentioned consensus. -  The paragraphs below offer a brief illustration using the Chilean pension fund system as a fresh case of the futility in advising active portfolio management.

The defined contribution´s pension system in Chile features five possible portfolios to choose from for both compulsory and voluntary savings of future pensioners. - Each portfolio allows for a different asset class composition: the riskiest, 80% max. held in stocks; the safest, 95% min. held  in money market, fixed income.- Although there are some restrictions to move into the riskiest funds to those near the age of retirement, the majority is free to move from one portfolio to another at a negligible fee.
Since 2012, concerns rise that an increasing number of contributors start to follow cheap advice from non-regulated investor counselors, the result being a boost in portfolio shifts and some subsequent disruptions in both stock and fixed income markets. 

As it turned out, the number of savers shifting to and from the riskiest pension portfolio peaked just during the days after specific recommendations were issued by a local ´guru´. Eventually, the authority issued further regulations to discourage market timing. 

Most interestingly, it was found out that six out of the eleven recommendations delivered by the referred ´expert´, proved wrong. - Indeed, that is slightly worse an outcome than failure chances when flipping a coin.

Others results came from research on pension affiliates’ moves from one fund to another between 2012-2013. - They did poorly. 
  • Almost two thirds individuals ended up gaining less than the least profitable of the five existing funds (bought high, sold cheap).   
  • As for the rest,  21% performed as well as one of the original portfolios and; 
  •  Only 13% outperformed the most profitable among the five existing portfolios. 
Chile: effective annual returns to market timers in pension funds
(Real rates; ap. 2012-mar. 2013)
Real return bracket
Percentage of those who shift
Above the best existing passive portfolio
Within range of existing portfolios
Below the worst existing passive portfolios
Source: Superintendencia de Pensiones

Moreover, when following up on each individual original position, 77% of those who decided to move ended up worse off than not doing so.
Indeed, nowadays there is no need to be a Nobel disciple to learn that market timing is generally naïve, usually self-destructing.