Academic Finance Destroys Yet More Capital

The recent equity market shenanigans has confirmed one of my biases: modern academic finance has been very good at destroying capital. If one were of a conspiratorial bent, one might guess that finance faculties were being secretly backed by the enemies of capitalism. (I have been currently watching a documentary series on secret societies, and such misdirection is not unprecedented.) The simultaneous advocacy of efficient markets as well as the ability of hedge funds to continuously outperform created the backdrop for short squeezes that even gamers can participate in.

Time, Time Management, Stopwatch, Industry, Economy

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Underlying Beliefs

The recent short squeeze in certain equities is quite remarkable, but the only somewhat surprising angle is how the hedge funds that imploded set themselves up. I am not an equity expert and I am reliant on media reporting, but I have seen it alleged that the short interest in some of the equities in question was 130% of the shares outstanding. This was obviously a very bad idea.

Furthermore, the ability to run up a share price is normally limited by existing holders exiting long positions. If equity management was dominated by long-term value managers, they could cap the gains on any equity of a reasonable size. (A penny stock with a tiny market cap will have too few such institutional holders, which is why penny stocks have always been synonymous with equity trading shenanigans.)

There are a few consensus beliefs from academic finance that explain why institutions developed in such a fashion to allow this to occur. To be fair, an individual finance professor might disagree with any or all of them. The problem with attempts to explain these away is that these are embedded in the finance industry. The finance industry is filled with finance students with advanced degrees, as well as ex-academics and academic consultants. In any event, the beliefs are as follows.

  • Markets are efficient, so portfolios should be mainly allocated to indexing (in some form), limiting the ability of portfolio managers to use their long-only balance sheet to lean against mis-pricings.
  • At the same time, some investors have skills that lead to steady outperformance of benchmarks -- alpha. (If one compares this point to the previous, all I can say is "consistency is the hobgoblin of small minds, etc.") One measures this by looking at short term returns and seeing whether they are consistently above benchmark. (The ugly reality is that the only instruments that offer that form of a return profile is short-term credit, or selling volatility.)
  • Following on the above, hedge funds are an "asset class" that offer high returns (courtesy of investment leverage).
  • We can analyse markets solely in terms of price; we do not need to worry about investors' balance sheets, margin or collateral calls, etc.
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