Wednesday, March 10, 2021

A conversation with Tyler Cowen

Conversation with Tyler podcast interview. Perhaps predictably, the most challenging interview / podcast I've ever done. Video here  and embed below 


My comments on efficient markets and active management provoked a lot of email. 

I mentioned Jonathan Berk, and should have mentioned his coauthors Rick Green and Jules Van Binsbergen, on how active management can persist even though investors don't make any money on it. The basic idea is really clever:  A manager has 5% alpha skill on $10 milllion, i.e. he can earn $500k, but the skill does not scale. So he earns 5%, charges 1% fee, investors get 4%.  Investors see his great performance and rush in.  Now he has $50 million assets under management. He still earns $500k. He charges 1% fee, and investors get zero alpha. It’s equilibrium – if investors leave,  alpha to investors goes up again, and they return. Investors are earning the same zero alpha they get on the index so why not. And that’s about what we see. Fees persist in equilibrium, fees are equal to alpha on average, alpha post fees are about zero, flows follow performance. The seminal paper is "Mutual Fund Flows and Performance in Rational Markets" Jonathan B. Berk, Richard C. Green  Journal of Political Economy 2004  112 1269-1295 and a series following, here . It's not a perfect theory, but the glass is nearer full than empty, and it's a lovely supply and demand starting place to understand an industry that persists for decades. 

More generally, the average fund earns no alpha, almost guaranteed by free entry. The trouble is distinguishing the good ones from the bad ones, on ex-ante characteristics. The filters used by academics are pretty weak -- past returns, ratings, education of principals etc. On the other hand, now we just move it all up to the meta-game. Picking managers is no different than picking stocks. Skill on skill, alpha on alpha, fees on fees...


  1. Why are real interest rates in Brazil positive compared to negative rates in the US?

    Here is why:

    Henry Paulson, Ben Bernanke, and Timothy Geithner can now take a bow.

  2. When someone asks me what is meant by "efficient markets", I give this intuition:

    1) There's a $100 bill lying on the street;
    2) Everyone agrees: that's a $100 bill lying there;
    3) No one picks up the bill.

    1. Just to be clear, this is the intuition for an INefficient market.

  3. What the industry ascribes to "alpha" is more often a case of mis-specification of the market index employed to determine the parameters "alpha" and "beta". This is an all-too-common occurrence in the business.

    The reason actively-managed portfolios have very high turn-over ratios is that to achieve the returns that justify the cost of management, the manager must exploit transient price inefficiencies that are of a very temporary and highly transient nature before his competitors do so.

    There are occasions when the market consensus offers opportunities to earn annualized rates of return of 100% or more to the adept portfolio manager, but those opportunities are both temporary in nature and carry a high risk of not turning out well. The client won't necessarily be able to discern that form of risk-arbitrage through the monthly or quarterly performance reports he receives. The rating service, such as Morningstar, will ascribe the fund's performance to "alpha".

    It doesn't 'scale up' because it is dependent on the manager's inherent work rate--the rate at which he finds and exploits those transient opportunities that lead to "alpha" in excess of "zero". Would that it could be done by algorithm, you might say. But, if it could, then it would quickly put itself out of business as ever more algorithms proliferated to grasp the same mis-pricing opportunities.

    Fun and games. Arbitraging macro-expectations is more rewarding, today, as the government continues to barrel pell-mell onwards to a new "Armageddon".

  4. Really enjoyed this interview. All kinds of gems to mine from it. The family history was particularly interesting. This isn't blowing smoke - it's just a well rounded, derailed interview.

  5. The best video I have listened to in a long time. Two very intelligent persons. I think I will also read your father's book on florentine achievements.


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