Spring 2016 Seminar Review

The Q-Group 50th Anniversary Meeting Spring 2016 Seminar Fairmont Washington D.C. Georgetown April 17-20, 2016 Reviews by David Modest and Russ Wermers Executive Summary Georgetown welcomed Q Members for their 50th Anniversary gathering with an impressive array of Nobel Laureates (and maybe some future Laureates?). The Q Group was thrilled to have many of finance’s pioneers and luminaries speak in Washington D.C. amidst blossoming cherry trees and terrific weather. This “golden anniversary Q meeting” featured a much broader set of topics than most—which seemed appropriate, as it served as a “capstone event” that reminded all of those present of the broad array of contributions of Q members and presenters over the past half-century. “Fixed-income markets are still in the 19th Century,” argued Q’s own Larry Harris. Although the technology needed to bring these markets into the 21st Century is similar to that used in “Let’s fix equity markets, there are large barriers-to-entry to competitive forces bringing about this fixed- income” modernization by themselves. Harris argued that increased intervention by the SEC and/or Finra is needed, as market forces cannot overcome these huge barriers by themselves. Robert Merton delivered a very impressive speech on the role of finance in improving economic growth as well as the welfare of humankind. He stressed that Q members have delivered a big “value-added”! Toby Moskowitz followed with a surprisingly simple solution to the “small stock anomaly” “Look for that has been so widely debated for decades. He argued that market capitalization of stocks good things is positively correlated with quality (earnings stability, management quality, etc.), a newly that come uncovered stock factor by Fama and French and others. After one controls for quality, in small Moskowitz found evidence that the small-stock premium is alive and well, and is much packages” larger than previously documented. Modeling Institutional trading costs was the subject discussed by Robert Engle. He showed empirical results that break down the “implementation shortfall” of trades into fixed-costs, variable costs, and market movements. “David vs. John C. Bogle delivered the Monday evening dinner keynote, and argued why indexing has Goliath” so much more power to deliver returns than active management. “3 Factors Robert Stambaugh presented two surprisingly parsimonious new factor models that are or 4?” robust to a large set of stock anomalies. To do so, he created factors that capture commonalities in the returns to 11 prominent anomalies—so-called “systematic mispricing factors.” 1 “Old, Andrew Lo delivered a talk on how time-series patterns in financial markets can be modeled new, using combinations of wave forms of different frequencies and amplitudes (Fourier borrowed, analysis). Later in his talk, he related his work on making finance improve the speed of blue” discovery in biotechnology—many Q members were visibly moved by this part of his talk. Q Members were treated to a unique panel discussion by Martin Leibowitz (moderator), Andrew Lo, Robert Merton, Stephen Ross, and Jeremy Siegel on the state of finance and how it has contributed to the economy. “Earthquakes Robert Shiller presented a wide-ranging talk about how humans are drawn to stories, and and stock how they subsequently overreact to negative stories in the media. In fact, investors become crashes” increasingly pessimistic about stocks in response to totally unrelated news! Robert Novy-Marx presented a very germane paper for Q members: the problem of backtesting of multiple signals, then using the best-performing of the bunch. Novy-Marx showed the inflated t-statistics that one must use in evaluating a model with such an “overfitting bias.” Steven Ross closed the Q meetings with new insights from his prior-presented “Recovery Theorem” paper (presented at the Spring 2013 Q Meeting). He discussed the implications of this new theory for the term structure of interest rates, which included many insightful and deep results. At the conclusion of this very “Golden Meeting,” it is clear that the Q-Group has created an enormous amount of value for the field of quantitative investing; the sheer number of luminaries willing to travel and present at this meeting is a testament to Q’s goodwill in finance. See you in the Fall for our “inaugural meeting” of the next 50 years! 2 Paper #1: Transaction Costs, Trade Throughs and Riskless Principal Trading in Corporate Bond Markets, by Lawrence Harris Q-Group’s own Larry Harris, Fred V. Keenan Chair in Finance at the University of Southern California, gave a tour-de-force talk about the current state of fixed-income markets, and suggested some things that regulators and Finra might implement to decrease trade costs in this market. Harris pointed out a couple of telling facts about trading in U.S. fixed-income markets. First, he noted that, in the early 20th Century, there were exchange-listed bonds, and they traded at a lower cost than today. Second he compared the opacity and structure of the current bond trading market to that of Nasdaq in the 1980s—which invited a comparison with how Nasdaq dealers exerted their power then, and how trading of Nasdaq stocks has progressed up to now. Often, Broker-Dealers (B-D) in fixed-income markets implement “riskless principal trades,” which are when the B-D lines up a buyer and a seller, and merely acts as a broker. In such cases, the B-D profits from the spread in prices (or markup) that he provides between buyer and seller—which is essentially a riskless commission. However, the problem is that customers do not see the markup prior to executing the trade, and would need to sort through TRACE data to be able to see the markup even after the trade. Further, customers also do not see the best bid and best offer in the marketplace, unless they take it upon themselves to communicate with multiple dealers before they trade. It is this lack of transparency that Harris criticizes, and implicates as a factor in keeping bond market trading costs elevated. In addition, even though innovative electronic trading markets are largely in place, they are controlled by B-Ds, and inaccessible to investors. And, there are no rules against “trade- throughs” (the filling of an order at a worse price than the best bid or offer) by B-Ds, which means that an investor may submit an order at the best bid or offer and still not be the first in line to be executed. Thus, investors find it difficult to provide liquidity to each other, and are almost forced to go through a B-D. To summarize, B-Ds exploit the advantage of superior information in a very opaque market, and current regulations allow them to do so in ways that are prohibited in equity markets (in equity markets, for instance, the broker must fill at the best bid or offer in the marketplace). After explaining these market-structure problems, Harris provided some compelling statistics to motivate changes in how fixed-income is traded. He compared 3 million trades in TRACE to about 464 million contemporaneous NBBO quote records in order to see how close the trades executed to the quotes before them. The unique NBBO dataset was provided by Interactive Brokers. Harris found that the average customer paid a roundtrip trade cost of 125 basis points, which amounts to about 4 months of interest for a 4% coupon bond! He also found that costs are larger for smaller trades, consistent with large institutions having better real-time information on quotes. 3 Harris also found that 47% of all trades trade through a standing quote, with 31% of such trades occurring at much worse prices (averaging 77 bps relative to the NBBO). Regarding riskless principal trades (RPTs), about 54% are done at a marked-up price averaging 54 bps, even though the B-D was basically operating as a pass-through broker. Here are Harris’s policy recommendations: 1. Finra should require B-Ds to post their RPT markup rates before trades are submitted to them 2. There needs to be a transparent NBBO system for investors 3. The SEC should enact a prohibition on trade-throughs 4. The SEC should require brokers to post limit orders submitted by customers to be widely disseminated Harris talked about B-D resistance to such changes, and dismissed that these changes would bring a decrease in liquidity to bond markets. He agreed that B-Ds would, to some extent, withdraw from the market, but he argued that investors would step in to provide even better liquidity. He concluded his talk by calling for the SEC to implement these steps quickly, rather than the usual incremental step process. Harris argued that the outcome of these steps are already known through their effect in equity markets, so why do regulators need to do pilot studies and move in small steps? After Harris’s talk, Joanne Hill took the microphone, and argued that bond ETFs represent competition to dealers. As a result of these trading costs, Harris agreed that retail investors should trade bonds through ETFs rather than attempt to trade bonds directly. 4 Talk #2: On the Role of Financial Innovation and Quantitative Finance in Financial Stability and Economic Growth: 50 Years of the Past into the Impending Future, by Robert Merton Robert C. Merton, School of Management Distinguished Professor of Finance at MIT, resident scientist at Dimensional Holdings Inc., and distinguished Q fellow—whose staggering contributions range over a myriad of seminal topics including option pricing, intertemporal asset pricing and portfolio theory, and the pricing of corporate debt—entertained Q listeners with both a look back and a look forward.

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