QS Investors Diversification Based Investing Whitepaper - FTSE

Academic foundations
The conceptual basis for DBI is supported by a growing
body of research. Academics and theorists have recently
argued that although modern markets show considerable
micro efficiency7 —simply put, that individual security
mispricings tend to be wiped out fairly quickly—they are
less efficient at the macro level. Jung and Shiller have
asserted that markets show macro-inefficiency “in the sense
that there are long waves in the time series of aggregate
indices of security prices below and above various
definitions of fundamental values.” 8
Put another way, “because the aggregate averages out the
individual stories of the firms, and the reasons for changes
in the aggregate are more subtle and harder for the
investment public to understand—having to do with
national economic growth, stabilizing economic policy and
the like—factors such as stock market booms and busts
swamp out the effect of information about future dividends
in determining price and make the simple efficient markets
model a bad approximation for the aggregate stock
market.” 9
We believe that there are three primary drivers of this
inefficiency caused by the uncertainty of the impact of
these drivers: monetary policy, fiscal policy and regulatory
policy.
1. Monetary policy: The future levels of interest rates,
potential and implemented asset purchases, as well as
other actions by central banks are uncertain, as is their
impact over the near- and medium-term. Investors
struggle with these issues when evaluating the value of
different parts of the market and the impact on
economic growth as well as the effectiveness of policy
actions. Recent examples include expectations around
interest rate levels in 2010 and beyond and the use and
effectiveness of quantitative easing policies and tools.
7 Irrational Exuberance, 2nd Ed. (2001), p. 243
8 Samuelson’s dictum and the stock market, Jung and Shiller (2005)
9 Ibid
10 Confirmation bias: A ubiquitous phenomenon in many guises, Nickerson (1998)
FTSE DBI Page 7
2. Fiscal policy: Similarly to monetary policy, fiscal stimulus
or austerity is debated, enacted and modified over the
medium-term and subject to disagreement by policy
makers as well as investors. It takes years to assess the
impact of fiscal policy often with uneven and
contradictory economic data that is released on an
infrequent basis. Recent examples include the perceived
impact and market reaction to the size and length of
fiscal stimulus, its impact on sovereign debt levels, as
well as the impact of fiscal austerity on country growth
rates.
3. Regulatory policy: Legislative agendas and reaction to
market events can have a large impact on perceived and
actual country competitiveness as well as industry
profitability and business strategy. These changes are
often debated over a multi-year time frame and the
impact of legislation is uncertain. One needs look no
further then proposed and enacted reform surrounding
banks and other financial institutions in the US and
Europe as well as healthcare reform in the US for recent
examples.
This macro uncertainty opens the door for behavioral biases
and sentiment effects. One that has been well documented
is that people – and investors are no exception – are subject
to confirmation bias. That is, that they tend to hang on to
hypotheses in the face of conflicting data. 10 Even when
certain country and industry valuations are very high or low
compared to history, investors often hold on to their beliefs
in the face of contradictory data until it becomes patently
obvious that they have misjudged relative values. This
creates many investment opportunities which add value
through macro based portfolio construction rather than
stock selection.