AOTW 2014 0425

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This week our article comes from the Pension Partners' blog. Mr. Bilello discusses the irrational behavior of the stock market and the efficient market hypothesis.
Regards,
Sam
Still Believe in Efficient Markets? Explain This…
April 22, 2014  Charlie Bilello
Pension Partners 
Each year, thousands of new undergraduate and MBA students are indoctrinated with the virtues of the almighty Efficient Market Hypothesis (EMH). Despite an abundance of evidence disproving the central tenets of the theory, the orthodoxy remains in place. In the academic world, the desire to explain market movements in one convenient theory seems to trump empirical data and common sense.

In relation to the stock market, a number of market anomalies have been uncovered over the years. In the Fundamental discipline, these include the value effect, the small firm effect, and the neglected firm effect.Technical anomalies include the momentum effect, calendar effect and the low-volatility effect. Our own contribution to the field of market anomalies focuses on the predictive power of the Utilities sector. As it turns out, the walk down Wall Street is not so random after all.

I first learned of the EMH in my college years in the late 1990’s. The theory never sat well with me. How could the stock market be efficient in any “form,” I wondered, with a bubble of epic proportions building before our very eyes?

My skepticism in the theory would only grow over the years, as I subsequently witnessed the tech stock crash, the housing bubble and its eventual collapse, and another stock market crash in 2008-2009.

What I came to learn through these events is that market participants have anything but “rational expectations” about the future, a key requirement of the EMH. To the contrary, their expectations are often quite irrational, leading to overreaction in the financial markets and the creation of inefficiencies.

Why are market participants irrational? Very simply because they are human and flawed. We all possess certain inherent cognitive biases such as overconfidence and overreaction (among others) that lead to errors in the way we process and act upon information.

In today’s market, finding such irrational behavior is not difficult. There are a number of candidates to choose from but in my view there is no better example than the buyers/holders of the PIMCO High Income Fund (PHK). For the uninitiated, PHK is a closed-end bond fund managed by PIMCO (Bill Gross) with assets in excess of $1.5 billion.

Where the story gets interesting is in observing the fund’s net-asset-value (NAV), or the value of all fund assets (less liabilities) divided by the number of shares outstanding. In an open-end mutual fund, the NAV is the price upon which all share purchases and redemptions are calculated. However, in a closed-end fund such as PHK, shares are bought and sold at market prices as determined by buyers and sellers. While market prices in closed-end funds often track the fund’s NAV, they can diverge and at times substantially so.

We are seeing that quite clearly today in the PIMCO High Income Fund. The market price of the Fund is currently $12.58, a 53% premium above the fund’s NAV of $8.23.
Surely this must be a recent phenomenon, you say,  as no market participant would hold a fund trading at such a high premium for very long. But that would be an incorrect assumption as indicated by the chart below, which shows that PHK has been trading at a persistently lofty premium over the past five years. If this isn't the most blatant evidence of the inefficiency of markets, I don’t know what is.
What could be the behavioral justification for someone wanting to purchase a fund at such a lofty premium?

While we can only speculate on the motivations of buyers, I would assume that the Bernanke/Yellen zero-interest rate policy (ZIRP) is a primary contributor. Investors have been starved for yield for so long (over five years now) that they are doing many irrational things, including purchasing funds at ridiculous premiums in a desperate chase for yield.
The average retail investor, of course, knows nothing about premiums or discounts. What they do know is that they want a monthly distribution, and the bigger that distribution is, the better. The PIMCO High Income Fund certainly fits that bill, sporting an NAV distribution yield of 17.7% and a market price yield of 11.6%. With interest rates at all-time lows, these yields are eye-opening to say the least.

For comparison purposes, the distribution yields on the total bond market (BND), investment-grade (LQD), and high yield (HYG) ETFs are 2.2%, 3.4% and 5.6% respectively. To more than triple the yield of a high yield bond ETF is a proposition most investors simply cannot resist. It is so enticing, in fact, that they are willing to pay $1.53 for each $1.00 of assets in the fund.

If you’re wondering how the fund manages to pay out such a lofty distribution while yields on almost every class of bonds are near all-time lows, you’re not alone. I was asking the same question the first time I came across the fund. After doing some digging, we find that the average coupon of bonds in the PHK portfolio is only 6.8%, and the 17.7% distribution is achieved through a combination of leverage, derivatives, and a return of capital.

The average retail investor, of course, neither has the capacity nor the desire to understand these intricacies. They see a 17% “yield” and Bill Gross as the fund manager and cannot buy PHK fast enough. As the old saying goes, a “fool and his money are soon departed.”

But I digress. The point here is that the market is not efficient; not in weak form, semi-strong form, and certainly not in strong form. If it were, PHK would not be trading at an unfathomable premium for so many years. In fact, if the EMH were correct, it would not be trading at a premium at all. After all, the premium information is readily available and no “rational” investor would buy a fund trading at such a high premium. Also, in the instant the fund deviated from its NAV arbitrageurs would step in and short the fund while buying the underlying assets until the gap was closed.

Again, this hasn’t happened precisely because investors are not rational and many are likely expecting PHK to deliver them a 17% risk-free return. Rather than lament this fact, though, we should embrace it. It is this very irrationality among the masses that creates short-term opportunities in markets for the few that can keep their wits about them, especially in times of “crisis.” We saw this most recently at the end of 2013 when closed-end municipal bond funds were trading at enormous discounts to their NAVs due to investors overreacting to events in Detroit and Puerto Rico and the fear of rising interest rates.

Naturally, these funds are among the best performing asset classes in 2014 as the discount to NAV has been closed and fears have subsided. A non-random walk indeed.
 
Sam Sweitzer, CFA │Principal│ANSON CAPITAL, INC.
o: 678-216-0795│f: 877-750-9088│[email protected]│www.Ansoncap.com│
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