NEW YORK (TheStreet) - Ask most veteran investment bankers or traders about the number-crunching techniques used on Wall Street and they will likely say something to the effect of: "finance is more of an art than a science."
The shared 2013 Nobel Prize in Economic Sciences awarded to Eugene F. Fama and Robert J. Shiller underscores that many of the most important mathematical assumptions used on Wall Street aren't a piece of science. Instead, they are often more of an artifice.
Both Fama and Shiller have dedicated much of their economic study to disproving key themes that run through present-day finance such as the efficiency of markets and validity of commonly used corporate and portfolio valuations. Their shared Nobel Prize should be treated by the ordinary investor as just another reason to be skeptical of the treatment of investment bankers and hedge fund traders as financial rocket scientists or 'the smartest guys in the room.' Lars Peter Hansen also was a shared winner of the 2013 Nobel prize in Economic Sciences, however, his work won't be discussed
In his seminal work, Efficient Capital Markets: A Review of Theory and Empirical Work, Eugene Fama asserted that financial markets were "informationally efficient," meaning that investment managers' search of risk adjusted returns was most likely a Pyrrhic exercise.
The 1970s academic paper spawned Fama's efficient-market hypothesis (EMH), in which he argued that future asset prices couldn't be predicted using historical returns, that prices adjust to new information quickly leaving few opportunities for an arbitrage and that financial markets reflect both public and non-public information. Such findings undercut the value propositions of most hedge fund pitch books, which celebrate some type of relative value or absolute return strategy and hinge on a use of historic financial data modeling or arbitrage to gain excess returns to the stock market.
Worse yet, even material non-public insider information wouldn't garner profits for a hedge fund trader in search of an edge, according to Fama's findings. He argued markets were efficient, and challenged the notion that investment managers such as high-fee hedge funds could outperform a normal distribution of industry-wide returns.
Fama's most recent public comments indicate just how much his findings undercut the money management industry. "Since I think everything is appropriately priced, my advice would be to avoid high fees. So you can forget about hedge funds," Fama was quoted as saying at the Investment Management Consultants Association's Advanced Wealth Management Conference in Chicago this September.
Cliff Asness, head of hedge fund AQR Capital Management, says on a biography page for his fund he "still feels guilty when trying to beat the market" after studying under Fama at the University of Chicago.
Fama's later work, co-authored with Kenneth French, further challenged conventional thinking on Wall Street and this time honed in on specific valuation techniques.
In the 1990s, Fama and French, in their Fama-French three-factor model, argued that the ubiquitous Capital Asset Pricing Model (CAPM), a linchpin for most corporate valuations, created biased results.
CAPM, developed by Nobel laureate William Forsythe Sharpe, is used by most bankers to estimate a firm's cost of equity. The formula uses a firm's stock market beta, a risk free interest rate and the average market risk premium to derive a firm's cost of equity. Cost of equity is the key metric that governs most leveraged buyout models and sum-of-the parts valuations.
However, Fama and French were able to prove that CAPM overstated the relationship between a firm's beta and its average return, meaning that the formula overstated the cost of equity for high-beta stocks and understated costs for low-beta, or less volatile stocks. As such, valuation techniques that hinged on CAPM likely undervalue high-beta firms.
The same could be said about the portfolios of investment managers. Fama and French, in their challenge of CAPM also undercut the notion of Jensen's Alpha, which is used to measure the performance of mutual funds and managed portfolios.
Jensen's Alpha is a time-series regression of a portfolio's CAPM that uses intercepts between historical returns to measure abnormal positive or negative returns. The only problem is that since the formula is derived from CAPM, it similarly applies too much risk to high beta stocks and unduly credits investment managers for owning low-beta and value stocks.
Still, Fama and French view CAPM and its derivations as a necessary piece of finance. "We continue to teach the CAPM as an introduction to the fundamental concepts of portfolio theory and asset pricing, to be built on by more complicated models like Merton's (1973) ICAPM. But we also warn students that despite its seductive simplicity, the CAPM's empirical problems probably invalidate its use in applications," the authors wrote.
Shiller's work, in contrast, challenges much of the efficiency in markets that Fama attempted to prove through his career.
In one paper, Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?, Shiller argued that if stock markets were truly rational, investors would value stocks on their expected future dividends at a present value discount. However, his study of stock market performance from the 1920s through the 1980s indicated that stock markets were far more volatile than what could be explained through changing expectations of future dividend payments. Put simply, markets acted on fluctuations in investors' irrationality, or over-and-under exuberance.
Shiller published Irrational Exuberance in 2000, near the peak of the Nasdaq bubble to make a clarion call that stocks were overvalued and Wall Street animal spirits had become disconnected from underlying financial performance. In the mid-2000s, Shiller famously applied his findings to the U.S. housing market. He argued that home prices had risen far faster than the inflation rate and were consequently overvalued.
While much of Fama and Shiller's work directly contradicts each other, as noted in Shiller's own writings, the studies of both laureates challenge much of Wall Street's so-called applied science.
Corporate and portfolio valuations are far less stable than M&A models and analyst valuations may indicate. Hedge funds advertising some type of absolute return are likely to be overstating their ability to find value, and may be reliant upon flaws in commonly used formulas. Stock market prices, merger valuations and the like are also not simply a matter of changes in underlying value, but also are attributable to Animal Spirits, which often run too far on the spectrum of greed or fear.
No matter how carefully prepared today's batch of Excel models and PowerPoint presentations are, Wall Street is just as much an art as it is a science.
-- Written by Antoine Gara in New York