4 ms·

I'm skeptical because it sounds like this effect should be tradeable, unless they're using some measure of shareholder returns which doesn't imply that you coul

by Eliezer 12y ago

I'm skeptical because it sounds like this effect should be tradeable, unless they're using some measure of shareholder returns which doesn't imply that you could short-sell high-paid-CEO equities and buy median-paid-CEO equities and get an excess return. In other words, it sounds like this study is postulating an exploitably inefficient market, unless this kind of data only recently became available. http://lesswrong.com/lw/yv/markets_are_antiinductive/ http://lesswrong.com/lw/yv/markets_are_antiinductive/ To be clear, I'm very willing to believe that the companies with the highest-paid CEOs have generally poor governance and will antiperform on some appropriate metric, like price-to-book. But that metric shouldn't be equity price changes because CEO pay is public info, people are already speculating about it as a negative sign, and the market should already be taking that into account and pricing such shares lower (meaning that the returns cost less, hence such stocks should return the market rate, albeit perhaps with greater volatility).

dnautics 12y ago
The treasurer of my nonprofit who worked the short book at a hedge fund for a bit, commented on using this effect in his analyses, although usually for him it was lavish compensation packages that don't count stock-based compensation. I'd worry that the inclusion of stock-based compensation introduces a different sort of artefact (a time-bias). By the nature of our bubblicious economy, CEOs in general are going to enjoy abnormally high stock-based returns in the 3-year run up to a stock market crash.
mtdewcmu 12y ago
I pretty much guarantee that if you ran the numbers with intent to profit off this phenomenon, you'd find that its predictive value is null. A commenter down below speculated that it sounds a lot like simple regression to the mean.
ucha 12y ago
It doesn't matter that the effect is tradable. What matters is that there is no possible arbitrage i.e. a way to make money with a 100% probability. For example, would you enter a bet in which you have a 50% chance of loosing $1000 and a 50% chance of making $1001 if you can enter it only once a year? There are many many observable patterns that contradict the efficient market hypothesis amongst which: - historical option volatility is lower than implied vol - you can make money by writing options. - sell in may and go away strategy - you can make money (and beat the index) by being long the SP500 only between october-may - strong contango in the VIX futures market - you can make money by shorting a volatility ETN like VXX that rolls near-maturation future contracts. - mean-reversion on the second day after an earnings release - you can make money by going short if the stock price rises after the earnings call or vice-versa In the end, what matters is how much risk (volatility, max drawdown...) you're willing to take for superior returns. That is often summarized by the information ratio of your strategy which is equal to (return of your strat - return of the bechmark)/vol(difference in returns).
- alexeisadeski3 12y ago
  To be tradable is only has to be right >50% of the time.
  - seizethecheese 12y ago
    False. Depends on the return when right vs. return when wrong.
- emmett 12y ago
  Yes, if this was a very high volatility bet with a low payout that can't be easily repeated it might not be arbitraged away efficiently. But this should let you make predictions about literally every single company in the world if it's true. You can take it thousands of times, not once per year. So I don't think the situation you're positing applies here. If CEO salary was a signal as to equity performance, you could make a "CEO salary weighted S&P index" that should outperform the S&P consistently. Which we don't observe. Therefore it probably isn't a signal. Or if it is a signal, it's very weak.
  - ucha 12y ago
    In short, you're saying that by diversifying your holdings across thousands of companies, you can statistically arbitrage the signal but it is not true. You could make predictions for every company in the world but you'd need both the signal to be right most of time, over any time period, be uncorrelated across companies and have an excess return collectable over a period short enough. If any of these conditions are not met, you will not be able to statistically arbitrage it. Take options for example, writing them (selling them) is a strategy you can backtest and it has positive return on average. You can write options on thousand of stocks, every week. But because volatility - on which the option price depends - is correlated across stocks, this strategy will incur a large loss on a financial crisis. Your diversification will not matter. Also, you say that we don't observe the signal but you can't know, maybe we do. There are tons of simpler signals - some of which I cited above - that we still observe.

by Eliezer 12y ago

dnautics 12y ago

The treasurer of my nonprofit who worked the short book at a hedge fund for a bit, commented on using this effect in his analyses, although usually for him it was lavish compensation packages that don't count stock-based compensation. I'd worry that the inclusion of stock-based compensation introduces a different sort of artefact (a time-bias). By the nature of our bubblicious economy, CEOs in general are going to enjoy abnormally high stock-based returns in the 3-year run up to a stock market crash.

mtdewcmu 12y ago

I pretty much guarantee that if you ran the numbers with intent to profit off this phenomenon, you'd find that its predictive value is null. A commenter down below speculated that it sounds a lot like simple regression to the mean.

ucha 12y ago

It doesn't matter that the effect is tradable. What matters is that there is no possible arbitrage i.e. a way to make money with a 100% probability. For example, would you enter a bet in which you have a 50% chance of loosing $1000 and a 50% chance of making $1001 if you can enter it only once a year? There are many many observable patterns that contradict the efficient market hypothesis amongst which: - historical option volatility is lower than implied vol - you can make money by writing options. - sell in may and go away strategy - you can make money (and beat the index) by being long the SP500 only between october-may - strong contango in the VIX futures market - you can make money by shorting a volatility ETN like VXX that rolls near-maturation future contracts. - mean-reversion on the second day after an earnings release - you can make money by going short if the stock price rises after the earnings call or vice-versa In the end, what matters is how much risk (volatility, max drawdown...) you're willing to take for superior returns. That is often summarized by the information ratio of your strategy which is equal to (return of your strat - return of the bechmark)/vol(difference in returns).

alexeisadeski3 12y ago
To be tradable is only has to be right >50% of the time.
- seizethecheese 12y ago
  False. Depends on the return when right vs. return when wrong.
emmett 12y ago
Yes, if this was a very high volatility bet with a low payout that can't be easily repeated it might not be arbitraged away efficiently. But this should let you make predictions about literally every single company in the world if it's true. You can take it thousands of times, not once per year. So I don't think the situation you're positing applies here. If CEO salary was a signal as to equity performance, you could make a "CEO salary weighted S&P index" that should outperform the S&P consistently. Which we don't observe. Therefore it probably isn't a signal. Or if it is a signal, it's very weak.
- ucha 12y ago
  In short, you're saying that by diversifying your holdings across thousands of companies, you can statistically arbitrage the signal but it is not true. You could make predictions for every company in the world but you'd need both the signal to be right most of time, over any time period, be uncorrelated across companies and have an excess return collectable over a period short enough. If any of these conditions are not met, you will not be able to statistically arbitrage it. Take options for example, writing them (selling them) is a strategy you can backtest and it has positive return on average. You can write options on thousand of stocks, every week. But because volatility - on which the option price depends - is correlated across stocks, this strategy will incur a large loss on a financial crisis. Your diversification will not matter. Also, you say that we don't observe the signal but you can't know, maybe we do. There are tons of simpler signals - some of which I cited above - that we still observe.