Tuesday, November 29, 2005

Is Stock Picking Declining Around the World? by Utpal Bhattacharya, Neal Galpin

SSRN-Is Stock Picking Declining Around the World? by Utpal Bhattacharya, Neal Galpin:

Short version: Bhattacharya and Galpin examine the relative use of indexing vs. stock picking in various equity markets around the world. They find that indexing is increasing pretty much everywhere but especially in more developed markets. They also estimate that the "long run steady state" fraction of stock picking in US markets is 11% (it is now 24% down from 60% in the 1960s."

Longer version:
Bhattacharya and Galpin use an innovative method to measure the degree to which stock picking is used in an equity market. Based on this model, they then compare the relative percentage of stock picking (vs. Indexing) both using a cross sectional analysis as well as time series analysis.

The key idea behind the paper model is that if everyone indexes, then volume should be proportional to size of firm. In their words:
"The idea behind this measure is inspired by a theoretical insight in Lo and Wang (2000). They proved that, if the two-fund separation theorem holds, dollar turnover of a stock, which is defined as the dollar volume of shares traded divided by the dollar market capitalization of the stock, should be identical for all stocks.

An empirical implication of the above theoretical insight is that if every person in the world indexes between a risk-free portfolio and the market portfolio (or a value-weighted portfolio that is a proxy for the market portfolio), trading volume in stock i should be explained completely by the market capitalization of stock i."
Given this, the authors the essentially regress actual volume on capitalization (more technically they run the
"regression of log monthly stock volume (measured by number of shares traded in that month for stock i in a country) against the log of monthly shares outstanding (measured by number of shares outstanding in the beginning of the month for stock i). We run this regression for 43 countries, of which 21 are classified as developed markets and 22 are classified as emerging markets."
Most of the analysis begins in 1995, but for US stocks they go back into the early 1960s to yield valuable insights as to how markets have changed.

Findings:

* "The first big result.... is that there is more stock picking in emerging markets than in developed markets." This is shown in figure 1 and table 1.

* "The second big result that Figure 1(a) illustrates is that, on an average, stock picking is declining around the world. The declines in stock picking are quite dramatic, especially in the emerging markets."

In their examination of US stocks, they find that there has been a dramatic decrease in stock picking:
"In the United States, the maximum fraction of volume explained by stock picking has secularly declined from a high of 60% in the 1960s to a low of 24% in the 2000s"
Additionally, stock picking is relatively more popular where theory would predict--
namely where information asymmetries are highest. Thus stock picking is more common in young firms, in industries where there is lower asymmetries, and (only somewhat surprisingly) where there are fewer analysts.


VERY cool!! I^3. Indeed their finding that stock picking is negatively related to analyst coverage is worth the price of admission!


Cite:

Bhattacharya , Utpal and Galpin, Neal E., "Is Stock Picking Declining Around the World?" (November 2005). http://ssrn.com/abstract=849627

By the way, Neal is a SBU grad, so I could be a tad biased ;) I tried not to be, but you can be the judge.

Class Classification: Investments

2 comments:

sjonas@convexity.com said...

Just a random thought..
If the stylized fact that 80% plus of all volume traded is from Stat Arb trading...

How would this impact their methodological conclusions???

Anonymous said...

not all that surprising...look at institutional (mutual fund) performance. very rarely do we see active money managers consistently outperforming their benchmarks even on a pre-tax/pre-fee basis. Even with proper fundamental analysis stock picking takes some luck, and therefore, investors without superior knowledge are better off indexing. What is your stance on the efficient market hypothesis?