I’m working on a piece on the Iowa Electronic Markets in my copious spare time at the moment. Just as a warm-up, here’s a few questions for finance mavens.
1. In the 1996 Presidential vote-share market, after the candidates have been nominated and adopted, what should the sum of the values of the CL|DOLE(Clinton vote share given Dole as opponent) plus V.DOLE (Dole vote share) contracts be?
2. What percentage return would you have made in the 2000 winner-takes-all market by buying the BUSH contract at the point when DEM was at its peak and holding to maturity?
3. You hold a porfolio in the current 2004 Presidential vote-share market long BU|KERR but short BU|CLINT. If George Bush were to announce tomorrow that he had decided to withdraw from the race, what would be your profit or loss?
Answers below the fold. Historical price and prospectus data available on the IEM website.
These are all trick questions, in case you hadn’t guessed …
1. In the 1996 Presidential vote-share market, what should the sum of the values of the VS_CLINT (Clinton vote share) plus VS_DOLE (Dole vote share) contracts be?
If you answered 1.00, 100% or some similar, you’re wrong and if you’ve got a finance qualification you should give yourself a slap on the wrist. That’s one answer that has to be wrong.
If you answered “100% minus Perot’s share of the vote”, then good try, you’re thinking, but wrong. The Iowa vote share markets are the share between the Republican and Democratic candidate; shares of third-party candidates don’t count. This is sometimes very relevant indeed; see below.
The correct answer is 1.00 minus the time value of money. Because you have to pay your money upfront to receive the return after the election, a portfolio of 1 Dole plus 1 Clinton should sell at a discount to face value reflecting that fact.
2. What percentage return would you have made in the 2000 winner-takes-all market by buying the BUSH contract at the point when GORE was at its peak and holding to maturity?
You would have lost all your money. The 2000 winner-takes-all contract paid out on Gore, not Bush. There are two factors at work here.
a) Although it is called “winner takes all”, the WTA market is not actually a betting market on the winner. It is a market in binary options which pay 1.00 if the underlying vote-share contract is above a strike price of 0.50.
b) Gore won the popular vote by a small margin. If you strike out Nader’s votes (as you have to for the VS market calculation [Update: Oh do you really, laughing boy? See below]), this margin became signficant.
3. You would neither win nor lose anything. BU is simply an identifier meaning “the Republican candidate”.
All of which is by way of suggesting that, whenever you’re doing research on any kind of financial time series, you need to be very careful indeed about the specification of the contracts involved. Lots of academic studies comparing mutual funds to the S&P500 index do not observe this basic requirement, by the way.
UPDATE Actually, my answer to 1 was only correct for the 1996 and market. In 1992, there was a Perot vote share market, and in 2000 a Buchanan VS market and both times the vote shares were calculated three ways. Consider me slapped.
{ 12 comments }
Steve Carr 04.22.04 at 4:40 pm
Daniel, your point about paying close attention to the specifications of the contracts in time series is an excellent one. But I don’t understand your reference to studies of mutual-fund performance vs. the S&P. What is it that academics aren’t paying attention to in these studies?
Also, with regard to the question of the time value of money, you’re right as a matter of theory. But in practice, aren’t the sums involved in the IEM so small that most investors feel free to neglect time value? Even if you invest the maximum in a contract, and hold it for a year — something few IEM investors do, I imagine — you’re talking about two dollars (that could have been earned at the risk-free rate). At that price, it’s probably not worth spending the time adjusting your forecast to take into account the discount rate.
dsquared 04.22.04 at 5:48 pm
Re Iowa, you’re probably right.
Re SP500, my bugbear is studies which refer to “a Buy and Hold strategy on the SP500 index”. You can’t “buy and hold” the SP500. It’s an index that gets regularly rebalanced. If you made the same trades, you’d typically find a cash shortfall between the value of the stocks you sold and the ones you bought and the index does not reflect the losses one would sustain on rebalancing. You could buy and hold the SP500 future, but then you don’t get the dividends and that kills your long term total return.
Hipocrite 04.22.04 at 6:25 pm
One issue-
1. “Risk-adjusted TVM.”
dsquared 04.22.04 at 6:35 pm
I think not; 1 Bush plus 1 Clinton on the contract specified is a cash-and-carry arbitrage, so it’s the risk-free rate, shurely?
Steve Carr 04.22.04 at 6:45 pm
Doesn’t an index fund do the rebalancing for you? Vanguard 500, for instance, has captured just about all of the S&P’s returns over the past three years (actually, it outperformed the index by a tiny bit: .01% in 2003, .12% in 2002, and .04% in 2001. So if you buy the Vanguard 500 and hold it, you’re effectively buying-and-holding the S&P 500. Comparing the performance of managed funds to the performance of VFINX is a straight apples-to-apples comparison: you can buy Mutual Fund X or you can buy VFINX.
wesley phoa 04.22.04 at 10:48 pm
Vanguard outperforms the S&P 500 by engaging in security lending; if you take out the excess return due to that, the return is lower than the “naive” S&P 500 return. For example, if they could lend 100% of their securities they would be picking up about 30 bp, I think.
Also, I believe that security lending reduces the after-tax return on a stock portfolio because a “payment in lieu of dividends” received on lent shares does not qualify for the lower dividend tax rate.
dsquared 04.23.04 at 1:00 am
Wesley has it right; Vanguard (and other trackers) do all sorts of things to make their money; they also play some games with their execution which look to me to be for all the world like a bank prop trading desk. Given that Vanguard doesn’t buy and hold, because it couldn’t both buy and hold and track the SP500, one comes to the conclusion that it has to generate quite material outperformance of the SP500 just to track it.
Academics often give absolutely no thought whatever to the operational complexities of conceptually simple strategies; I used to sit near someone who did the Royal Dutch/Shell arbitrage for a living, and I can tell anyone who asks that arbitrage trading is neither “simple” nor “risk-free”, and that 99.9% of people who tried to do it would get their faces ripped off.
But I agree; comparing VFINX to a mutual fund is a legitimate comparison, as long as you don’t make the mistake of assuming that VFINX is equivalent to buy and hold. If you sneaked a look at the last chapter of Campbell, Lo & McKinlay’s “A Non-Random Walk Down Wall Street”, you’ll see their conclusion is that it is possible to sustainably outperform the market, but that the gains which can be statistically shown to be there come from execution and market impact, not investment strategy.
Anno-nymous 04.23.04 at 7:20 am
I think your questions #1 and 2 are written differently below than they are above. Question number 1, for instance, makes absolutely no sense to me above the jump but is perfectly clear below. Eh?
Steve Carr 04.23.04 at 7:59 am
As with the IEM, the theoretical point that VFINX is not using a pure buy-and-hold strategy (which is mainly a function of the fact that the S&P 500 is itself in a perpetual process of rebalancing, adding and dropping stocks, etc.) is right. But practically speaking, it surely isn’t a coincidence that index funds that try to emulate the S&P 500 index do, in general, a very good job of duplicating the returns you’d get if you bought-and-hold (with rebalancing, etc.) the index. To put it differently, it’s not as if the strategies that index-fund managers use to track the index involve taking on market risk.
More important, the reason we care about this is because we want to know if money managers can outperform the S&P. That question would be significantly less interesting — and perhaps unfair to money managers — if there were no way for investors to guarantee themselves the S&P’s return. But practically speaking, there is: buy VFINX. So I don’t really think there’s a problem with studies that compare managed funds to a buy-and-hold strategy with the S&P.
At the same time, you’re absolutely right about the operational complexities involved. Vanguard’s index-fund money management has been exceptional at keeping down costs and capturing returns, and other index funds have been significantly less successful at that.
dsquared 04.23.04 at 1:43 pm
Question number 1, for instance, makes absolutely no sense to me above the jump but is perfectly clear below. Eh?
Ahh. I typed it from memory, copied and pasted, then corrected the contract names above the fold but not below. Since the error improves comprehensibility, as you suggest, I’ll keep it.
But practically speaking, it surely isn’t a coincidence that index funds that try to emulate the S&P 500 index do, in general, a very good job of duplicating the returns you’d get if you bought-and-hold (with rebalancing, etc.) the index. To put it differently, it’s not as if the strategies that index-fund managers use to track the index involve taking on market risk.
Good point; it’s no more a coincidence than that bakers make bread (which is better for you than a buy-and-hold strategy with respect to flour and yeast).
My point is, I think, your own. Vanguard does a much better job than you would be able to do yourself (trying to build your own replicating portfolio is a mug’s game).
I’m less convinced than you are, though, that the outperformance built into Vanguard’s trading returns represents pure alpha (generated through execution) rather than market risk. I suspect that VFINX is taking on considerable market risk in the tails — in other words, I suspect that its replication strategies rely on good liquidity, which is a risk positively correlated to the market.
So I don’t really think there’s a problem with studies that compare managed funds to a buy-and-hold strategy with the S&P
Probably right from a statistical point of view. But it betrays a certain mindlessness (I’d also comment that I’ve seen studies published in decent journals that completely ignored the little matter of dividends!)
dsquared 04.23.04 at 6:52 pm
In vaguely related news, the Economist’s Big Mac index has been claiming for the last ten years that a Big Mac is a homogeneous product around the world, despite no fewer than four letters from me telling them that it isn’t; fat content, calorific value and even weight differ significantly between local markets.
Dean Jens 04.30.04 at 3:20 am
http://biz.yahoo.com/ifunds/040428/20040428_putcallparity_adv_bon_jb_1.html notes a dramatic violation in put-call parity on bond ETFs. Shares for shorting simply can’t be had, so there’s no arbitrage.
When single stock futures were introduced, I was asking people whether the futures price of a potential short-squeeze might drift a bit below fair value for basically this reason. As with many of my questions, nobody seemed to care. At the time I looked at the options market for Krispy Kreme, but saw no significant effect.
This is related to the previous point about the first question; if you can’t short the futures and pull the procedes out, and the IEM doesn’t pay interest on cash, it’s hard to see that there’s going to be a compelling force keeping the prices in line with interest rates.
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