Academic versus Practitioner Research“Errors” academics often make when

conducting research in empirical finance

Ralph Goldsticker, CFAPresentation to Berkeley Haas MFE Students

February 19, 2016

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Academic1. Get published2. Contribute to the body of knowledge3. Be useful to investors

Practitioner1. Improve investment results2. Demonstrate thought leadership3. Get published

Different research objectives

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No data snooping, survivorship or look-ahead bias Minimize data mining Robust statistics

Both should be rigorous.

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Simplistic portfolio construction Little or no risk control Universe may not be investable Long-short strategies Equal-weighted strategies

Performance metrics Full period average results Risk-adjusted returns

Common “errors” made by academics

Simplistic portfolio constructionPortfolio simulations should reflect an approach that would be adopted by an investor Institutional portfolios incorporate risk controls

Industry diversification Factor exposures

Most don’t use Fama-French factors.

Institutional portfolios have other limitations Investable universe Capacity, concentration, liquidity Turnover

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Too often academic research presents only the average results for the full period.

But, performance in sub periods matters to investors. Clients may not be able to tolerate long or sharp drawdowns. All value added may have occurred in early periods.

Look at time series of value added. Are results episodic or cyclical? Do results trend? Are results correlated with macro or other factors?

Does strategy perform better in some sectors/styles than others?

Focus on full period average results

Long-short strategiesOften academic tests of stock picking are performed using long-short strategies. But,

Most investors do not short. The costs of shorting may be understated. There are constraints on shorting. Liquidity and transactions costs not properly incorporated. Most of value added may come from short side.

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Equal-weighted strategiesResearch often performed using equal weighted portfolios.

Note: OLS regressions represent equal weighted strategies.

But, equal weighted strategies ignore: Liquidity and capacity Turnover and transactions costs Risk controls

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Risk-adjusted returnsOften academic research uses Sharpe Ratios or other types of risk-adjusted returns to evaluate/compare strategies.But, using Sharpe Ratios implicitly assumes that the strategy can be levered to the desired level of risk and return.

Not all strategies can be levered. Not all investors are willing to lever. Leverage is not free.

E.g. which is the superior investment without leverage? 6% expected return at 10% volatility 4% expected return at 5% volatility

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Empirical research should be implementable.

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Investment organization Philosophy & style Investment capacity

Client preferences Investment objectives Risk controls Investment horizon

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