Finance Ph.D.s Are Pretty Good at Finance If They Do Say So Themselves

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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The core principles of academic finance are:

  • markets are efficient and incorporate all available information into prices, so it is impossible to predictably outperform the market, but
  • let's find the exceptions!

And so the field is a parade of papers that identify factors reliably associated with statistically significant outperformance. But last month Ranadeb Chaudhuri, Zoran Ivkovich, Joshua Pollet and Charles Trzcinka won. They wrote the most perfect possible finance paper, so everyone else can stop. Well, actually, they can't, because Chaudhuri et al.'s conclusion is "the world needs more finance papers." Sort of. Here (via Tyler Cowen) is the abstract:

Several hundred individuals who hold a Ph.D. in economics, finance, or others fields work for institutional money management companies. The gross performance of domestic equity investment products managed by individuals with a Ph.D. (Ph.D. products) is superior to the performance of non-Ph.D. products matched by objective, size, and past performance for one-year returns, Sharpe Ratios, alphas, information ratios, and the manipulation-proof measure MPPM. Fees for Ph.D. products are lower than those for non-Ph.D. products. Investment flows to Ph.D. products substantially exceed the flows to the matched non-Ph.D. products. Ph.D.s' publications in leading economics and finance journals further enhance the performance gap.

Give them tenure! Or at least a job at a hedge fund! Ahhh they'd probably take the hedge fund.

This paper gets a lot done. Most important, it confirms the value of academic finance. The training for a finance Ph.D. teaches you rigorous methods for identifying financial-markets anomalies that can, in theory at least, lead to predictable outperformance. Not all of those anomalies can profitably be exploited, though there is evidence that many can be and are.

This study is further, even better evidence that toiling in the anomaly mines can be profitable: It is! In actual businesses! That manage actual money in actual markets! When young aspiring financial academics go home for Thanksgiving and their uncles ask them, "a Ph.D. in finance? What are you going to do with that?," now they'll have an answer.

But it also works at a meta level in that it identifies an anomaly itself. And it is no small anomaly: It's that you can predict a money manager's future performance based on her educational credentials. That is a big deal. Most anomalies identified in the literature require a fair amount of capital and computing power to exploit: Hedge funds might put them into operation, but the average individual can't.

This, though, is news you can use: Just make sure your broker has a Ph.D.! I mean, not really, but it does suggest that you'd do well to pick mutual funds and other products managed by Ph.D.s over those that aren't. More broadly, it suggests that investment-management ability is more rationally predictable than is often assumed : It's not just luck and mojo and intangibles; it's teachable in a degree program and deducible from a resume.

There is a third level that is so ethereally meta that it has floated off into a footnote.

The results aren't huge -- Ph.D.s outperform their less-educated peers by about 43 basis points a year -- but they're interesting. Though I guess you should take them with a grain of salt. A good exercise might be replicating this exercise in different contexts and on different samples -- Ph.D.s at hedge funds, Ph.D.s at mutual funds, only Ph.D.s who are chief investment officers, firms with only Ph.D.s in senior roles, etc. -- to make sure that they're not just a result of cherry-picking.

A little skepticism is always in order with academic papers. Every academic is tempted to report the result that he wanted to find. But since this result is at some level the single result that every financial academic most wanted to find, it probably makes sense to be especially careful.

  1. When I say "most important," of course I mean, "for the authors and readers of this paper," insofar as it affirms their career choices. Not, like, for the world.

  2. Actually this paper is not limited to finance and also includes degrees in "economics, management, accounting, physics, applied mathematics, and others" in the sample. So if you're getting your degree in classics or art history, feel free to tell your uncle that it will make you a better stock-picker. Anything's possible.

  3. Sort of. The paper is about institutional money managers, not mutual funds, and it's always possible that the mutual-fund, or whatever, genre would constrain the Ph.D.s and prevent them from fully exploiting their genius.

    Also, gah, this is not investment advice, come on.

    Also, tangentially related, here is an article about how Wells Fargo doesn't want its brokers to be picking stocks for clients. One gets a sense that a lot of those brokers don't have Ph.D.s.

  4. Including by me. I once said "Predicting investing performance based on anything other than investing performance is surprisingly difficult. But it turns out that predicting investing performance based on investing performance is also surprisingly difficult." I was using "surprisingly difficult" to mean "not worth attempting."

  5. That is: If finance Ph.D.s are so good at identifying anomalies, maybe all they're doing is identifying the money managers that will outperform, and going to work for them, rather than actually contributing to the outperformance:

    Another alternative explanation is that Ph.D.s may be better able than non-Ph.D.s to determine which firms will do well in the future based on the performance history and other firm characteristics. It is possible, then, that Ph.D.s would choose employers accordingly, favoring superior firms in the process of selecting an employer.

    Which would itself be a valuable skill! But no, or probably not: Brand-new money management firms founded by Ph.D.s outperform even other firms that employ Ph.D.s, so the mechanism can't just be that Ph.D.s are good at identifying firms that will outperform based on past performance.

  6. This study seems to count products with any Ph.D. in any "key role," which includes not just CEO or chief investment officer but also "Chief Investment Strategist, Senior Investment Officer, Partner, President, Portfolio Manager, Investment Manager, Chief Portfolio Manager, Senior Portfolio Manager, Lead Portfolio Manager, Advisor, Strategist, Chairman, Managing Director, and Director of Research."

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Matthew S Levine at