Download 4 Empirical Results. - Econ

Are Investors Uninformed or Misinformed? A Proposition and a Test.
James Kurt Dew
401 Ocean Drive, Apt 411
Miami Beach, FL 33139 USA
Abstract: Fama and French (2006) show passive investment creates outsider efficient
portfolio choice when inside information is exogenous. However, in Kane’s alternative,
investor passivity leads to outsiders’ demise. We show that both results are consistent with
the Fama-French analysis. It is the initial conditions that differ. Exogenous inside
information –learned but not disclosed – produces Fama-French results. Kane assumes
inside information is endogenous – generated “creatively” to maximize insider wealth. This
difference is decisive for passive investors. A test shows that Mexico, Turkey and Thailand
markets behave as though misinformed; German markets, as though better informed; and
United States, best informed.
JEL Codes: G11, G15, G21, G28
Key words: rational investors, liberalized markets, CAPM, financial disclosure.
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Are Investors Uninformed or Misinformed? A Proposition and a Test. 
1
Introduction.
The Theory of Finance is based on implicit moral underpinnings. We forget this at our risk.
How inside information influences portfolio choice in liberalized financial markets is the
focus of this article. It extends a result due to Fama and French (2006). These authors
show that after removing one of the CAPM assumptions, the assumption that all investors
have equal information – outsiders (investors who possess incomplete information) will
ultimately hold the same efficient portfolios chosen by insiders. Suppose, as Fama-French
(2006) assumes, insiders provide outsiders with no information. Outsiders, by repeatedly
choosing the market portfolio, will ultimately hold a portfolio arbitrarily close to insiders’
optimum portfolio. In this case outsiders need not expend significant resources in a search
for the optimal portfolio. They simply need to hold the market, as they might do for
example by purchasing shares of an index fund.
Much of the institutional structure of current financial institutions and markets is likely to
be changed in response to the global financial crisis that began in 2007. But what of the
theory of Finance? Its usefulness is at risk too, we contend. The challenge brought by the
Behavioral literature has proven a credible threat to the theory by presenting evidence that.
investors may not always be rational. But of far more importance than investor rationality
is investor belief that they can safely invest their funds based on the information found in
financial reports provided by insiders. At a minimum, as Fama and French argue, imitation

The author would like to thank the anonymous referee, Edward Kane, Graham Partington and attendees at
the French Financial Association Meetings and the Accounting and Finance Association of Australia and
New Zealand Meetings.
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of the average investor should not lead investors astray. Holding the market index should
provide an adequate reward for risk, given sufficient time. Has the crisis has rendered this
belief a dubious proposition? This paper shows that faith in the information provided by
insiders is subject to more doubt in some circumstances than others and that long term
credibility of insiders is testable by investors. This should salvage the threat to the theory
and replace it with a means for investors to evaluate the integrity of the markets they use. It
should also present regulatory policies more conducive to broad portfolios carrying a
maximal return for the risk implied.
Perhaps the most important proposition in the theory of investment is the Capital Asset
Pricing Model of Sharpe and others. This model assumes that all investors have equal
information. If so, a portfolio containing the entire market portfolio should be the best
investment for the average investor on an ex ante basis. However, as Roll () points out, the
CAPM is therefore not testable – this equal information assumption being manifestly
counter to fact.
In what follows we will make a transition from the benign, investor-friendly market
environment of Fama-French (2006) to the more chaotic, investor-unfriendly market of
Kane (2004, 2000). In Kane’s model passivity is a costly mistake. We show that the Kane
results depend not on a different theory, but upon a difference in the process by which
inside information is shaped. In the following empirical analysis, we produce market-based
evidence that that both Fama-French and Kane markets exist and are both consistent with
the “liberalized economy” tag that has become the global standard.
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The article proceeds as follows. Initially we show that the Fama-French (2006) conclusion
that investor passivity leads to portfolio optimality assumes insider passivity as well as
outsider passivity. We then show that Kane’s introduction of the possibility of insider
active provision of misleading misinformation reverses the optimality of outsider passive
investment. The article then raises the empirical question: “Is there evidence that some
countries are characterized primarily by lack of information and others by
misinformation?” The answer is partially provided in the empirical literature, which
considers insider effects on investment performance in various liberalized markets. Using
stock return data from Germany, Mexico, Thailand, Turkey and the United States, we
investigate the portfolio efficiency of passivity. In what countries is holding a market
portfolio of common stocks prudent? Is the market index portfolio on the efficient portfolio
frontier? The test allows us to reject the hypothesis that passive investment is efficient in
Mexico, Turkey and Thailand. In Germany and the United States the results are less clear,
but efficiency cannot be rejected.
2
2.1
Information and Investor Classes.
The Fama-French Version.
Fama-French (2006) initially identifies two investor classes: noise investors and full
information investors. The root issue this permits them to examine is the cost of being an
outsider. There is a body of empirical evidence to the effect that inside information is
different and better than outside information – in the sense that insiders tend to invest in
portfolios that produce higher returns than those of outsiders, which makes this issue an
important one.
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So it is necessary in Fama-French (2006) that insider and outsider information sets are
different. This is simply a reasonable working definition of the difference between insider
and outsider. However, there are two possible ways to drive a wedge between insider and
outsider portfolios: a change in the information possessed by insiders or a change in the
malicious information possessed by outsiders. Any material difference between inside and
outside information will improve the lot of insiders and may result in outsider portfolio
inefficiencies by the definition of the two classes. Any difference between the inside and
outside information sets that affects relative returns or risks produces differing portfolio
choices. Insider holdings then change relative to outsider holdings in a way that directly
benefits insiders, producing the situation characterized by Figure 1 from Fama-French.
(Figure 1)
Once the initial conditions of Figure 1 are established, the Fama-French conclusions
follow. Following Fama-French, point T on the graph is the optimal portfolio from an ex
ante risk and return point of view. D is the average portfolio held by outside investors.
Since the classes hold different portfolios, neither class holds the market portfolio,
represented by M in Figure 1.
Subsequent adjustment to efficiency is straightforward. By implication of the decision to
invest in the entire market, outsiders choose a new average portfolio that includes more of
T. However, although the new outsider average portfolio is the average of D and T, when
the market clears passive investors do not hold M as planned. Inside investors in T do not
change their holdings, and thus the average of D and T is still not M. Outsiders again
rebalance their holdings in period t  1 , expecting to hold the market portfolio. The result
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is still closer to T, but not T or M. But in the limit as t goes to infinity, D, M and T are
identical.
However Fama-French (2006) uses an unnecessary and ultimately distracting device to
produce the initial condition of outsider portfolio inefficiency. In Fama-French noise
investors irrationally collect information that generates risk and return estimates that have
no forecasting merit. As a result these noise investors choose, on average, an inefficient
portfolio. Fama-French then ask what effect a more rational decision on the part of outside
investors, to buy the market portfolio, would have on their portfolio performance.
It is the subsequent adjustment to optimality resulting from this passive investment strategy
that is the primary focus of Fama-French, not the question of how investors come to hold
initial inefficient portfolios. But it matters greatly how outsiders come to hold an inefficient
portfolio. In fact the original source of inefficiency is the key distinction between FamaFrench and Kane, not the subsequent adjustment to equilibrium.
And the Fama-French “noise” approach that produced Figure 1 initial conditions begs a
pair of questions. First, the Fama-French noise assumption relies on investor irrationality.
However, economists prefer not to rely on investor irrationality to explain behavior,
because irrationality can be used to explain any behavior. If such an assumption is
unnecessary, it would be best to avoid it. The noise hypothesis also begs a second question:
What noise? Even noise has a production cost and requires a profit motive. No explanation
is provided. Importantly, the noise of Fama-French is unnecessary to produce the important
Fama-French result. There are more reasonable ways to produce the initial conditions of
Fama-French analysis.
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We suggest that it is both more consistent with the norms of economic analysis and also an
appropriate use of Ockham’s razor to simply assume an exogenous change in inside
information and allow outsiders to rationally choose the market portfolio from the outset.
Rather than outsiders beginning with more misinformation than insiders, coming from
some unknown source, we assume that insiders begin with more good information than
outsiders.
As we demonstrate, this change does no violence to the Fama-French analysis or results.
However it does put the focus of attention directly on insider disclosure and thus draws
attention to the key difference between Fama and French assumptions and those of Kane.
What matters is not the adjustment from Fama-French Figure 1 to outsider efficiency in
period t. That process is identical in Fama-French and Kane. The aspect of the market
adjustment process that drives the optimality of investor passivity is the process by which
the inefficient portfolio, D, of outsiders comes about in the previous period, t  1.
To see why the t-period adjustment in Fama-French is beside the point, we move to the
earlier period, t  2 . We drop the noise assumption and assume both insiders and outsiders
hold the market portfolio from the beginning. Thus all investors hold the same optimal
portfolio initially. But there are separate reasons for holding it. Outsiders hold it because it
is the market portfolio, M. Insiders hold it because they know it is the efficient portfolio, T.
Then we permit a change in the inside information set in period t  1. We will assume an
exogenous change in technology, resulting in an increase in wealth through an expansion of
the production possibility frontier. If relative prices do not change, there is no adjustment.
Insider’s wealth rises, but so does that of outsiders in equal proportion. Portfolios all
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remain at T. However, if relative risks or returns change, insiders trade to capture the
benefits of a new efficient portfolio on a new efficient frontier. Outsider’s portfolio
becomes inefficient and different from the portfolio of insiders, creating the conditions of
Fama-French Figure 1. The adjustments from there follow Fama-French, with both
outsiders and insiders holding the efficient portfolio in the limit as before. Thus the
reassuring implications of Fama-French adjustment for outsider portfolio management are
consistent with no loss of wealth by outsiders as well, in the case where inside information
is changed exogenously – that is, where outsiders are uninformed, not misinformed.
2.2
The Kane Version.
How does misinformation lead to Kane’s results? The simplest example of which we can
conceive follows. It is suggestive of the structure of the other counterexamples
characterized by Kane and of a different process by which intra-period information is
generated. As before, equilibrium prevails in period t  2 . To generate Kane results,
insiders generate misinformation. For example, suppose that one asset, A, worth PA  A in
the market portfolio, is controlled by insiders who incorporate and issue claims on 100% of
A, which replace A in the market portfolio. Under Modigliani and Miller (1958)
assumptions, the claims are also worth PA  A .
The manager then absconds with the real asset A, forming a second corporation, Firm A ,
with no apparent assets but in fact in control of the rights to A. The salient fact is that the
value of assets is concealed from the market. Thus there is misinformation. Insiders take
possession of the claims on A . Claims on A have zero market value, since only insiders
know Company A is in control of the former assets A. Returning to Fama-French’s Figure
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1, T is now the insider’s portfolio, containing only A since the returns to A are initially
infinite. If we assume insiders consume some of the proceeds of A , then A must produce
returns and will have a non-zero market value, driving a wedge between outsider portfolios
and the market portfolio as before. The model once again meets the conditions of Figure 1.
The analysis of convergence to efficiency is that supporting Fama-French Figure 1 as
before. However, outsiders have lost wealth of value PA  A to insiders, with no change in
the real assets on the optimal point of the efficient frontier.
This simple misinformation example readily extends to include all cases that fit the
characteristics of purposeful misinformation as characterized in the following from Kane,
2004: “Financial information may be deemed perfectly true and timely only if it conforms
to all relevant facts that are knowable at a given time. Disinformation consists of false and
half-true statements or opinions that interested parties convince others to take seriously. Its
message is designed to be negatively correlated with unfavorable information that insiders
manage to withhold from outsiders and sometimes (through the psychological mechanism
of denial) even from themselves. Financial disinformation relies on deceptive reports and
misleading claims about upside and downside risks. The spurious elements or false
implications of these claims are shaped for the express purpose of preventing outside
counterparties from grasping the full-information or ‘inside’ risks inherent in holding a
particular class of assets.” The unifying characteristic of Kane’s different forms of
misinformation is that each involves convincing the average dollar investor of real asset
values counter to fact.
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Kane assumes information changes are endogenous. Insiders do not learn new information,
they generate misinformation. Thus the change in information is such that insiders do not
change their holdings. Instead they mislead outsiders, resulting in an unanticipated change
in the real assets held by outsiders. There is no expansion in the production possibility
frontier, but instead an unintended shift in outsider holdings to inefficient portfolios interior
to the unchanged efficient portfolio frontier. Thus this misinformation returns investors to
Fama-French Figure 1, because misinformation creates differences among insider and
outsider holdings. The subsequent adjustment process is identical to that of Fama-French.
The important distinction is that the “learned” exogenous information of the first FamaFrench example increases the wealth of both investor classes; the “created” endogenous
information of the second example due to Kane results in a shift in the share of the
unchanged total stock of investor wealth from outsiders to insiders in period t . Since the
Kane information generation process is endogenous, a choice by insiders that works in their
favor, rationally there will be further endogenous changes with the limiting result that
passively investing outsiders’ share of total wealth will be zero.
Thus the convergence to efficiency of outsider market portfolios in CAPM models
permitting different information sets is not guaranteed. Outcomes depend upon whether
inside information is generated endogenously or exogenously.
3
Evidence of Investor Disinformation around the Globe.
Recent literature has produced substantive evidence that Mexico, Thailand and Turkey,
among other markets that were liberalized before the early 1990’s, are in some respects
inefficient in allowing market forces to allocate capital to its most productive uses (c.f.
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Harvey and Bekaert (2000) for a short rationale for the “liberalized” designation of the
three markets.) In these three countries, market liberalization and conversion to capitalism
may have been to a degree self-serving ventures of the elite that have caused some damage
to less informed investors. This possibility is developed in emerging markets literature
examining financial market impact of insider decision-making by several authors. For
example, Bhattacharya and Daouk (2002, 2005) identify costs associated with lack of
enforcement of insider trading laws in various countries. Peek and Rosengren (2001) detail
the effects of fraudulent bank lending practices in Japan. Dyck and Zyngales (2004)
present evidence of substantial premiums for corporate control relative to simple share
ownership, for which evidence exists in Mexico, Thailand and Turkey among other
emerging markets.
The experience in these countries stands in contrast to the corporate/government nexus in
Germany. Germany is more directly comparable to emerging markets such as Mexico,
Thailand and Turkey than might be thought, due to the German tribulations related to the
absorption of formerly Communist East Germany. Dyck (1997) provides a detailed insight
into East Germany’s transition from a control economy to a market economy. While he
indicates that the experience was expensive, fraught with conflict, and characterized by
setbacks; he argues that it was on the whole the most successful of the Eastern European
privatization efforts.
However, the articles considered leave open the critical question raised by Fama-French
and Kane; whether and how market forces might counteract the observed effects of the
agency problems the authors identify. They do not tell us whether investors discount the
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prices of associated securities, leaving post-adjustment returns consistent with risk
assumed. In addition, the articles focus on specific aspects of the general phenomenon of
market dissimulation. In this sense, they may be thought of as components of a “bottomup” construction of the costs of insider duplicity.
Although this article is consistent with these other earlier articles, it considers the cost of
corruption identified from the investor side of the equation, through investors’ rational
pursuit of misinformation-inspired economic rents, a “top-down” approach to estimating
part of the cost of insider misinformation. An alternative theoretical top-down discussion of
conditions under which market forces are consistent with sustained asset stripping is
provided by Hoff and Stiglitz (2005) with a focus on the interaction between privatization
and the rule of law in the countries of the former Soviet Bloc – Russia especially.
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4.1
Empirical Results.
The Data.
The data series used in this study were stock indexes constructed by Datastar and interest
rates provided through DataStar by the country being studied. In each country the series in
question were monthly returns calculated from each index from the earliest date for which
there is available data to the end of 2006, with the exception of the United States, where 20
years of data ending in 2006 was used. Table 1 lists the series used for each country and the
time period over which returns were measured. Each return series was the return in the
home country currency, since currency translation has no effect on efficiency of
investments as long as performance is measured in a single currency.
Table 1
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4.2
The Test.
We use a simple Markowitz model. The Markowitz model specifies
rt    et with et ~ N (0.)
(1)
Where rt is the vector of returns to each initial portfolio of investments,  is the vector of
expected returns to the portfolios,  is the covariance matrix of the expected returns, and
et is the vector of errors in meeting expected returns. The efficient portfolio frontier is then
constructed from the estimated covariance and correlation matrix and mean returns equal to
the sample means of the chosen time series of returns in each country, based on the
algebraic technique of Huang and Litzenberger,1988, as implemented for example in
Jackson,2001.
The test compares the simple mean and variance of the index portfolio of each country as
defined by DataStar with an efficient portfolio frontier constructed from the index
portfolio, three other industry index portfolios, and a single short term interest rate series.
We reject the hypothesis that the country allocates private resources efficiently if the
market index portfolio does not produce a higher return than the minimum risk portfolio of
the market in question. In other words, if minimizing risk using the county’s least risky
Treasury securities outperforms passive investment in an index portfolio in a given country,
that country fails to reward passive investment. In a Fama-French (2006) financial market,
the market index portfolio would tend to pass this test. In the markets of Kane, failing such
a test is imaginable. The results appear in Figures Two through Six. As the figures display,
Mexico, Thailand and Turkey fail the test, but in Germany and the United States, efficiency
cannot be rejected.
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This analysis suffers from at least two shortcomings. First, we pick only five investments in
each country. The CAPM is a theory of all available portfolios. The effect of this
shortcoming is, however, predictable. By including more portfolios, the efficient portfolio
frontier is inevitably expanded, and individual portfolios will all be found less efficient.
Thus the rejection of passive investment as an attractive alternative in Mexico, Thailand,
and Turkey is robust to this problem, but doubt is raised about the efficiency of the index
portfolios of Germany and the United States.
A second problem is less tractable. The covariance matrix of portfolio returns in our
investment universe are nearly singular, and as a result there is substantial round-off error
in the estimated values of the efficient frontier, which depend on the values of the inverse
of a near-singular matrix with predictably large round-off errors. This flaw is apparent in
Figure 6, as the index portfolio, one of the portfolios used to construct the efficient
portfolio frontier, cannot actually be outside the efficient portfolio frontier as the diagram
suggests.
But this is not simply a problem faced by econometricians. It is also a problem faced by
investors. If portfolios available to investors are not statistically different, investors cannot
be expected to choose among them wisely. In the end, we must be skeptical about the
ability of investors to choose “the” efficient portfolio, but we are free to conclude that
passive investment was unsuccessful in Mexico, Thailand and Turkey. Both these
qualifications tend to suggest that while one may find it difficult to find the efficient
portfolio in a Fama-French economy, it is not so difficult to distinguish between economies
that are misinformed in the main or uninformed in the main.
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Significance of Country Inefficiencies: If the statistical significance of the efficiency of
the countries’ index portfolios is measured by a simple t-statistic, with the numerator the
return of the market portfolio less the return of the efficient portfolio of the same variance,
significance can be identified by inspection of the Charts. Since the returns for Mexico,
Thailand and Turkey are actually less than the minimum variance returns, the t-statistics of
these countries show significant inefficiencies. Germany, as stated above, is indeterminate.
In the United States cannot be rejected as round-off error produces a t above zero,
statistically impossible, indicating super-efficiency due to round-off error.
5
Conclusions.
Two versions of a model of investor difference of opinion are constructed. In this model
investors trade rationally but are either misinformed or uninformed. A Fama and French
2006 version assumes insiders provide no information; a Kane version assumes
misinformation. In the case of insider secrecy, passive investment leads to investor
optimality in the limit. In the case where misinformation is the rule, passive investors
ultimately are left with nothing.
The behavior of actual returns in five markets – Germany, Mexico, Thailand, Turkey and
the United States – is examined. We reject the efficiency of passive investment in Mexico,
Thailand and Turkey but not in Germany and the United States.
Why did the index portfolio perform so poorly in the three countries? If investors believe
they are better off if they do not consider alternatives to CAPM, they might ignore
evidence of the inefficiency of CAPM over substantial periods of time. Little would be lost
by them in a Fama-French world. In the Kane version, if most investors are similarly
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credulous, accepting the textbook version of CAPM, and unwilling to pay the costs of
obtaining full information, a window of opportunity exists in which insiders can exploit
outsiders. Thus our empirical results are evidence of insider duplicity in the presence of
sustained naïve investment despite substantial losses in the three countries.
There are alternatives to investor lassitude in explaining the failure of CAPM in these
countries. The author’s other work on banking agency problems in Mexico, Thailand and
Turkey suggests that outsider acceptance of poor returns in the financial sector may be in
large part involuntary as governments permit insider-controlled banks to invade the tax
base, using the proceeds to cover insider losses.
These results raise a few interesting questions:
1. How should foreign investors measure risk and return in these countries? Should they
be seeking to hold a diversified international portfolio including securities issued in
duplicitous markets? How should we characterize the risk/return alternatives available
to foreign investors? If these conditions are common in other countries, conclusions
based on risk/return comparisons of representative international composite stock
indices are overturned. Local country bias may be outsider wisdom.
2. Most intriguing is the possibility that by encouraging investor adoption of the
assumptions of Neoclassical Finance embodied in CAPM and its implementation,
Finance specialists may be invalidating the theory. A financial system composed of an
excess of model-mimicking zombies may result, thereby making a continuation of the
unremitting series of financial scandals of the past twenty years easier and more
profitable. This is an example of a familiar econometric problem. Just as adoption of
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monetary growth rules may have weakened the relationship between measures of GDP
and money in macroeconomic analysis, rule-based investing may have weakened the
relationship between market portfolio returns and individual stock returns in much the
same way.
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Figures
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Table 1 – Time Series, Monthly Stock Indexes and Interest Rates
Period Beginning
Index
1/01/1973
Germany - DS Industrials
Germany - DS Construction
and Materials
Germany - DS Banks
Germany - DS Market
Germany - Overnight
Mexico
8/19/1992
Mexico - DS Banks
Mexico - DS Retail
Mexico - DS Telecom
Mexico - DS Index
Mexico - Commercial Paper
Thailand
9/25/1993
Thailand - DS Hotels
Thailand - DS Telecom
Thailand - DS Banks
Thailand - DS Index
Thailand - Repo
Turkey - DS Construction
Turkey
4/30/1994
and Materials
Turkey - DS Diversified
Industrials
Turkey - DS Banks
Turkey - DS Index
Turkey - Repo
United States
8/31/1987
US - DS Pharmaceuticals
US - DS Oil and Gas
US - DS Computer Services
US - DS Index
US - Fed Funds
Country
Germany
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Figure 2
Investment Opportunities and Portfolios, Thailand
Efficient
Portfolio
Frontier
20%
15%
Market
Portfolio
10%
5%
0%
0.0%
-5%
Minimum
Risk
Return
0.5%
1.0%
1.5%
2.0%
2.5%
-10%
-15%
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Figure 3
Investment Opportunities and Portfolios, Turkey
80%
Efficient
Portfolio
Frontier
Market
Portfolio
70%
60%
50%
40%
Minimum
Risk Return
30%
20%
10%
0%
0%
200%
400%
600%
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800%
1000%
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Figure 4
Investment Opportunities and Portfolios, Mexico
80%
60%
Efficient
Portfolio
Frontier
40%
Market
Portfolio
20%
Minimum
Risk
Return
0%
0%
100%
200%
300%
400%
500%
600%
-20%
-40%
-60%
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Figure 5
Investment Opportunities and Portfolios, Germany
20%
15%
Efficient
Portfolio
Frontier
10%
Market Portfolio
5%
Minimimum
Risk Return
0%
0%
20%
40%
60%
80%
-5%
-10%
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Figure 6
Investment Opportunities and Portfolios, United States
12%
Efficient
Portfolio
Frontier
10%
Market Portfolio
8%
6%
4%
2%
0%
-50%
0%
50%
100%
25
150%
200%
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