8.1 The Sources of External Finance #Notebook

 8.1 The Sources of External Finance #Notebook

The financial system connects savers to spenders or investors to entrepreneurs in two ways, via markets, and via financial intermediaries. But most of the real action, however, takes place behind closed doors in banks, non-bank financial companies, and other institutional lenders.

Most companies are small and most small companies finance most of their activities by borrowing from their suppliers or, sometimes, their customers. Most such financing ultimately comes from loans, bonds, or stock. 

Companies that extend trade credit act, as nonbank intermediaries, channeling equity, bonds, and loans to small companies. This makes sense because suppliers usually know more about small companies than banks or individual investors do.

A $1,000 year-long bank loan renewed each year for 20 years would count as $20,000 of bank loans, while the sale of $1,000 of equities would count only as $1,000. 

Most external finance does not come from the sale of stocks or bonds. 

In less economically and financially developed countries, an even higher percentage of external financing comes to nonfinancial companies via intermediaries rather than markets.

Why are bank and other loans more important sources of external finance than stocks and bonds? 

Why does indirect finance, via intermediaries, trump direct finance, via markets? 

Why are most of those loans collateralized? 

Why are loan contracts so complex? 

Why are only the largest companies able to raise funds directly by selling stocks and bonds? 

Why are financial systems worldwide one of the most heavily regulated economic sectors?

Those questions can be answered in three ways: transaction costs, asymmetric information, and the free-rider problem. 

How Does Dimensional Fund Advisors make money by taking advantage of the Efficient Market Hypothesis

 Introduction

Dimensional Fund Advisors, an investment consulting firm, is a believer in market efficiency and its managers make money by applying this strong belief. This company was founded in 1981 who has a long history of applying academic research to practical investing. They offer a full range of equity and fixed income strategies designed to target higher expected returns. But, how does the investment consulting firm make money by taking advantage of the efficient market hypothesis? In their intro, it states "We are passionate about what we do, and through our close relationships with institutional investors, consultants, and financial advisors globally, we’ve seen the difference our approach has made in people’s lives over the past 35 years". Is this company really great at doing this, or something else? This is what we are going to find out.

Before we dig into what they are actually doing, some basic concepts and key terms we need to understand, the market efficiency, arbitrage, risk versus return, and indexing.

The Market Efficiency

Market efficiency refers to the degree to which market prices reflect all available, relevant information. In other words, "the prices have already reflected all available information". Therefore, if markets are efficient, then all information is already incorporated into prices, and so there is no way to beat the market because there are no undervalued or overvalued securities available. This is so-called the efficient market hypothesis, states that investors can't outperform the market, and that market anomalies should not exist because they will immediately be arbitraged away. 

Arbitrage

Arbitrage is the purchase and sale of an asset to profit from a difference in the asset's price between markets. Simply to say, it is a trade that profits by exploiting the price differences of identical or similar financial instruments in different markets. Arbitrage exists as a result of market inefficiencies and would not exist if all markets were perfectly efficient. 

For example, many sellers on Amazon.com are actually purchasing their products from Alibaba.com, put on their marks, brands, send them to Amazon Fulfillment Center, and then sell them on Amazon.com. Even those products are identical, you can also purchase them on Alibaba.com all by yourself. But due to you don't put the efforts on finding these kinds of opportunities, you will buy them at a higher price on Amazon.

Indexing

Indexed investing is a strategy designed to match a market, not beat it. Done properly, it can be cheap and efficient. Many mutual funds and exchange-traded funds, make it possible for individuals to invest some or all of their assets in indexed strategies. However, the manger of an index fund doesn't have much to do, only passive investing or active investing. How good is the performance of active and passive strategies? Suppose the market as a whole returned 10.0% in that year. Before costs, what did each passive investor get? Approximately 10.0%. How about active investors? It's maybe 15%, 3.4%, or -23.0%, depends on how you did it. 

How big is the advantage of this approach? It depends on the average added costs for active management. Therefore, investors who highly agree with the efficient market hypothesis tend to buy index funds that track overall market performance and are proponents of passive portfolio management. However, many studies have shown that actively managed mutual funds do not systematically outperform the market.

Risk vs Return

Investors think of the information they know in common differently because their utility functions differ, different holding periods, and different sensitivities to risk. Financial market efficiency means that it is difficult or impossible to earn abnormally high returns at any given level of risk while returns increase with risk. If holding risk and liquidity constant, returns should be the same.

How Does This Firm and Other Make Money by Taking Advantage of The Efficient Market Hypothesis?

Now, let's talk about this investment consulting company, Dimensional Fund Advisors. The first I want to mention is that they take the advantage of some principles of persuasion, to persuade their clients that they are the best. Principles such as authority, liking, and reciprocity have been used to encourage people to join their projects. Some of their reports are reprinted by permission of Morningstar, which is a famous company in the financial field. 

Take a closer look at what they said on their website, "We seek to impact governance in several ways, including through proxy voting and listening to companies held in the portfolios we manage. We also seek to improve internal processes through research on governance matters and participation in industry surveys and events". So, it looks like they are trying to do research on the companies they invested in, and it may be much more insightful and worthy. But, recall the market efficiency hypothesis we mentioned earlier. If markets are efficient, then all information is already incorporated into prices, and so there is no way to beat the market because there are no undervalued or overvalued securities available. This doesn't make sense and it's contradictive because they just dig into more information than the general public would do. However, I think it probably depends on the information asymmetry since a 100% efficient market does not exist also.

In the report, it also mentioned that Dimensional’s investment philosophy is based on the idea that "market prices reflect all publicly available information commonly known as market efficiency." and they offer strategies that attempt to beat the market "by targeting exposures to what it views as the types of risks that the market compensates". 

Summaries the report, this company takes advantage of the information asymmetry pretty well. In order to profit from it, they targeting the unexposed profitabilities. However, unexposed opportunities will soon become exposed due to the availability of information technology is improving day by day.

Reference

Chappelow, J. (2020, August 29). Market Efficiency Defintion. Retrieved September 20, 2020, from https://www.investopedia.com/terms/m/marketefficiency.asp

DFA’s Disciplined Approach Earns It a Top Mark. (2015, July). Retrieved 2015, from https://www.oakwoodcap.com/wp-content/uploads/2017/07/Dimensional_Morningstar_Stewardship.pdf

Dimensional Investing: Dimensional Fund Advisors. (n.d.). Retrieved September 20, 2020, from https://us.dimensional.com/

Sharpe, W. F. (n.d.). Indexed Investing: A Prosaic Way to Beat the Average Investor. Retrieved September 20, 2020, from https://web.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm