John Cochrane: Function Matters Not Size

I came across an interesting paper from John H. Cochrane (University of Chicago) and his insights and opinions on financial markets. My own view has always been that it is important to make arbitrage easier. This is in line with most of the points from Cochrane. He also argues for more research on high frequency trading.

 “The social question for high-frequency trading- like all of finance, really is whether it screws up markets or makes them more efficient and “liquid”." 

Just a few highlights out of his paper below and here the link to it.


 “The majority of TRIP’s [Total Return Investment Portfolio] assets are managed by external managers specializing in a specific asset class, geography, or strategy. These asset managers outperformed their respective benchmarks in every asset class, adding over 500 basis points of performance versus the strategic benchmark.” Five hundred basis points! Put that in your pipe and smoke it, effificient marketers. At least we know one active manager’s perception of what they get for their fees. These endowments’ approach to portfolio management is pretty much standard at endowments, nonprofits, sovereign wealth funds, family offifices, pension funds, and so forth—anywhere there is a big pot of money to invest. These investors pay a lot of attention to allocation among name-based buckets, as represented in the pie charts, “domestic equity,” “international equity,” “fixed income,” “absolute return,” “private equity,” and the like. Then, they allocate funds in the buckets to groups of fee-based active managers."

 “Remember, “efficiency" means that prices incorporate all available information, not that markets are clairvoyant. The definition of “efficiency” is widely misunderstood. I once told a newspaper reporter that I thought markets are pretty “efficient,” and he quoted me as saying markets are “self-regulating!”


"If information is not incorporated into market prices and to such an extent that simple strategies with big alphas can be published in the Journal of Finance, there are not enough arbitrageurs. If asset prices fall in “firesales,” only to rebound later, there are not enough buyers following the fire trucks. If credit constraints are impeding the flow of capital, there is a social benefit to loosening those constraints. The literature on short-selling is revealing on this point. Short sellers uncover far more financial fraud than the Securities and Exchange Commission”.


“Unless we adopt the arrogant view that what we don’t understand must be bad, it is clearly far too early to make pronouncements such as “There is likely too much high-cost, active asset management,” or “Society would be better off if the cost of this management be reduced.” Such statements are not supported by theory or evidence. Nor is their not-so subtle implication that resources devoted to greater regulation—by politicians and regulators no less naive than current investors, no less behaviorally-biased, armed with no better understanding than academic economists, and with much larger agency problems and institutional constraints—will improve matters. This proposition amounts to Samuel to Samuel Johnson’s dictum on second marriages, the triumph of hope over experience.”


Here also the link to his blog. I think it is worth reading.


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