Evidence based investment analysis (EBIA): A new term every financial analyst and investor should know

Evidence based investing (EBI, see Ritholtz/IMNis a pretty new term and evidence based investment analysis (EBIA, see DVFA-Blog) is a brand new terminology. Is EBIA just another fad or useless buzzword? I do not think so. I think that EBIA may be much more important than EBI. 

EBI – Original Definition

“Evidence-Based Investing (EBI) is a disciplined approach to asset management that combines the data we have from the past and present with honesty about the unknowable future. Where others would use forecasts, relationships or emotions to guide their decisions, practitioners of EBI would substitute facts, logic and reason“ according to the invitation for the first EBI conference which took place in November 2016 in New York.

Original definition is too generic to be useful

This seems so convincing that it seems obvious to me that all investing should be evidence based. Who would admit to be non-evidence based? And that is the basic problem with EBI: It cannot be used to seriously differentiate oneself from others.

„Smart Beta“ is a smarter term: All investors want to be smart, but traditional investment managers want to deliver alpha, therefore they will no claim to produce smart beta. Also, smart beta is typically rules based and most traditional investment managers do not fully rely on rules. „Smart beta“ therefore can be used to differentiate rather simple quantitative (rules based) from more complex (e.g. macro or managed futures hedge funds) quantitative as well as from discretionary investment managers. 

Therefore it is not helpful to define Evidence-based investing (EBI) as an investment philosophy, since almost everybody would claim to use such a philosophy.

The first EBI products

The first mutual funds are now marketed as „evidence based“. They claim to use clear past evidence for future investment decisions. Some use the EBI-term for factor investments, whereas others use the term for passive investments. We certainly do not need two terms for the same thing. And, in my opinion, EBI is not the same as either factor investing or passive investing. 

Current EBI definition misses some important points 

EBI as defined above in my opinion misses or misuses some major elements: 

  1. EBI should always be research-based and therefore should develop with further research over time. 
  2. EBI is not necessarily completely forecast-free, since forecasts can be based on evidence (e.g. see 215 years of Momentum)
  3. EBI is not necessarily passive because there is no such thing as 100% passive investing (see Blog). Passive investing is only possible after restrictions have been applied such as long-only or US-only or large-cap only etc..
  4. EBI should consider emotions since they influence investment decisions which has been well documented by research. 
  5. EBI is not necessarily the same as quantitative investment. Quantitative investing could base on data mining or spurious correlations and therefore is not evidence-based. 

EBI guidelines

In my opinion, an investment can be described as evidence based if it follows these principles:

1) Use all data and research which you can gather efficiently, e.g. Damodar (since 1928), Shiller (since 1871), French (since 1920) and SSRN or Researchgate (for the data sources see „externe Quellen“ at www.diversifikator.com). Forecasts are allowed but should be falsifiable (see Blog). Contradicting data and/or research should be mentioned if they can be known with reasonable effort. 

2) Use adequate models. This means not to base on the efficient-market hypothesis and to take behavioral aspects into consideration.

3) Make assumptions and restrictions (e.g. long-only, no leverage, costs of implementation) transparent and explain them. If possible, previous trials should be mentioned.  Unrestricted (big) data analysis and usually „hypothesis-free“ data-mining should be avoided. Research/hypothesis driven data-analysis to discover new relationships is permitted, though.

4) Make sure or transparent that small variations in inputs, models or restrictions do not result in large variations in output (robustness).

5) Use fitting and challenging benchmarks. This means that equity portfolios should also be benchmarked against often difficult to beat equal-weight (1/N) portfolios, multi-asset portfolios against 50/50 equity/bond allocations  and „risk managed“ portfolios against simple trading strategies such as 200day trendfollowing. 

6) EBI is rules based but rules can evolve over time and the rules may be changed by people. The rules can also be „individual“. Imagine a rules-based ESG (Environment, Social, Governance) portfolio which contains several stocks and one of them is (additionally) excluded by an investor because she is vegan and the standard ESG portfolio did not have a rule to exclude „non-vegan“ stocks. Typical discretionary investment is usually not compatible with EBI, though. 

Others should be able to replicate the EBI results. Only if an investment fulfills all the above mentioned guidelines, it should be called EBI. 

EBIA explained

Evidence based investment analysis (EBIA) should use these principles to analyse investment portfolios. Most importantly, EBIA should critically question investment recommendations regarding the evidence on which the recommendations are based. Especially, EBIA focuses on the assumptions, data, models and restrictions used.

EBIA should be applied to all portfolios, not only the few portfolios which claim to be evidence based. EBIA is therefore much more important than EBI. 

Problems with EBI and EBIA

The problem with EBIA is that most of the investment products currently offered would not look very convincing. But that is no reason to discard EBIA. 

For products following the EBI guidelines above it may be problematic to protect „investment“ secrets, since they have to be very transparent so that the evidence can be analysed. For non-public portfolios this should be solved with  „confidentiality agreements“. For public EBI portfolios we need good intellectual capital protection and also good ethical behaviour by portfolio managers and investors alike.

Good examples of EBI?

I found several not so convincing examples of „passive“ and data-mining based „factor“ portfolios which claim to be EBI.

Although at the time of launching my own company Diversifikator (www.diversifikator.com) at the beginning of 2016 I did not know the concept of EBI, I think that my approach with Diversifikator comes pretty close to EBI:

All Diversifikator portfolios are fully rules based, the rules are transparently documented (see „Das Diversifikator Buch“), we document all backtest-failures and variations (see „Diversifikator Test von Risikomanagementmodellen“), we also archive all previous documentations (see „Archiv“) and provide daily data for backtests and live performance analysis (see „Excel-download“). Also, all trades are documented (see „Alle Portfolioänderungen“ in „Archiv“).