Just a question that popped into my head: what would happen if everyone followed a passive strategy, ie, no one was active? Isn't some sort of active strategy required, somewhere, for funds to be directed at all?
Though, I do think on average fund managers probably don't actually make anything like useful predictions. But perhaps we do need someone, somewhere, looking for good investment.
My guess is that there is a role in society for some conservative, value based investing, but at the moment there are more people trying to do this than is useful, and even more people trying to find good investments by worthless strategies (like trying to predict future movements from past movements).
The advice against trying to beat the market is based on the fact that there are tens of thousands of highly intelligent people paid to analyze securities, and they're all feeding off each other's behavior. To beat the market, you have to beat a conventional wisdom based on the accumulated expertise of a lot of people. For instance, if you want to buy stock in a Malaysian steel company, you have to decide that you understand the current value of this stock better than a crowd-sourced price generated by the research of a horde of steel industry specialists, people with intimate knowledge of the Malaysian economy, business environment, and political environment, people who can afford to spend all day reading forecasts of economic conditions in the countries where this company's steel is consumed, and people who have a drink with a VP from the company and get gossip about the CEO's health and the competence of his likely successor.
If no one was trying to beat the market, it would be easy to beat the market. But since so many people are busy trying, it's silly to try to compete unless you want to take it as seriously as the professionals do and get plugged in the way they are.
The "random walk" hypothesis says you can beat the professionals. About half the time. By flipping a coin. But the professionals are insiders, and as well-regulated as the stock market is, I would assume that an outsider playing against insiders in a 50/50 game will not quite win his full 50% share.
The hope that a person can price stocks better than the market as a whole rests on a couple of possibilities:
1. Beating full-time professional analysts at analysis in your spare time, because you're just so bad-ass.
2. Identifying a price that is heavily influenced by ignorant people and beating them by just being reasonably well-informed -- but this is not an original idea and hence is a special case of #1.
3. Finding a niche that you know intimately for some reason, and in which you have no professional competition. Oh, wait, this is just #2 again. Or maybe you found a niche small enough that it doesn't get a lot of attention from professional analysts, and you can make a little bit of money at it. That might work!
4. Being the first one to take into account a new idea or source of information. This one will make you wildly rich, and it's fun to dream, but while you're looking for that brilliant idea, there's no reason to risk real money on your ideas-in-progress.
As you suggest, we do need "value traders". In particular we need traders who buy and sell stocks in reaction to news. These traders don't have to be necessarily the active fund managers the article is talking about. They could be prop traders working for their own account or for a bank, broker or hedge fund.
"News" is any new information that affect the expected present value of a company cashflow. It could be a new product, a possible merge or macroeconomic indicator.
If you invest in an index fund, you're basically following the trades of those value traders. You won't make as much money as them, because often you'll be buying "good" stocks after they've already increased in price, i.e., by the time passive fund managers buy the "good" stock, the price will often have already incorporated the value of the good news. The same holds for the "bad" stocks.
There will always be market participants with vested interest in specific shares, and by definition they are following an active strategy by associating with that company. It follows that they will have a vested interest in hedging against dangers that might adversely affect that company.
“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.” - Warren Buffet
> Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
This argument is wrong? edit: it's like saying this about strategies of chess players, one group is using strategy A and another is using strategy B:
Chess players using strategy A are known to perform about average (by the nature of their strategy). So this new strategy, B, has to perform about average too.
This neglects that there are other strategies than A and B. The whole world is not either passive investors or hedge funds.
And he's saying something even stronger: there is no subset of B players that is better than average.
So while he may well be correct in his prediction, he makes it sound like he has a mathematically tight argument for why he is correct. But the conclusion of his argument (that active investors will perform about average) is not the prediction of his bet (that hedge funds will perform about average, and because they have higher operating cost they will lose).
Index investing (applied to extremely wide market indexes) makes an assumption that there will be a continuous and infinite increase in the total market capitalization of that index. As time marches forward I beleive we will experience a deceleration of worldwide market cap increase.
Warren Buffet said sort of the same thing in one of his annual shareholder letters a few years ago. That exponential economic growth has natural limits, and that if we extrapolate the stock market's 20th century returns to the 21st century, you end up with a mind bogglingly (and unrealistically) large market cap in 2099.
I forgot what year he wrote that, but it was sometime between 2006 and now. I don't have time to dig it up and find it, but here are his letters for anyone interested:
Edit: Got myself curious, had to find it. Here it is, from the 2007 letter, ps 18-19:
"Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this
assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.
The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.
This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.
How realistic is this expectation?
Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have
received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.
Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the
market needed to travel in this hundred years to equal the 5.3% of the last.
It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?
Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high-priced managers (“helpers”).
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-
digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees."
This has crossed my mind a lot of times and I think the comment is right - market capitalization of index cannot increase to infinity. There is a finite number of companies that the Index is comprised of and there has got to be a theoretical upper limit to that.
Moreover, the investment psychology also comes into play here. The growth rate of index may slow down as it becomes large because investors always compare today's index with the previous values and are likely to conclude that the index is "over-valued" if it keeps rising.
I'll be curious to find evidence of deceleration as the index value rises.
I have several concerns with index fund/ETF investing:
1. How much of the underlying stocks, that make up the Index, are really owned by the Index fund/ETF? I doubt that such funds/ETF actually own 100% of the required underlying stocks, may be using some sort of option/hedge strategy.
2. In what scenario, not owning the actual underlying stocks can be detrimental to index fund/ETF? I am looking for what may cause failure of such funds/ETF and who may lose.
3. Is index fund/ETF investing artificially inflating price for underlying stocks compared to price of the rest of the non-index stocks in the market?
2) The world's industry, per capita, is getting more valuable over time.
3) Even if the first two were untrue, there is still a time value to money. People will spend capital to get value immediately, and investing is the opposite of that.
I think this has to do with the age distribution in Western countries. As the baby boomers retire, they no longer are adding but start removing funds from the system.
A friend and I talked about this 20 years ago when 401(k)'s became the rage, lamenting that we were on the wrong side of the boom.
Financial markets can't beat the real economy forever. As a bet on the future growth, they must return to reality from time to time. Furthermore, as growth as we've known it will most probably soon end forever (or for the long term at least), financial markets are on for some future "correction" of humongous proportions when the sovereign debts will be wiped out by inflation.
Look at the DAX index, it includes re-invested dividends, and thus mirrors the actual performance of a passive-investment strategy better than a pure-stock price index.
Index funds were as widely adopted as you could ask for back in 1996 when I first started investing in them. And it was common knowledge even then that the S&P 500 tended to outperform 70%+ of managed mutual funds.
If that's the message this article is trying to convey, it certainly has the wrong title.
Having also read this a lot, it makes me wonder how the clever financial world will find a way to take a lot of people owning index funds and somehow fleece them.
I also find myself pondering the macroeconomic effects of a lot of the market simply being in index funds, though I'm sure we're a long ways from that.
My personal rule-of-thumb "By the time you've heard of it, it's too late to get in on it" is also triggering, though I have to admit for the life of me I really can't imagine how to exploit this tendency. But I am anything but a financial wizard.
Just because a question is interesting doesn't mean it has multiple right answers. (I need to stop talking like this or they'll take my ArtSci degree away...)
true, you get this advice everywhere. but actually implementing it for realz isn't for the faint of heart. it's not impossible either, especially if you don't mind horseshoes-and-hand-grenades approximation.
If you want optimal as in mathematically optimal fund selection, then Bill Sharpe's startup, Financial Engines, does that (if you have at least $100k at Vanguard, you get it for free, also through many employers).
https://personal.vanguard.com/us/insights/retirement/financi...
You probably have a breadth of knowledge that comes from reading sites like HN, but the problem of course is that most people get their investment advice from banks and other investment professionals.
I suppose index funds are fine if you can time buys/sells with the booms and busts. These days I sure don't feel like holding them. It's sad but the best bet is just picking the hot algo stocks.
I got a wake up call about 4 years ago when my broker tried to convince me to buy into a hedge fund. Buried in the prospectus was an entry load of 8%. Fired him, and have been in index funds since.
I'm 28, and I don't want to end up like Liz Lemon ("well I have $12,000 in checking"). What's a good primer on investing? I don't have a ton of money but I'd like to get into it.
Depends on what country you (or your money) live in.
In the US has some low fee index funds. In Germany I used an ETF of max-blue.
Just find a low fee diversified index fund, and then get back to your normal work. (Unless you enjoy playing the stock market, than there's nothing wrong with active investment. Just as some people enjoy playing the lottery (only the expected value of active investment isn't as dismal as playing the lottery).) Benjamin Graham's "Security Analysis" is a good primer, if you really want to get into stock or bond trading, or are just interested on an intellectual level. It's a hard book.
Make sure you use a tax efficient way to invest. If you can invest with pre-tax money, do so.
You have to pay for a membership but the site is top notch. They parse investment fund's sec filings and allow you to backtest strategies to see how well they would have performed over a given time frame. You will find strategies that crush any index fund.
You can't just invest in a hedge fund, there are some crazy requirements. As an individual investor you have to make $200,000 for at least two years straight.
Index funds seem to me to work by reducing churn - the percentage of your stock that is sold and bought each year - because every time you sell then buy you lose a lot of money. I am not yet convinced you have to follow an index.
If you had a fund that did not sell anything and bought a random stock from an index as funds came in would this beat an index fund?
Think of the index fund as reducing the risk of depending on any one stock for your gains. I don't know what the distribution of gains is like on an index fund but an answer to your question would likely come from an examination of one.
[+] [-] weber88|15 years ago|reply
Though, I do think on average fund managers probably don't actually make anything like useful predictions. But perhaps we do need someone, somewhere, looking for good investment.
My guess is that there is a role in society for some conservative, value based investing, but at the moment there are more people trying to do this than is useful, and even more people trying to find good investments by worthless strategies (like trying to predict future movements from past movements).
[+] [-] dkarl|15 years ago|reply
If no one was trying to beat the market, it would be easy to beat the market. But since so many people are busy trying, it's silly to try to compete unless you want to take it as seriously as the professionals do and get plugged in the way they are.
The "random walk" hypothesis says you can beat the professionals. About half the time. By flipping a coin. But the professionals are insiders, and as well-regulated as the stock market is, I would assume that an outsider playing against insiders in a 50/50 game will not quite win his full 50% share.
The hope that a person can price stocks better than the market as a whole rests on a couple of possibilities:
1. Beating full-time professional analysts at analysis in your spare time, because you're just so bad-ass.
2. Identifying a price that is heavily influenced by ignorant people and beating them by just being reasonably well-informed -- but this is not an original idea and hence is a special case of #1.
3. Finding a niche that you know intimately for some reason, and in which you have no professional competition. Oh, wait, this is just #2 again. Or maybe you found a niche small enough that it doesn't get a lot of attention from professional analysts, and you can make a little bit of money at it. That might work!
4. Being the first one to take into account a new idea or source of information. This one will make you wildly rich, and it's fun to dream, but while you're looking for that brilliant idea, there's no reason to risk real money on your ideas-in-progress.
[+] [-] nandemo|15 years ago|reply
"News" is any new information that affect the expected present value of a company cashflow. It could be a new product, a possible merge or macroeconomic indicator.
If you invest in an index fund, you're basically following the trades of those value traders. You won't make as much money as them, because often you'll be buying "good" stocks after they've already increased in price, i.e., by the time passive fund managers buy the "good" stock, the price will often have already incorporated the value of the good news. The same holds for the "bad" stocks.
[+] [-] blurry|15 years ago|reply
[+] [-] regularfry|15 years ago|reply
[+] [-] derefr|15 years ago|reply
Do programs on investment-bank servers perform this function?
[+] [-] bravura|15 years ago|reply
http://www.longbets.org/362
[+] [-] jules|15 years ago|reply
This argument is wrong? edit: it's like saying this about strategies of chess players, one group is using strategy A and another is using strategy B:
Chess players using strategy A are known to perform about average (by the nature of their strategy). So this new strategy, B, has to perform about average too.
This neglects that there are other strategies than A and B. The whole world is not either passive investors or hedge funds.
And he's saying something even stronger: there is no subset of B players that is better than average.
So while he may well be correct in his prediction, he makes it sound like he has a mathematically tight argument for why he is correct. But the conclusion of his argument (that active investors will perform about average) is not the prediction of his bet (that hedge funds will perform about average, and because they have higher operating cost they will lose).
[+] [-] philfreo|15 years ago|reply
Index investing (applied to extremely wide market indexes) makes an assumption that there will be a continuous and infinite increase in the total market capitalization of that index. As time marches forward I beleive we will experience a deceleration of worldwide market cap increase.
Anyone have thoughts on this?
[+] [-] SkyMarshal|15 years ago|reply
I forgot what year he wrote that, but it was sometime between 2006 and now. I don't have time to dig it up and find it, but here are his letters for anyone interested:
http://www.berkshirehathaway.com/letters/letters.html
Edit: Got myself curious, had to find it. Here it is, from the 2007 letter, ps 18-19:
"Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.
The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.
This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been. How realistic is this expectation?
Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.
Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.
It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?
Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high-priced managers (“helpers”).
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double- digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees."
[+] [-] paraschopra|15 years ago|reply
Moreover, the investment psychology also comes into play here. The growth rate of index may slow down as it becomes large because investors always compare today's index with the previous values and are likely to conclude that the index is "over-valued" if it keeps rising.
I'll be curious to find evidence of deceleration as the index value rises.
[+] [-] akg_67|15 years ago|reply
1. How much of the underlying stocks, that make up the Index, are really owned by the Index fund/ETF? I doubt that such funds/ETF actually own 100% of the required underlying stocks, may be using some sort of option/hedge strategy.
2. In what scenario, not owning the actual underlying stocks can be detrimental to index fund/ETF? I am looking for what may cause failure of such funds/ETF and who may lose.
3. Is index fund/ETF investing artificially inflating price for underlying stocks compared to price of the rest of the non-index stocks in the market?
4. Can index investing cause Index "Bubble"?
[+] [-] cynicalkane|15 years ago|reply
1) The world is getting bigger over time.
2) The world's industry, per capita, is getting more valuable over time.
3) Even if the first two were untrue, there is still a time value to money. People will spend capital to get value immediately, and investing is the opposite of that.
[+] [-] e40|15 years ago|reply
A friend and I talked about this 20 years ago when 401(k)'s became the rage, lamenting that we were on the wrong side of the boom.
[+] [-] wazoox|15 years ago|reply
Financial markets can't beat the real economy forever. As a bet on the future growth, they must return to reality from time to time. Furthermore, as growth as we've known it will most probably soon end forever (or for the long term at least), financial markets are on for some future "correction" of humongous proportions when the sovereign debts will be wiped out by inflation.
[+] [-] eru|15 years ago|reply
Look at the DAX index, it includes re-invested dividends, and thus mirrors the actual performance of a passive-investment strategy better than a pure-stock price index.
[+] [-] jeffmiller|15 years ago|reply
[+] [-] jasonkester|15 years ago|reply
Index funds were as widely adopted as you could ask for back in 1996 when I first started investing in them. And it was common knowledge even then that the S&P 500 tended to outperform 70%+ of managed mutual funds.
If that's the message this article is trying to convey, it certainly has the wrong title.
[+] [-] adamjernst|15 years ago|reply
[+] [-] jerf|15 years ago|reply
I also find myself pondering the macroeconomic effects of a lot of the market simply being in index funds, though I'm sure we're a long ways from that.
My personal rule-of-thumb "By the time you've heard of it, it's too late to get in on it" is also triggering, though I have to admit for the life of me I really can't imagine how to exploit this tendency. But I am anything but a financial wizard.
[+] [-] patio11|15 years ago|reply
[+] [-] a5seo|15 years ago|reply
If you want optimal as in mathematically optimal fund selection, then Bill Sharpe's startup, Financial Engines, does that (if you have at least $100k at Vanguard, you get it for free, also through many employers). https://personal.vanguard.com/us/insights/retirement/financi...
[+] [-] michaelkeenan|15 years ago|reply
[+] [-] JSig|15 years ago|reply
[+] [-] sram|15 years ago|reply
[+] [-] kevinburke|15 years ago|reply
[+] [-] antareus|15 years ago|reply
[+] [-] eru|15 years ago|reply
In the US has some low fee index funds. In Germany I used an ETF of max-blue.
Just find a low fee diversified index fund, and then get back to your normal work. (Unless you enjoy playing the stock market, than there's nothing wrong with active investment. Just as some people enjoy playing the lottery (only the expected value of active investment isn't as dismal as playing the lottery).) Benjamin Graham's "Security Analysis" is a good primer, if you really want to get into stock or bond trading, or are just interested on an intellectual level. It's a hard book.
Make sure you use a tax efficient way to invest. If you can invest with pre-tax money, do so.
[+] [-] wrs|15 years ago|reply
[+] [-] JSig|15 years ago|reply
Check out http://alphaclone.com/
You have to pay for a membership but the site is top notch. They parse investment fund's sec filings and allow you to backtest strategies to see how well they would have performed over a given time frame. You will find strategies that crush any index fund.
I am not affiliated with alphaclone.com.
[+] [-] eru|15 years ago|reply
[+] [-] jteo|15 years ago|reply
http://en.wikipedia.org/wiki/Renaissance_Technologies
[+] [-] jedc|15 years ago|reply
1) They're a huge, huge outlier
2) Any of Renaissance's funds are not nearly as scalable as a passive index fund
3) As a hedge fund will still take a big chunk out of returns as fees
[+] [-] ladyada|15 years ago|reply
[+] [-] dschobel|15 years ago|reply
[+] [-] rorrr|15 years ago|reply
[+] [-] GFischer|15 years ago|reply
"a list of advantages of active management, which essentially boiled down to the fact that it’s more fun"
also:
"There is an innate cultural imperative in this country to beat the odds"
and the stock market is viewed as better than casinos for this kind of gambling.
[+] [-] by|15 years ago|reply
If you had a fund that did not sell anything and bought a random stock from an index as funds came in would this beat an index fund?
[+] [-] hnhg|15 years ago|reply