Last time on How to Win the Loser’s Game…
Art Barlow, Vice President of Dimensional Fund Advisors, says: “Really the cornerstone of all what we call Modern Portfolio Theory rests on this idea of diversification.”
Ken French from Turks School of Business says: “We happen to know that small stocks tend to move together and big stocks tend to move together, and then we also move value stocks: something where it was a fundamental of the company divided by the price. Those value stocks tend to have a higher average return than growth stocks.”
Professor Fama from the Booth School of Business in Chicago says: “Will there be factors in the future? Possibly. A model stands until it doesn’t stand anymore - until a better on comes along.”
So, how can ordinary investors apply the academic evidence - the lessons learned from more than a hundred years of rigorous research? How can they apply that to achieving their financial goals?
Well, this might sound dramatic, but the work of Louis Bachelier, and of Nobel Prize-winners like Samuelson, Sharpe and Fama, should make us question almost everything we thought we knew about investing; and almost everything the financial industry and the media tell us we should be doing.
Most of all, the evidence should make us extremely wary of anyone who claims that they have the knowledge to beat the market. Because markets are fundamentally efficient, consistent outperformance is almost impossible.
So, instead of paying large sums in fees to active fund managers to deliver average returns, we should invest instead in passive funds that simply track an index at a much lower cost.
Ultimately, though, it’s not about theories or intellectual arguments at all. It all boils down to simple mathematics.
Nobel Prize-winning economist William Sharpe says: “Think about all the securities in a marketplace and think about a strategy of investing proportionally, or broad indexing. If I have 1% of the money in that market, I’ll buy 1% of the stocks of every company in the market and I’ll buy 1% of the outstanding bonds. So I’ll have a portfolio that truly reflects the marketplace. Then think about all the people engaging in other strategies, active strategies, holding different amounts of this or that. Then you ask at the end of any period - be it a year, a month, you name it - What did the passive investors earn before costs? And let’s say that’s 12%, just to take a number. What did the active investors make before costs? It has to be the same number. So, before costs, the total market made 12%, the indexers made 12% and the active investors made 12%. After costs is a different story. A well-designed index fund should have a very low cost of management. It should also have very low turnover, very low transactions costs. Actively managed funds by their very nature have higher management fees, they employ more skilled people. They also have transaction costs because they’re active. So, after costs, the average passive investor must outperform the average active investor. That’s just arithmetic.”
Despite the mathematical superiority of passive investing and the welter of empirical evidence supporting it, the industry has constantly tried to discredit it. When Vanguard introduced its first index fund in 1976, the idea was slated.
Vanguard founder Jack Bogle says: “The head of Fidelity said their shareholders would never settle for average results - they expect to be superior. A famous poster came out in Wall Street - Stamp out index funds: they’re un-American, and there was Uncle Sam with a cancel stamp bam bam bam bam bam cancelling all the stock certificates. Among the many claims: you wouldn’t settle for an average brain surgeon, if you needed brain surgery, so why would you settle for an average manager, as if there is any relevance to those two different things.”
It was Bogle who had the last laugh. Vanguard now has more assets under management than any other company in the world - including Fidelity - which, incidentally, is now the second biggest provider of index funds.
And yet, even in the United States, where passive has a bigger market share than in the UK, active remains by far the most popular way to invest.
Professor Fama from the Booth School of Business in Chicago says: “I laugh because I have been telling the same story for 52 years now. We’ve gone from zero passive investing up to about 20% or 30% in the US markets, so penetration is very slow. What I like to remind people is that active management is a zero-sum game before costs.”
Vanguard CEO Bill McNabb says: “The cost argument, from an investment perspective, is counter-intuitive. If you think about your life in other areas, if you’re out buying a car, you can buy a Rolls Royce or an inexpensive Hyundai - you’re going to feel a difference in the car. Whether it’s worth that price huge differential to you, only you as the buyer can make that decision. But you are definitely going to feel that there is a difference in quality in terms of durability and so forth. In investing, that equation does not hold. When you think about the average investor, who is also a consumer and they are used to ‘the more I pay, the higher the quality, typically the better the results I get’. You come to investing and that is just the opposite, and that is a really hard behaviour for people to un-learn.”
Perhaps surprisingly, another longstanding advocate of passive investing is the most famous active investor of all. Warren Buffett once said: “When the dumb investor realises how dumb he is and buys an index fund, he becomes smarter than the smartest investors.”
More recently, Buffett gave this instruction to the trustee of his estate: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost index fund. The long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
Larry Swedroe from Buckingham Asset Management says: “Warren Buffet is sort of a contradiction here and so people take what they want to hear from Buffet and the contradiction is this. Clearly Buffet believes the Efficient Market Hypothesis isn’t correct and he himself and said if it was true I wouldn’t be here and people like me and Charlie Munger would not get the great results. On the other hand Buffet has told people in advice in his 1996 shareholders letter, he’s said to people, he said the following. If you invest in an index fund you’re virtually guaranteed to outperform the vast majority of investors both institutional and individual, virtually guaranteed. Now it’s only virtually guaranteed because he doesn’t know if you’re gonna be able to stay the course, if he knew you’d stay the course which is the second part of it, he would say that it is guaranteed, it’s simple math, passive investors must outperform active investors in aggregate because they have less costs. If you look in the mirror and see Warren Buffet or maybe Charlie Munger or Peter Lynch go ahead and invest and try to pick stocks and beat the market. The rest of the world looking in the mirror doesn’t see such a sight and then I would suggest that you should follow Buffet’s advice and you should invest in index funds and other passively managed funds.
In recent years, even the great Warren Buffett has failed to beat index funds after costs. It’s not surprising then that fund managers themselves are starting to acknowledge that this really is a losing game.
John Redwood from Charles Stanley Pan Asset says: “I think I realised it years ago when I was a full time active investment manager, and there were times when we could beat the index, we made the right calls and it was very satisfying but is extremely difficult to sustain it year after year and the more research I did into it the more I realised there were very few people who were able to sustain our performance sufficiently to cover all the other costs of active investing. So I gradually came to view that a fund should have rather more in index tracking than was then common I think in those days I favoured a mixture. More recently, the more I’ve looked at the build-up of numbers the more I think it’s very difficult to find those star managers who are going to win, and there’s always the danger that they had a very strategy that works for two, three, five years, you then buy in because you’re persuaded and that may be just the point where that strategy start to go wrong through no particular point of their own. Fashions come and go, and quite a lot of so called stellar manager performance is just being on the right particular theme at a time when that’s popular in the market.”
So, the fund industry won’t tell you this - it has far too much to lose by doing so - but by far most appropriate investment vehicle for the vast majority of investors is the humble index fund.
No, it’s not perfect - we’ll explain why later. And although it’s a relatively simple way to invest, requiring very little maintenance, there are still some very important decisions for index fund investors to make.
Somerset Webb: “There is really no such thing as passive investing because you have to choose where the money is going to go. Somebody has to choose whether the money is going to be in Japan or South America or Russia. Those decisions have to be made; those are active decisions. Then once you have made those decisions you are choosing the ETF or you are choosing the tracker, and in doing that you are choosing a strategy.”
There is another, much bigger, issue that needs to be addressed. Passive, as we’ve heard, is still far less popular than active investing. But what if it continues to grow? What would happen if, eventually, most people invested passively?
John Cochrane: “Here is how perfect world of the Chicago efficient markets theory of finance works. We all get religion and we all just index. And then one guy thinks oh, you know what, the new iPhone is great, I’d like to buy Apple. Apple is only say $500 a share. It’s worth $1000. I’m going to buy some Apple. So he says hey guys I’ll buy your apple I’ll offer you $600 a share. And we say we’re just indexers we’re not going to alter our market. You must know something we don’t know, so we’re going to hold Apple in it’s market weight. How about $700, we’re just indexers and then finally he bids the price up to the $1000 a share. In the ideal world, and this isn’t the real world, if we all indexed we would never loose to the active managers, because we would never sell and they would just bid the prices up so prices reflect the information. You can see the hole in this story. The active manager should go and drive a cab. He is not earning any money. Our world is one in which active managers do trade and they trade and make money and bring the information in. The big puzzle is who trades against them? For those of us who don’t know anything, why don’t we defend ourselves just by indexing?
Next time on How to Win the Loser’s Game…
Nick Blake, Head of Retail, Vanguard Investments UK, says: “I think that the name is unfortunate in that it seems to suggest that it’s a smart outcome, when in fact smart is a requirement when it comes to Smart Beta.”
David Swanwick, Regional Director, Dimensional Fund Advisors, says: “The best question that an investor can ask is where do returns come from, and no one has studied this more deeply than the academic community.”
John Cochrane, Professor of Finance, Booth School of Business, says: “What is the risk, why are some people not willing to bear that risk, why can’t I bear that risk is a good place to start thinking about what are these alternative betas that I want to invest.”