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How to Win the Loser's Game

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How to Win the Loser's Game, Part 8

October 15, 2014
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Index funds are by far the best option for the average investor. But is there ever a case for choosing an actively managed fund?

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Part 8, Transcript and References

Last time on How to Win the Loser’s Game…

Nobel Prize-winning economist Eugene Fama says: “There isn’t one strategy that’s optimal. There’s a whole spectrum that’s optimal. There’s a whole spectrum.”

Stephen Thomas from Cass Business School says: “Is there a better way of constructing a portfolio? Is there a better way of constructing, if you like, an index?”

Professor John Cochrane from the University of Chicago says: “What is the risk? Why are some people not willing to bear that kind of risk? Why can I bear that risk? is a good place to start thinking about these alternative betas you want to invest in.”

Before moving on, let’s briefly summarise.

Mathematically, after costs, the average returns of a passive investor have to exceed the average returns of an active investor.

The market cap-weighted index reflects the consensus view of the market and therefore is the ideal starting point for a passive investor.

But the cap-weighted index isn’t perfect and, depending on how much risk they’re prepared to take, investors may want to tilt their portfolios towards other types of risk, or beta, such as small company or value stocks.

Beta, as we’ve said, is a measure of overall market risk. But what about alpha? that’s the name given to any return provided by a fund or an individual security over and above the benchmark index.

First and foremost you should be indexing. Alternatively you could tilt your portfolio towards different types of risk.

But is there ever a case for chasing alpha - either by choosing stocks yourself or by employing an active fund manager?

Professor Ken French from Tuck School of Business says: “That’s a great question. Does it make sense for the average investor to invest in an active fund? What I know is that the active investor who does invest in an active fund has to expect to lose relative to a passive strategy. Why do I say that? What I know is if an active investor chooses to overweight some stock then at least, one other active investor has to underweight that stock. One might win by overweighting, if he wins, he loses by underweighting. So it’s a zero some game before we start thinking about costs. And what I expect, what we see over and over again, is that active trading costs money and active managers charge a lot for their services. And notice, one of them might have been brilliant. But to the extent that one of them is brilliant, another person must have been whatever the opposite of brilliant is here… Minus brilliant.”

Professor John Cochrane from the University of Chicago says: “I take a dim view of active management. For any investor to invest, you have to understand why the person you’re giving your money to is in the half that’s going to make money, and not the half that’s going to lose money. What’s special about him? What’s special about you that you know how to evaluate him? Somebody has to have some skill. There’s evidence on how much skill there is out there… How many good managers are there? How many bad managers are there? And it’s really depressing. If you don’t know what you’re doing, don’t step into the casino.”

So, let’s be clear about this. All the evidence is stacked against active fund management. But, say for example, in spite of everything our experts have said, you still want to take a gamble with part of your portfolio, how DO you choose an active fund from the thousands of funds available?

Daniel Godfrey from the Investment Management Association says: “Well certainly not just by looking at past performance. A consumer would need to do a number of things. Firstly they can just offset the decision-making altogether and go to an independent financial adviser, and many do. And they will select funds for them, and that may be a mix of active and passive funds, and that’s a perfectly sensible thing to do. But they may also, if they wish to make decisions for themselves, they may wish to look not only at managers’ track record, but to actually read about what they say about themselves, their style of choosing stocks and to read what people say in the media about them.”

Bill McNabb from Vanguard says: “What they want to look for are generally broadly diversified portfolios. They want to look at the portfolio manager and the company behind that portfolio manager, and make sure that they’re long tenured, that they have a consistent process and consistent philosophy. You don’t want people who change their stripes every couple of years or every market cycle. The other thing you want to look at is what price you’re paying. Morningstar did some really ground-breaking work a couple of years ago where they found the best predictor of future performance is actually cost. So if you get the right manager, with a long-term philosophy and a consistent philosophy, and you have a low-priced portfolio, your chances of actually performing as well or better than the index go up.”

An example of a fund management company that does take a long-term view, and which keeps costs down by trading less, is Edinburgh-based Saracen Fund Managers.

David Keir, Head of Research at Saracen, says: “I think in the old days, everyone tried to take a long-term approach. But it feels with the advent of hedge funds, quarterly numbers, that a lot of the financial industry has been getting caught up in the short-term noise and volatility caused by quarterly results and news flow. We try and strip that out and actually take a long-term view. What we do here is we forecast out five years, which is much longer term than the market does, and we try and take advantage of identifying opportunities.”

Statistically, small funds like those run by Saracen, tend to perform better than very large ones. And their managers are more likely to invest their own money in them, which is always a good sign.

Chief Executive Graham Campbell says: “With many of the large firms, the managers aren’t aligned with their investors, because they’re paid by bonuses from performance, not for how well the fund does directly. One thing that Warren Buffett certainly has is a huge amount of his own personal savings involved with his fund, and investors should always consider, Is the fund manager aligned with them as much as they should be?”

Also, remember the benefit of having exposure to different factors of risk.

Value investing is particularly worth investigating - as are the writings of the man usually credited with founding it - the British-born American academic and professional investor Benjamin Graham.

For an insight into Graham’s investment philosophy, we visited the university where he studied and taught - Columbia in New York City.

Professor Bruce Greenwald from Columbia Business School says: “You’re looking for cheap, ugly, disappointing, obscure and otherwise orphaned stocks. Portfolios formed on those bases significantly outperform portfolios of glamour stocks. And I think there are three fundamental human characteristics that account for the persistent outperformance of those portfolios. The first is that people will systematically overpay for the dream of getting rich quickly. And that’s why these glamour stocks get overvalued, and remember, the average return has to be the average return on all stocks. People who specialise in the glamour stocks are going to underperform the market, and so staying away from them will benefit you. The second thing is that people don’t like to look closely at ugly. The behavioural finance name for this is loss aversion. And if you look at these portfolios of cheap stocks, two thirds of them go bankrupt. But the ones that don’t do so well that the portfolios of these stocks substantially outperform the market. The third thing which I think cements the first two effects is that humans are not good at dealing with uncertainty. And therefore when they think about situations they try and assume the uncertainty away and are over-confident.”

Like Bachelier, Samuelson, Sharpe and Fama, Graham’s aim was to take the guesswork out of picking stocks. He famously inspired one of his pupils, Warren Buffett. And Buffett’s subsequent success is testimony to the validity of Graham’s approach.

Buffett has described Graham’s book The Intelligent Investor as by far the best book about investing ever written.

In it Graham wrote that investment is most intelligent when it is most businesslike,

In his preface to the fourth edition of the book, Buffett said:

The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.

Next time on How to Win the Loser’s Game…

Merryn Somerset Webb, Editor-in-Chief of MoneyWeek, says: “All sorts of things work, but they only work if you stick with them. And the problem that active managers have is that it’s very, very difficult for them to stick with any kind of style.”

Vanguard founder Jack Bogle says: “Why in the name of peace do we pay any attention to the stock market?”

Igors Alferovs from Barnett Ravenscroft Wealth Management says: “When it comes to investor returns the media is definitely a bad influence on the retail investor.”


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