I'm a big believer in index funds and have been putting my money into them for a long time. But... you have to wonder where this is all ending up as more and more people move to passive index funds. The power of the market is based on millions of individual opinions on the price of a company's stock. On average, over time, these collective opinions will be correct. But say in the extreme case, it got to the point where all funds were invested passively, we'd lose this pricing mechanism. Individual stock prices would not reflect the true value of a company. Instead, the price of each company's stock, healthy and sick alike, would just rise and fall in synch with the market as a whole. But then perhaps this would be self-correcting as sophisticated investors would notice the pricing errors, create managed funds and the cycle would start anew...
Warren Buffett says it's OK, and has an excellent explanation for this. If I recall correctly: imagine you take all the investors in the US economy and put them in a room. Divide the room in halves. One side contains all the active investors, the other side contains all the passive investors. If each side owns roughly half of the economy, their returns will be equal. In that case, it's better to sit on the side with the lower fees... so one should naturally sit on the passive side.
Setting Warren Buffett aside, what you neglect to mention is that the stock market is both a primary and secondary capital market. We can speculate about how to speculate... whether to be passive or active... but this concerns only the functionality of the secondary market. There's still primary market functionality: companies issue stock to raise capital, buyback stock, and issue dividends. Thus, even if all the investors are passive, there's still always one active agent in the game: the company itself. And a capitalization-weighted index is ideally suited for this activity: it automatically shifts capital away from companies buying back stock (essentially, companies returning money to investors) to those issuing new stock (essentially, companies seeking to raise capital).
Precisely by being an investor in the old sense, the sense of being a businessman who allocates capital. He buys entire companies based on his analysis of their financials and management, and then operates them as businesses. He tries to take stakes in companies in deals where he holds an advantage, such as his Goldman Sachs investment. I don't consider him a stock picker, he's a very shrewd businessman.
He's absolutely a stock picker, not a businessman. That's the definition of value investing, which is his self proclaimed mode of investment. He looks for undervalued (by the stockmarket) companies with good cash flow, competent management, room to grow, etc. and waits until the market price catches up to his expectations. Meanwhile, he leaves the management alone to do their best work while reinvesting the cash flow (from dividends) into other undervalued companies. Most financial institutions were probably undervalued after the 2008 collapse so if Buffet saw an undervalued cash flow positive business, that's why he invested.
Berkshire Hathaway is more involved and hands on than mutual funds. They don't really micromanage, but they do at least a little bit of basic management.
Buffett made most of his money in deals that were nothing like the Goldman Sachs arrangement. Very few of his big returns provided him any special advantage like that.
His biggest returns for the first 3/4 of his adult life involved him going against the market when equities were out of favor and scooping up extremely large positions in the likes of The Washington Post, GEICO, American Express, Wells Fargo and Coca Cola.
His extraordinary history of stock picking is what enabled him to begin buying entire substantial businesses in the first place. The stock picking is what accumulated the capital necessary to buy Blue Chip Stamps and See's Candies. The Buffett partnerships for example were not built around buying up entire businesses and operating them for decades to reinvest the cash flow, and yet his returns were dramatic - regularly stomping the Dow - during those years precisely because he was such a great stock picker.
Buffett does very little business as you describe. He takes no real active role in the companies which he purchases and definitely doesn't "operate" them.
The advantage he had in the GS preferred stock offering in 2008 was his ability to provide liquidity and his name - if GS told people that Warren was investing in them then it was a real vote of confidence.
Buffett's main argument against the hedge funds was that their fees are too high and services too poor rather than active investment never works. He started running the Buffett Partnership which was basically a hedge fund and did great for his investors and charged modest fees by modern standards - zero on the first 6% of return and 25% above that. Try finding a modern fund that doesn't charge anything if they only make a 5% return. Your typical 2 and 20 fund would charge 3% out of the 5 splitting the real return after inflation approx 100% to the manager and 0% to the investor.
True, but he (and Munger) generally invest quite conservatively. He doesn't buy for capital gain, but to hold indefinitely. He buys businesses he understands, with financials he understands, for prices he figures reflect a fair discount on the economic value, plus a generous margin of error.
When full ownership is taken (his preferred option), the original management is almost always left in place. No rules or guidance are given. The subsidiaries work however they worked before acquisition.
That said, after reading through his 50 Berkshire Hathaway letters, the main lesson I drew was: own insurance companies which underwrite for profit under all economic conditions.
> True, but he (and Munger) generally invest quite conservatively. He doesn't buy for capital gain, but to hold indefinitely. He buys businesses he understands, with financials he understands, for prices he figures reflect a fair discount on the economic value, plus a generous margin of error.
The Bank of America deal shows how good a deal you can get when you can put $5B where your mouth is
> In exchange, Berkshire Hathaway received $5 billion worth of preferred stock yielding 6% a year plus warrants to purchase 700 million shares of Bank of America common stock at an exercise price of $7.14 per share.
Right. In fact the financial crisis was a busy few years for Berkshire-Hathaway. Like everyone else they took a drubbing, but they also unleashed a lot of their unused cash to make deals on generous terms.
It helped that they were structurally inclined to build up cash. As Buffet explains, a booming share market is bad for him: everything is too expensive to buy.
So cash piles up, waiting for good deals of sufficient magnitude to arise.
When a bust arrives, there are bargains everywhere and a lot of money to buy into them.
Investing successfully is all about adding value. Buffett is an active investor, but he makes his money managing the businesses, not just picking stocks.
Warren Buffett was referring to traditional (long-only) investment funds...
He himself was for many years running a hedge fund (and had learned from the pioneers of hedge fund investing.)
imagine you take all the investors in the US economy and put them in a room. Divide the room in halves. One side contains all the active investors, the other side contains all the passive investors. If each side owns roughly half of the economy, their returns will be equal.
Won't the "tracking fee" of the index funds keep increasing, as a larger and larger fraction of the market is covered by them? Whenever a stock rises to X$, billions' worth of index funds will rush to buy the stock to rebalance their holdings, but clearly that should further raise the price of the stock (and they'll have to buy it at X+0.10, or X+0.50).
Cap-weighted funds (like anything tracking the S&P 500) already hold the stocks in comparison to their market cap.
If a stock goes up, they don't need to buy more of it - the value of the shares they hold will increase to exactly the right proportion that they should have.
(There do exist other types of funds which try equally weight the stocks they hold, which means the fund has to rebalance when the stocks change price.)
Typically, cap-weighted funds only have to rebalance when individual members of the fund buy/sell - and they try to make it so people are buying/selling to those within the fund where possible to avoid having to do even that. The result is a very low churn, which is part of why index funds have lower fees.
Usually, the more assets an index fund has under management, the lower an index fund's fees get.
That makes sense, thank you. Where does the tracking fee come from then?
EDIT: and doesn't my above argument hold at the boundary? When a stock is brought into the S&P, suddenly all of the index funds need to stock up on it, further bolstering its price, no?
Fees come from the transaction costs of having to buy/sell shares (churn is low but non-zero), operate websites, paying salaries, running customer support, doing tax paperwork, etc. Not much magic there.
You're correct about what happens at the boundary, yes.
There's a well-known arbitrage opportunity for stocks that are known to be about to be brought into the S&P 500 (their prices DO tend to increase, I believe), if you want to research that. Like all publicly known arbitrages, I doubt you can make any money off it personally anymore though.
This is part of why the recommendation is not to use an S&P 500 fund, but something more like Vanguard's Total Stock Market fund, which includes medium/small-cap companies. Not that it's a huge deal, though - mutual fund companies are usually pretty clever about spreading large orders out over time.
"owns roughly half of the economy" is doing a lot of work. It's not necessarily true that the choices that active investors make average out to be roughly equivalent to the choices that passive investors make. Like, the active investors could very well own the better-performing half of the economy, because they put in the work to figure out what portion of the economy is actually worth more than the market thinks it is.
I seem to recall a claim that companies no longer issue stock to raise capital. Instead they issue bonds, much the same way as a government or municipality.
True, but we are having a lot less IPOs lately: We see companies with valuations well in the billions, venture backed, that aren't IPOing. We are seeing non-public companies writing contracts with dual-trigger RSUs because options have become completely worthless.
So while it's still possible to raise capital by printing stock, this is happening less and less lately.
It gets easier and easier to beat the market (due to less people trying) until eventually investors can make enough money doing that to earn the fees they charge for trying. There's an equilibrium when that happens.
EDIT: Or, to put it in EHM analogy terms, the number of people looking for loose change on the sidewalk will go down until there are few enough to support themselves from the money people actually drop.
The other thing to keep in mind that index funds slice and dice the market in many different ways. The classic "Index 500" fund is a market-cap weighted fund. But there are many other types of funds. For example, Vanguard has 62 different index funds. And there are fundamental weighted index funds which, "...may be based on fundamental metrics such as revenue, dividend rates, earnings or book value". (http://www.investopedia.com/terms/f/fundamentally_weighted_i...) There are funds which take different selections of the market (top 1000 stocks or top 100 stocks, etc).
So somebody might purchase an index fund and think they are investing passively, they are really actively choosing a passive strategy.
In any auction, there has to be the first person declaring what the item is worth. If 100% of the investing is passive, there is no first bidder, so how is a stock's value determined?
In the current situation, 34% of the money passively follows the active investors. That gives the active investors a 34% amplifier in their action.
I'd say the possible bad news is that the larger the passive pool, the less capital it takes to manipulate a stock price.
This is exactly how it will balance out. If this passes a threshold such that funds that take advantage of the phenomena will produce a meaningfully higher return than index funds then money will start flowing into such funds balancing out the effect.
Not just actively managed funds. There will always be proprietary traders speculating with their own or their employer's capital. As long as some kind of active investors make up ~10% of the market that will be sufficient for price discovery.
I don't understand how this is supposed to work. Won't active investing still be a zero-sum game? So on average won't they still be making the same as indexers?
Ned Johnson had it right way back when. Why would anybody want average returns when they could pay him big money for below-average returns and the occasional black-monday disaster?
Seriously, index fund investing assumes an optimistic outlook. It assumes the managers of companies will do an OK job in the long term and the companies will grow. Index funds allow investors to participate in that growth without having a big chunk of it going into Mr. Johnson's pocket. A low fee burden turns OK company performance into acceptable retirement savings growth.
It's not a zero sum game. It's a slightly-positive-sum game. That means a lot of people can play and slightly win.
As for pricing the equities, the fundamental qualities of the businesses behind them are, even in the stock market casino of the 21st century, still important. Warren Buffet understands fundamentals. There's no reason a market dominated by index funds must ignore them.
There are two other aspects of successful index investing.
1. Diversification. Don't put all your money in one index. What if you have all your money in the NASDAQ index when the cultural narrowmindedness of Silicon Valley (the rule of young white brogrammers) catches up with them?
2. Disciplined rebalancing. Set a goal for diversification percentages: 60% growth equities, 20% growth-and-income, 10% nonUSA, 10% bonds for example. When your investment values move away from those percentages, sell the excess in one category and reinvest it in the other categories. This amounts to buy-low sell-high. It will serve as a ratchet to capture the upside and limit the downside.
Panic buying and selling is for the other guy. I'm grateful to that other guy; he's helped me set up a nice 401k balance.
Any good reading on how to determine your allocation strategy? I read up on Bogleheads but there isn't always much on the "why" that is backed by data.
There's plenty of good material on the top page of results on your favorite search engine.
It's more important to choose an allocation strategy and stick to it than it is to select the perfect allocation strategy.
Here's the hard part: determine your household's tolerance for risk. Are you willing to sit tight and not panic-sell if one or two of your funds decline by 40% in value? 20%? It's hard to know for sure how you will react until it happens. But, a decline like that means you should buy, not sell.
I mention "your household" because your spouse or other relatives might influence your risk tolerance. It doesn't matter if your anatomy is solid brass if your spouse insists on panic-selling. Part of the deal with risk tolerance is having conversations with family stakeholders about risk, to prepare for the inevitable downturn.
As the time grows nearer when you need to use the funds in your portfolio (retirement? college tuition?): reduce your stated risk tolerance once a year or so, and rebalance accordingly. This will help you lock in your gains even if something bad happens.
In the old, pre-junk-bond, days, "bonds" were considered lowest risk, "growth-and-income stocks" medium risk, and "growth stocks" highest risk. You can probably find index funds like those. Certainly you can find funds that invest in an index basket of low-risk bonds, or an index basket of dividend-paying (growth and income stocks).
"Unmanaged" is the key word to identify index funds. Vanguard, DFA, and others are the companies offering them.
One last thing: If you don't understand a fund's strategy, DO NOT INVEST IN THAT FUND. If the promises seem too good to be true, well....
There are _always_ investors trying to beat the market on fundamentals, even if many of them are just overconfident. We'll never got to the point where the entire market is index funds because, as more people invest in index funds, the possibility (and pay-off) of actual alpha by picking stocks rises. This isn't sustainable because people will notice the sustained performance difference between stock-picking and index funds (the same way we do now) and the opposite tendency will push things back towards an equilibrium
I think you're correct on your last statement; anytime there's predictability introduced into a system, there's going to be a counter-action you can perform to exploit those tendencies.
Well, you've always got insiders in the sense that most people know their own industry better than they know other industries. Passive funds are great when you want to diversify or lack knowledge.
But for example I've got a ton of money in cryptocurrency right now, it's my field and I've got way better-than-average knowledge about some of the coins. This helps me make informed investments, and I've been able to beat the passive rate by doing high risk investing into assets that were obviously priced incorrectly.
I'm not a day trader. I'm like the guy who goes about his way normally, but isn't afraid to pick up $20 off the ground when I see it. I spend some time looking for it, but it's not where I put most of my energy.
Can you expand on how having better-than-average knowledge about some crypto currencies allows you to make money investing in them?
I doubt you mean that you actually have knowledge of when and how the price is going to change. Are you just betting on a general increase in value, or doing some form of pairs trading or arbitrage? How comfortable are you with rapid 30% price swings?
I'm very comfortable with rapid price swings. My strategy is to buy when they are silly underpriced and wait. They may drop further but almost always if there's a good dev team it'll jump when they have big enough news. So you just wait.
I've yet to be bold enough to short something overpriced but there are plenty of cases where something has struck me as obviously overpriced and within a year the price has corrected.
Game plan definitely involves waiting months at a time.
Agreed - it's what the average investor should do. Even if it's really hard to beat Index Funds consistently, there are two factors that will make active trading always important:
1. Some people will beat the market, and regardless, someone has to try or there's a massive opportunity left on the table.
2. Indexing actually has more of a certain type of risk than passive investing, because if you take a huge loss for some period of time, you can't hedge it and cut the short term loss. You have to just hold. Active investing can be really valuable for folks as they enter phases of their life where big losses are unacceptable and they're willing to forgo some of the upside.
Your second point has nothing to do with indexing and everything to do with asset allocation. If you're nearing retirement, you shouldn't be holding risky assets like equities.
> If you're nearing retirement, you shouldn't be holding risky assets like equities.
That is not quite right. When entering retirement, most people can expect to live for at least 20 more years, which means they should hold a non-insignificant fraction of their wealth in stocks.
Further, those who find themselves in the fortunate situation of being overwhelmingly likely to leave a significant estate to their children should consider investing their funds according to the life expectancy of the children, not their own.
"The stocks were often described as "one-decision", as they were viewed as extremely stable, even over long periods of time.
The most common characteristic by the constituents were solid earnings growth for which these stocks were assigned extraordinary high price-earnings ratios. Fifty times earnings was not uncommon."
They are creating managed funds that make money, you can't access them. The problem with index funds is that a lot of the active capital is moving to closed markets.
So when the bogleheads endlessly debate the perfect portfolio mix, they miss the point that they have zero exposure to private equity and other markets.
Index funds are better than managed funds, and are mostly better than individual equities. That doesn't mean that 100% of your money should be in them.
There are companies which will fairly obviously perform well in the future. However, because of active investing, this projected performance gets priced in, so they aren't a bargain. If the whole world except one active investor invested in indexes, then the active investor would have a very easy time, since that projected performance wouldn't be priced in and the stock would be a bargain.
I'm not an expert, but index funds still purchase the stocks, so when the active investor bought a stock at an increased price, it would increase the market cap and so the index fund would buy some more of it from them.
Fair enough, for stocks the index already owned, but what about for the others? If the investor took a stock that wasn't in the top 500 and inflated its value above the 500th stock, wouldn't an S&P 500 index fund then buy it?
but that won't happen because companies will still have to disclose financials, and companies with poor fundamentals will be shorted by arbitragers. The pricing mechanism can never go away completely
Even if you would only have passively invested funds, you'd still have the pricing mechanism. Each index fund has an individual portfolio distribution and different rules of how to adjust it to market changes. Passive investing doesn't mean that there is no "active" part to it.
Furthermore, a great number of stocks won't be part of any index fund, hence you'd still have active investors (humans and/or machines).
Obviously day traders and fundamental investors still are doing their job to price each individual stock accurately.
This doesn't mean PASSIVE investors can't all do the same thing. In fact because risk over time is the fundamental reason passive investors make money, they can do exactly this. This isn't some loophole in the system. They are taking risk!!! It's amazing how many people don't understand this.
Simple. When everybody is in an index fund composed of the whole market, then everybody agrees their money ought to become more valuable and poof, so it is.
No. Fund shareholders do not get a proxy vote in the underlying stocks. Not with Vanguard or most large funds anyway. The fund votes. And the fund managers and analysts will have a lot more resources and information on their holdings than fund shareholders.
That being said, there are all sorts of problems with the incentives here.
> Individual stock prices would not reflect the true value of a company.
I would argue that this is already the case.
I invest solely in market-wide or top-75%-of-market-caps strategies (in stocks), because they're the only strategies that seem to accurately reflect my opinion of the markets:
1. The game is rigged.
2. People are dumb. (Especially me.)
Analysis of those strategies seems to indicate that they outperform even (traditional) index funds over long periods (likely because they're quicker to respond to risk/opportunity during transitional periods, eg, a new technology coming out). I like to think it's because my premises are true, but there's lots of other premises that lead to the same model of investing, so it's hard to say. (I think of them as a really diverse index fund, so at some level, it's really just the advice that Warren Buffet gave about long term investing.)
If everyone used this strategy the market would... basically do nothing once a company IPO'd, because everyone would hold a portion of every company forever (creating no selling once the initial bidding on IPO was over). That's not necessarily such a bad thing, because it would remove a lot of the noise that boards respond to while still incentivizing (healthy) long-term growth (because the only way the stock increases in value without trading and the current market gambling is from the underlying asset -- the corporation -- increasing in value, and distributing that as payouts or buybacks). There still is a valuation mechanism, however, because the passive funds do need to buy and sell when new stocks appear or someone is looking to change a position (which, is every IPO plus whatever is needed to generate cashflow from the portfolio), and how they negotiate that provides a value on the stock, even if they're just rolling shares they control between pools and clients of their own.
However, we'd still have the whole pipeline of pre-IPO private ownership, which definitely wouldn't settle in to the same kind of lock-in, but already uses the same kind of invest-across-the-board strategies.
So in short, I'm actually very unworried about the effects of main Wall St stock markets settling down due to most money being passively invested in long-term growth strategies, because it actually deincentivizes a lot of bad behavior on the part of trading firms. Much harder to execute your fraud if most people aren't going to react to it in any capacity, and won't be closing out their positions for 20-40 years, if ever. It's also perhaps easier to get a case to stick if you have basically every investor to choose a client from, because they'd all be impacted by those actions.
I suspect that if there is a big bond crash which is likely to happen a lot of those invested in index funds that robotically invested in bonds will be taking some big losses.
You're arguing against a strawman. Index funds do not protect you from market crashes, that's not the point and never was. Index funds save you from forking over tens or hundreds of thousands of dollars in fees to active managers who may or may not outperform the market as a whole.
Being lucky doesn't explain the existence of Renaissance Technologies[1], one of the very first quant fund companies, which has averaged a 71.8% annual return from 1994 through mid-2014. In fact, "the fund’s worst year was a 21 percent gain, after subtracting fees". Of course, it's very much of an outlier — just like Facebook / Google / Uber, if we retrospectively see startup funding and hedge fund investing.
Here's a couple of stand out items I cherry picked for no particular reason what-so-ever...
According to the Center for Responsive Politics, Renaissance is the top financial firm contributing to federal campaigns in the 2016 election cycle, donating $33,108,000 by July.[33] By comparison, over that same period sixth ranked Soros Fund Management has contributed $13,238,551.[33]
On 25 September 2008, Renaissance wrote a comment letter to the Securities and Exchange Commission, discouraging them from implementing a rule change that would have permitted the public to access information regarding institutional investors' short positions, as they can currently do with long positions. The company cited a number of reasons for this, including the fact that "institutional investors may alter their trading activity to avoid public disclosure".[32]
They may also play version of martingale strategy where they pay for higher returns now with increased losses if some rare event in the future happens. This is how very successful hedge funds can beat the market for decades. There is hidden risk somewhere and you better jump off before it is realized.
No, luck cannot be the explanation for what these quant funds do. These funds are run by mathematicians. People with PhD's in probability and physics. They are not being fooled by randomness. They are right, and they are right consistently.
However, they are also at least generally, not making traditional 'investing' decisions. They are making statistical arbitrage bets - they are looking for instances where mispricing exists in the market, and they can make a guaranteed (statistically) profit by buying and selling statistically equivalent securities at different prices. The classical simple example is pairs trading: you notice that coke is always worth 10% more than pepsi, so when you see coke trading at 15% more than pepsi, you short coke and buy pepsi, betting that the gap will close to its traditional norm. Now, what they are doing is obviously substantially more complex and rigorous than that, but that is its flavor.
Wow, this is the height of hubris. Of course luck can play a factor. There's no law of the universe that a correlation you observe over the past century of human activity is going to hold indefinitely. Obviously some quant funds have better models than others and it's not wrong to attribute that to intelligence and skill, but they absolutely can have the rug pulled out from under them by changing market conditions make no mistake.
They trade very, very often. You can be lucky if you buy a couple of stocks and wait around a few years. Someone I know had parents who bought Nokia in the 1980s and sat on it until the mid 200s. That's luck.
You can guess a coin flip 5 times in a row. A few people out of a hundred will do so.
But you cannot get significantly over 50% correct on millions of coin flips. That's not luck.
First of all, I explicitly said that it's not wrong to attribute winners to skill, but you still feel the need to put my argument in a binary box, very well.
Your mistake is treating each trade as an independent event. But in reality all those trades may share a single methodology which can be invalidated by a single unprecedented market change. Yeah, a fund is a perennial winner until it's not. You can call it being unlucky or you can say they went from being smart to stupid. It doesn't really matter what you call it, the point is past performance is no guarantee of future returns.
>>Your mistake is treating each trade as an independent event.
They largely are.
The people who fall under your criticism are the old school stock pickers. For instance, people who've grown up during the long decline of inflation and rates might have hit a wall over the last few years. A lot of those guys were essentially riding the same wave over multiple trades.
But the kind of trading done in stat arb is largely independent of such long term trends. They change around their positions so often that there's hardly any regime that they are biased towards. High vol? Been long and short. Rates going up/down? Been long and short. Economy? Been long and short.
Sure, there might be some hidden regime that we've yet to hear about, that's possible. But there's quite a difference between the quantitatively astute funds and the other long-lived ones.
Sorry, not drinking your koolaid. Any exploitable "stat arb" will go to zero as it's exploited, or if it grows large it will move the market. There are no statistical axioms which are guaranteed to make you money, because if there were it would change once enough people discovered it. Anyone that's far out enough ahead can find these things for a while, but there's no way the average investor ever gets close to it, they're not exactly cold-calling senior citizens with these amazing opportunities.
That's still using the past to predict the future. There's nothing inherent about coke and Pepsi being 10% apart - so they may have that ratio, until they don't.
I had a conversation with a co worker about this. Its basic probability. Lets assume they make at least 1 trade a day and they have been doing this for the past 25 years. Its a simple binomial probability problem. For them to be correct on that many trades and it to be 'luck' would be a probability in the ~0.00001% range.
That's the argument from A Random Walk for index funds: even if such skills exist, they're indistinguishable from luck, therefore one can't make an informed choice of active fund.
It's impossible to perfectly distinguish them. Anyone that seemed to be skillful could just be incredibly lucky.
But you can get determine a likelihood that they are lucky by monitoring their performance over a long time / lot of games. It's just that if you are evaluating a whole lot of people looking for a rare skillful person, you need a whole lot more time/games to be sure they aren't lucky than if you just had one person to evaluate.
I believe his point is that you can't, because "actual skills" need not exist. It might ALL be luck, and outliers will exist. And, their existence doesn't prove anything about luck or the lack of it.
Conversely, if the difference between luck and skill is unknowable, everyone who wins might be skillful. As you said, the existence of winners is not revelatory about the existence of skill.
Related: one can be highly skilled and still lose to someone who is highly lucky.
Believe me, Jim Simons didn't rely on luck. He's a mathematics genius and rather creative. You could say he was lucky in that he sort of pioneered the entire algorithmic trading thing and was well ahead of the curve because of that. It was simply low hanging fruit for a long time before others began to catch on.
Point is, could you have identified Renaissance Technologies in 1994 as one of the few companies to beat the market? If not, then your odds are better going with an index fund.
At this point, because of Renaissance Technologies' success, their fees will likely offset the gains they'll net you.
They still make you tons of money net of fees. However, because of their success, they very quickly attracted all the money they thought they could handle and closed the fund to new investors.
I think recently their performance slipped a bit and they started taking money again, but the above point was true for a long time.
Renaissance is a company which manages hedge funds. They're famous because their main fund, Medallion, has done exceptionally well. The only investors in Medallion are Renaissance employees; it's capacity is limited, so that even employees can't generally invest as much as they'd like. Renaissance also manages several other hedge funds, which have much higher capacity, and have both employee and outside investors.
The point of index funds isn't that at any moment in time no one can have a market beating strategy. The point of index funds is that by definition the bulk of the market can't have above average returns. So as a retail investor your best bet is to just find a cheap way to ride the average of the market.
True but some of my active funds correctly saw the problems with the UK banks and got out before the big losses an index fun would have had to buy those banks and taken the loss.
The saying is "a broken clock is right twice a day." Correctly reading and responding to market conditions is not sufficient. You have to do it continually.
And yet one of the assumptions of the EMH is that there are people who beat the market (using pre-public information), which is why you can't. The EMH is just saying that 31/32 teams will not win the Super Bowl.
Unless there's a version of the EMH that doesn't believe in the speed of light.
this company is like citadel, which is that their main business is market making and non-directional trades. They dont pick directional investments, as most investors do. rather they are in the middle picking up pennies, except many billions of them. But these returns may be exaggerated or there is information missing...20% a year far exceeds the rate capital is being created by the global economy. At that rate, it would eventually own the world and all markets. I think their actual returns, assuming the fund still trades (its operations are very opaque) are much less...maybe 5-6% year. The bigger a fund gets, the more impact its trades have on markets, which limits its size
Go over to Bogleheads and say that. They'll set you straight pretty fast. The point is that over a long enough period of time, there is no advantage to managed funds vs. index funds and the managed funds usually underperform. Some firms have played tricks with their funds to make them appear to beat the market, but it's never sustained.
Time travel. You land in 1990, you can either try to replicate netscape/broadcast.com/yahoo/google/myspace/etc coding your heart out, or you start an investment fund and let money snowball by picking obvious winners from memory.
As someone who's been at hedge funds for over a decade, I often wonder what I'd do if I just had ordinary access to the markets.
First of all, I have to ask why the equity market should be your benchmark. And if it's because you think the market generally goes up (not obvious) why don't you just get leverage on your ETF, so that you basically always beat the market?
There's another way to beat the market. Smart beta products do variations of it, but here's a concrete one. Basically my brother had some class about markets and needed something fast, so I just told him to take the S&P 500, lop off the top 25% of stocks measured by beta, and scale up the rest. Ta-da. You'll probably find costs are high, and there's a bunch of admin, but I suspect there's now a bunch of smart beta ETFs that do the same thing.
As for the EMH, I doubt that it's true. The problem for ordinary people is you won't be allowed to invest in strategies that are very good.
It makes sense for people on the inside: suppose I have a strategy, with a Sharpe > 5, that uses very little capital. What am I going to do with that? Get investors? No, I'll borrow money and take the profits myself.
What does that leave? A bunch of strategies with much less attractive risk profiles. If I have a Sharpe of around 1, I'm expecting long flat periods. I'll have to get investors for that. But investors are fickle. One bad year and they flee, even though you should have one every few years. You could easily have a couple of losing years with that kind of Sharpe. So what do we find with that type of shop? They're made of marketing. Box-checker salespeople who know what to say to institutional investors. IIs who buy IBM. Or are quick to jump the gun. /rant
It would be interesting to have a fund which was mostly an index fund, but avoided "losers" based on simple criteria. Picking overpriced losers is easier than picking winners. (I did that for the first dot-com boom, at "downside.com".) That's a concept worth testing against historical data.
I recommend Weathfront and Betterment to all my less mathematically inclined friends. However, if you spend only a few hours getting acquainted with asset allocation and rebalancing principles, you can do pretty everything that these services do without their fees.
Wealthfront is 3x (.25% vs .05%) more expensive than a lot of great Vanguard funds [1]. And with Wealthfront you might be investing in major index funds anyway except you end up paying more. Why not go with any of Vanguard's S&P 500 funds (mutual fund or ETF) or any other index fund of your choice under Vanguard? I doubt Wealthfront can beat their returns after you factor in cost in the long run (20+ years). Also Vanguard is owned and run by the shareholders, their entire structure is setup so that there is no conflict of interest and they really are on your side, since basically you are part of them when you invest [2]. Wealthfront is a corporation whose sole purpose is to turn a profit.
Right, which is why for people who are comfortable working out asset allocation, rebalancing, and TLH for themselves I recommend they do it themselves with low cost index funds.
One of the two companies actually says in their FAQ (paraphrasing): "Couldn't I just invest a small amount of money with you, then manage a second much larger account myself by hand, mirroring each trade? Yes, but we think our fees are cheaper than the time you'd spend doing that."
> There are no commissions when you buy and sell low-cost Vanguard mutual funds and ETFs.
> If you buy and sell the same Vanguard ETF® in a Vanguard Brokerage Account more than 25 times in a 12-month period, you may be restricted from purchasing that Vanguard ETF through your Vanguard Brokerage Account for 60 days.
That said, mimicking could entail more than 25 transactions per ETF per year. I don't know that we really have the ability to predict the number of trades that the robo-advisor will do from the outside though.
You're definitely correct, but also Wealthfront recommends Vanguard ETFs disproportionately for their value [1]. A glance at my personal portfolio tuned to the higher end on their risk scale shows ~30% Vanguard ETFs.
With enough money invested I find Betterments fees very reasonable. Especially when you consider features such as tax loss harvesting. Is that something that requires little to no time if you actively manage your index funds? Maybe there are tools which aid you with that?
Really the only thing you have to do is rebalance. I do it every half year, but some people even do it every two years. And it takes all of, maybe, 20 minutes. Of course, you need to grasp the principles, which takes reading a book or two, so that's, say, 10 more hours. With compounding over the next forty of fifty years, saving those 25 basis points or whatever it is that betterment charges over Vanguard's fees is not insignificant. It's not a ton, but totally worth an hour a year to me.
Oh, and I tax loss harvest at the end of the year if any funds are down for the year by the end of December. Again, this is maybe 10 minutes per fund. 5 minutes for selling a fund, 5 minutes for buying a similar fund (and making sure I don't get into a wash sale situation.) So, that's at most, say, 20 minutes a year.
The end of the year isn't the best time to capture tax losses. And where do you go to get trades with fractional shares for less than 0.25% in trade fees?
None, just put your money in an S&P 500 fund. I doubt you will be able to beat that in the long run anywhere else (Even though there are flaws w/ how the S&P 500 is run now [1]).
You can do better by diversifying more. By picking asset classes with a low correlation, you can reduce risk while increasing return. Hence, you can eek our more from a simple mix of say:
60% US
30% Int'l
6% REITs
4% Gold
All of this can be bought with low cost mutual funds.
Yeah, that is all fine a few decades back. But today we are experiencing huge bubbles caused by central banks.
Stocks are hyper-inflated by QE and near-zero rates. When all that stops it will pop violently. And sooner or later, they will have to stop. This affects bonds even more, of course.
For Canadians interested in learning about index-based investing I recommend the Canadian Couch Potato site[0]. If you don't want to put a lot of thought into it he has some sample portfolios, but also has a lot of resources for learning more. He's also very good about answering questions in the comments on his posts.
Me, I don't even believe in funds. If managers are not better than blindfolded monkeys, why should we even pay them? Just buy diversified stocks, and never sell unless you need cash.
Many funds don't try to outperform the market, but instead limit drawdown. That's because everyone is a huge fan of ETFs when the market is doing fine, but many people don't have the nerve to hold ETFs during a downswing. Thus these funds try to reduce losses during recessions at the cost of somewhat lower profits during booms. It's a valid trade-off, but if you have a long investment horizon and good nerves, then ETFs are probably the better choice. If you don't, you stand to make great losses with ETFs by buying high and seeking low.
I think it's much cheaper to buy ETFs compared to buying single stocks. Also easier to rebalance in a diversified portfolio. The key is to pay as little in fees as possible.
I don't think this conversation can really proceed in a sensible manner without the introduction of some numbers.
Retail brokers typically charge a commission per trade. If you want to buy many different securities ('cuz diversification), and you don't have a whole lot of money to invest in the first place, you're going to end up paying a large percentage of your initial investment in commission. The exact amount will depend on your broker and how much money you had to begin with, and how many stocks you're diversifying among. That means you might be starting from a fairly deep hole to have to dig yourself out of before you're truly earning a positive return.
By contrast, with ETFs you only have to pay commission on no more than a handful of trades to get a well-diversified initial investment laid out. Your expected earnings rate might be fractionally lower, but since you're starting from a much shallower hole, you might have a decent head start compared to buying a well-diversified portfolio individual stocks.
So then you've got two theoretical curves describing how your wealth might grow, and whether one is more favorable than the other depends on whether those two lines are likely to intersect at a point that comes before your investment horizon.
Then you can throw in still more complications that, IMO, can make ETFs still look quite a bit more favorable than stocks for most investors. One is that many retail brokerages (Vanguard, for example) will let you buy a selection of ETFs for zero commission. That's a gift that keeps on giving, since it dramatically reduces the cost of making smaller investments more frequently.
Another is that picking stocks is a time-consuming process - you have to spend time learning how to do it, and then you have to spend time researching stocks. If you agree that time is money, then you should probably be including some estimate of the value of your time into the formula. You want your expected returns from manually selecting a portfolio to be great enough to justify your time. Which is yet another calculation that is going to be heavily influenced by individual factors, particularly how much money you have to play with, what your current earnings are, and most importantly, whether or not you think it's fun to pick stocks.
> Another is that picking stocks is a time-consuming process
Just buy them all. Or pick them randomly. Let me remind you that this thread started with an article about the guy who wrote about the blindfolded monkeys.
It would cost $2500 in fees for me to buy a single share of every stock in the S&P500. Compared with $0 + some negligible MER to buy an ETF with the same money.
My guess is that he was being hyperbolic. But even if he weren't, you can still get something that has the same expected return over time as picking individual stocks at random for a much lower up-front price by choosing a total stock market ETF. Remember that he was writing that comment at a time when the latter option didn't exist.
So your strategy isn't, "buy the whole market", it's "buy the market as it existed in $current-year", which misses all the new stocks that come out. (Also it assumes you have a fixed amount to invest and never want to invest more)
But then it's not a one time-fee. More generally, your strategy only works if you're investing a large amount every time, it doesn't scale down. You can't put 10k into 5000 stocks, and even 500 stocks would be difficult.
It scales down just fine if you're willing to accept that you're going to pay a lot in broker fees, with the only consolation that you'll pay them only once per line in your portfolio.
If you have say 500 stocks and pay like $10 in broker fees per stock, in the end you'll pay $5000. That's not the end of the world for a long term investment.
At a 0.05% expense ratio, you need to hold $250k for 40 years to pay $5000, not to mention the extra fees if you want to rebalance as the market changes. It doesn't seem to make sense for lower-end investors, which are many of us.
> If you have say 500 stocks and pay like $10 in broker fees per stock, in the end you'll pay $5000. That's not the end of the world for a long term investment.
If you only buy each stock one time. Which is absurd if you want a balanced portfolio you would need to buy a little bit of all 500 stocks a lot of times. A ETF lets you do this cheaply.
I agree buy and hold diversified stocks is good. As well as no ongoing fees it can be more tax efficient for capital gains tax. If you buy a S&P tracker, it doubles and you sell, some you have a gain. If you buy 10 stocks and they double on average and you need cash just sell the one that didn't go up.
I love articles like this. I get so frustrated when I see colleagues hire a financial advisor that sells them a "managed portfolio" that is on-par with it's market comparable index and/or sell them on products like annuities that make no financial sense whatsoever. And they charge 1%-1.5% of assets under management which can be 10x what something like Vanguard would charge you.
Personally, I use Betterment (a competitor to WealthFront) simply becasue I can set a target asset allocation, and they will balance my portfolio accordingly. The tax loss harvesting capabilities that both companies offer are really interesting, theoretically, but there is no empirical evidence either way as to whether it actually will save you money in the long-run. Before betterment, I invested in mid-large cap index funds from Vanguard.
Risk management and asset allocation that matches changes in your personal life and your risk profile.
For example: If you know you need to use $200,000 within next two years, you might want to start moving part of that sum slowly from stock index fund into other less volatile assets (like bonds etc).
You can do that for yourself approximately without knowing about theory, but if there is cheap automated system that can provide personal solution based on portfolio management theory with few bucks, it's can be worth of the small sum they ask.
The most important advice is to stay the course and leave your investment alone. I read somewhere that the biggest gainers at Fidelity (?) were those who forgot they had an account at all.
> “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns.”
Ah, instead he believes he can talk "the vast majority of investors" into believing that they can significantly beat "average returns"? Hmm. Maybe in Lake Wobegon.
IIRC the index fund idea, W. Sharpe's work, etc. DOES need stock pickers also doing their best. Or, for anything with any promise in public a stock market, there has to be some smarts in there someplace. The reason throwing darts works so well is because of the stock pickers with the smarts working hard to buy the winners and sell the losers.
A discussion between the father of modern finance, Nobel prize winner Gene Fama, known for the Efficient Markets Hypthesis and his colleague and father of behavioral economics, Richard Thaler, of Chicago Booth, dissecting this question. http://review.chicagobooth.edu/economics/2016/video/are-mark...
Returns are used to quantify results, but you can't compare returns between a hedge fund or trading or market making operation - and a retail customer putting away their retirement money. Two entirely different operations at work that result in an overall annual return for each.
In buying a stock, you're buying exposure to a number of factors that affect the stock price: the company, the money flows into/out of that company's industry, and the flows in/out for stock market as a whole. In buying an index you get a more pure exposure to the stock market as a whole. When indexes do well, its only because money is flowing into it from other asset classes (or "money printing" by central banks).
Whether we should accept Efficient market hyposisis as explanation of Indexes beating pros, is a little more complicated. Yes, its true everyone has access to the same information. In fact, it's illegal to trade on insider information.
However, when Indexes beat pros, people are quick to say, 'yep.. Efficient market..', but Indexes have support that the individual stocks or baskets don't have. A pledged support by the Fed to print money to prop it up.
Take Wells Fargo. Maligned in the news, down stock price, but still a powerful bank. Buying the stock - not a irrational decision. But, will the Federal Govt let them go down? They didn't AIG, but who knows. Now imagine the Index crashes, the Fed steps in. Indexes have the advantage here.
Why do you say that we can't compare the results of each? Aren't individual stock and index's competing within the same environment (same systemic and unsystemic risk factors)? Difference being that the unsystemic risk is non-existent.
What surprised me the most about the article was that Mr. Malkiel could still hold an executive position in such a competitive industry (sixth paragraph). I hope at least some of us here are chief-of-something at the age of 84. :)
I'm going to use this as an opportunity to yet again rail against the idea of indexing. It's a good thing in theory, but like most things, when it's taken to extremes, it's horrible.
Passive investments wherein the investor takes zero interest in these investments are and have always been a terrible idea, and nothing in modern history has facilitated this more than index funds. When you give a friend of a friend $10,000 to start a company, do you just hand it over no questions asked and with no follow-up? Or do you try to get engaged with your investment? Make sure the CEO isn't sitting on his ass collecting a paycheck? Scrutinize it for potential frauds?
Well, that's what you do in an index fund. Except it's not even a friend of a friend that you're trusting. It's some group of people who likely live thousands of miles away who may or may not have an opiate or alcohol addiction or are complete sociopaths or are just regular humans who know how to legally take advantage of you when you aren't paying attention.
You want to know why CEO pay is so high? It's because CEOs have no accountability for raising their pay when investors aren't paying attention to what they're doing. You want to know why CEOs are taking short-term action to boost stock prices at the expense of long-term viability? It's because they care about the short, you care about the long, and you have no voice when you're in an index fund. You want to know why CEOs are issuing debt to do stock buybacks? To empire build by paying too much for their competitors? To play accounting games to boost short-term earnings?
Index funds are the tail that's wagging the dog, and they are going to be a disaster. And unlike derivatives, which can mess with stock prices but largely leave the fundamental structure of the company untouched, the dog that's being wagged here is the viability of globally important corporations that we depend on.
They were fine when 5% of the market just piggy backed onto the other passive (though attentive) investors. But now passive and inattentive investors are a massive proportion of the market.
For one thing, there are still plenty of active investors around. The fact that the less active investors around, the easier it is for them to make returns, will help the market stable and full of "enough" investors.
It is absurd to worry right now about not having enough finance professionals, considering just how many people are in the market.
In terms of what's best for a single person deciding where to invest money right now, indexing seems to provide the best opportunity. It's clear that most investors will not spend the requisite time tracking companies, nor should they considering the benefit of specialization.
I appreciate your opinion, but when I see that companies like JNJ are 67% owned by Mutual Funds and Institutional Investors[1], most of whom are low-cost and inactive, it tells me we've gone too far.
An I am not advocating for more finance professionals. Paying active managers to invest for you can cause the same problems I'm talking about. I'm advocating for personal responsibility and attentiveness.
I think we as hackers can use our abilities to analyze certain companies better than the professionals.
Example 1: track the Google rankings of companies that rely a lot on search engine traffic. see if any have dropped a lot from a major algorithm change (i.e. Demand Media)
Example 2: use the Facebook graph API to do the same for companies that rely a lot on Facebook for traffic.
Example 3: at the end of every month create a profile on weightwatchers.com. Note the user id number. Use this to extrapolate the number of users that signed up every month.
Example 4: track the number of websites that installed a JS script for vendors like Hubspot.
Example 5: every month scrape Ecommerce sites and track the increase % of reviews for major brands.
On the contrary, they are a leap forward into an age of abstraction. They address the reality that what people really want is for their capital to increase, period. As such, if you can do an index fund where everything is going to increase because it's part of the index fund and everybody knows index funds beat the market, the consensus opinion is that if you're in the index fund your value is going to increase, and therefore the companies listed can go about their business because their values increase thus justifying them being in the index fund.
Complete abstraction. Always has been, this is just the codification of it. The future catastrophe isn't so much the companies becoming more irresponsible than they already are, because they never particularly were. The catastrophe is more 'the concept of capital becoming meaningless', a sort of conceptual Reichsmark inflation where the numbers we talk about steadily become meaningless and absurd.
>When you give a friend of a friend $10,000 to start a company, do you just hand it over no questions asked and with no follow-up? Or do you try to get engaged with your investment?
That would depend on the company and the agreement we make on how I'll get compensated (will I own a %, etc)? That agreement is clear when investing in a fund. Once we have an agreement, my only concern is he/she keeps their end of the deal.
>Make sure the CEO isn't sitting on his ass collecting a paycheck? Scrutinize it for potential frauds?
Unless you're buying your own stocks, this is a potential problem with every fund, not just index funds.
You are ignoring that with investing you are taking risk. If you ignore risk passive investments would already be priced higher. Risk == return when it comes to passive investing, of course over a very long time frame.
Here is a graph of my personal account which I manage myself vs the S&P 500 index. I am currently beating it with gains on the year of 7.3%, but only thanks to the last couple of strong months. I was deep in the red early on.
There's an aspect of self-fulfilling prophecy to this. Higher demand leads to higher prices, and as more money flows into indexes the stocks in those indexes are going to rise relative to the rest of the market. Thus their earnings become harder to beat.
Not exactly, as money flows to those stocks, they become overpriced, and will under-deliver returns in the future. On the other hand, other stocks will be undervalued, giving better returns in the future.
So it is a self-correcting system, not a self-fulfilling prophecy.
Only if people (and funds) continue to not invest solely in index funds, to which there would be economic incentive, because in the short term, those might perform better.
Index fund tracking has become successful because one of the goals of US Government policy is to maintain that things like the S&P 500 continue to go up over time. If they go down people get voted out of office.
So the index funds have the full force of the US Government watching over them. This is why economics is not just some math puzzle but often more about politics and sociology.
The goals of the Federal Reserve are "maximum employment, stable prices, and moderate long-term interest rates." The real goal, though, is economic growth, and we just happen to believe that those intermediate goals are good at serving long-term economic growth.
The prices of stocks are one of the most forward-looking macroeconomic measures that we have available to us. The better we get at improving long-term economic growth, the higher stock prices will go, other things being equal. So basically, if you have good policy, stock prices should always go up (in real terms). If the Federal Reserve were perfect at preventing recessions and everyone knew it, stock prices would be higher.
While you would probably not want to make stock index growth the target of monetary policy because of Goodhart's Law, it is very reasonable to take it into account as a part of a forecast of how well your policy is working.
The article mentions the Vanguard 500 Index fund and states that it launched 3 years after 1973. So it's hard to understand what you mean when you call it a novelty in the US.
(without being deeply familiar with the history, I think the Vanguard 500 fund must have been one of the earliest index funds anywhere, if not the very first)
