IndexUniverse posted an interview with William Bernstein who is known for strong beliefs in index investing and has written several books. In there he made two points that I would strenuously disagree with.
First he reiterated a point that many indexers make that I think is overly academic as he noted that "passive still beats active in the long run because it has to by mathematical certainty." I believe this ignores way too many variables to be useful for most folks.
I have heard versions of this argument that focus on management fees (based on the article this was Bernstein's point) and other versions that focus on there only being so much alpha out there.
It is not clear to me what Bernstein thinks of as long term but most indexers are talking about market cap weighting. If you recall last summer the ALPS Equal Sector Weight ETF (EQL) came out with a ten year back test of beating the regular cap weighted S&P 500. It should be noted that the ten year period backtested for EQL was probably the best possible time for such a thing because of excess and subsequent fallout of the tech sector and then the financial sector. I would also concede that Bernstein probably thinks long run is longer than ten years and I would not disagree with that but ten years of outperformance is a long time.
I believe I have made a reasonably compelling case on this site in the last few years for the importance of correctly avoiding a given sector or country. It does not take a lot of acumen to see that an S&P 500 sector is greater than 20% of that index which is a huge warning sign and easy to heed. Realizing that a country is on shaky ground takes a little more time but most certainly does not require a PHD.
Bernstein's point also ignores the fact that active management is a series of decisions; some right and some wrong. In this light success depends on being right a little more often than you are wrong. If the wrongs can be mitigated one way or another and the rights do well there is a good chance of outperforming. This point is difficult to win the argument with but as a supporting factor a stock I have been writing about for more than five years is Vale (VALE) which is a client holding. Vale as a proxy for materials is up 350% versus about 25% for the Materials Sector SPDR (XLB) in the last five years. This just an example which has flaws of its own but one (mega cap) stock pick combined with one sector avoided (the financials) and an investor would be noticeably ahead of the market for a decent chunk of time, that being five years.
I will say it is very reasonable to question how many people should be making a lot of active decisions in the market. People tend to not understand the volatility they have taken on until after a big decline resulting in panic sales so I am not saying everyone should be actively managing their portfolio but the idea of "has to by mathematical certainty" seems far too simplistic. I won't go into detail on another point here so the at post is not too long but another variable is the occasional buying and selling of stocks or funds that can add value as opposed to what I believe is a static portfolio in Bernstein's comments.
Bernstein also has choice words for levered and inverse ETFs, "But in practice, they’re being used as speculative tools. Some of them are silly, some are dangerous, and some, such as inverse and leveraged ETFs, are downright criminal" noting that they do not "work" over longer periods of time. He adds "what is this concept that an investment can only be used for one day? This is not an investment. Who has the predictive power of knowing which way the market is going to go on one day?" and finally "To the extent that people are using them more for speculation than for long-term investment, it’s a horrible thing."
I would not disagree with an opinion that says many people will misuse a levered fund but speculation plays an important role in the functioning of capital markets. I think this is a rather elementary point actually--markets need liquidity to function and speculators are a source of liquidity. Again any argument that says most people should not be speculating is one I would agree with but the framing that speculation is a bad thing and tools that facilitate speculation are bad things is, again, too simplistic.
To the extent new investors are trying to learn and seek out Bernstein as a source I believe they are learning the wrong thing. There is a difference between a fund being "downright criminal" and a fund simply being unsuitable for many people.
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10 comments:
Good article by BillW., thanks Roger. I read his comment on mathematics of active in the context of all active vs. passive. I.e. market returns minus costs of trading equals less than average (passive). He acknowledges that some managers do better than average.
PS: Interesting charts yesterday from Doug Short on the 200-week MA:
http://tinyurl.com/2b5p8hs
It is just as much of a "certainty" that some people employing active management will beat the average by a lot.
I was snowed for a while with the arguments about indexing. But I realized that all you have to do to put yourself in the top echelons of traders is to not watch CNBC or Cramer before making decisions ;)
Maybe if people can't see through the FUD regarding active management and levered ETFS then they should not be engaged in those activities. If you do a careful study and actually try your hand at employing these tools then you find out they are not so horrible... Proshares have made a lot of money for me in particular ;) If you haven't done a careful study then stay away.
Think what the economy would be like if passive indexers started preaching to the small business owners. In that realm failure is even more certain! "There is no reason to start a coffee shop, if there was any marginal profit left for coffee shop owners then someone would have already started a coffee shop... just buy a coffee shop index fund with low expenses..."
The international bond market is rather clearly anticipating a Greek default but Portuguese, Spanish and Italian bond spreads are also increasing rapidly so my thinking is the EU better figure out how to put a cork in this because there currently does not appear to be the necessary political will for the kind of government outlays required if Greece should default and the contagion grow wider.
States such as Germany where the principle that economic purges can be beneficial has greater influence may dig in their heals at the cost of relief which means we may all get front row seats to a real, old time bank run but on an intercontinental scale.
My long t-bond positions appreciated more than my gold holdings today not surprisingly but both real estate and financial sector shorts did even better (pace Bernstein but I use double inverse ETF's as well as direct shorts, mea culpa): Hedges can be a drag on performance but that's the way of insurance.
Still net long and hoping the EU rises to the occasion but, for now, pass the popcorn.
Roger, Appreciate your blog. I have asked the below before, but not sure you have given me your thoughts. I would appreciate them: What areas do you see as under-valued in this market?? I was looking at Platinum and other mining ETF's, but believe even those are over done at this time. Are you bullish on any areas at this time??? Thanks!!!
Roger,
I agree with Bernstein, Bogle, Sharpe, and all others who state that active managers *in the aggregate* cannot beat the market. This really is a "mathematical certainty". I'm a long-time reader of your blog, and I know you have a counter-argument. In one post a while back you gave the example of active managers who move to cash during a bear market, and you stated that this messed up the "zero-sum-game" claim of the academics. It doesn't. The problem is, active managers *in aggregate* cannot move to cash - for every active manager that "pulls money out" of the market, some other active manager is "putting money in" to the market. So for every smart active manager who moves to cash during a bear market, there's another dumb active manager who moves *out* of cash in a bear market. As Bogle says, investors as a whole are buy-and-hold market-cap-weighted index investors. The subset of investors who try to beat the market, *either* by market timing or security selection, will always tie the market in aggregate. They have to, because in the aggregate investors can neither put new money in nor take money out of the market.
- aagold
The problem is, active managers *in aggregate* cannot move to cash - for every active manager that "pulls money out" of the market, some other active manager is "putting money in" to the market.
Maybe but what did the money come out of and what is it going into?
They have to, because in the aggregate investors can neither put new money in nor take money out of the market.
what about 401k and IRA contributions? what about spending dividends or selling a stock to buy a car?
either your comments are academic to the point of being useless or you are having a conversation I cannot hear (meaning I'm not smart enough).
Roger,
First of all, I know you like to read Hussman, so you must have seen his discussions of how money neither moves in to nor out of any secondary market such as the stock market. Here's a quote and a link:
"Once those pieces of paper are issued, they are traded between investors in the “secondary market.” When we talk about the stock market, we're talking almost exclusively about the secondary market, because new issues make up a very small part of total activity.
Dear Wall Street analysts and financial reporters – when investors purchase a stock in the secondary market, the dollars that buyers bring “into” the market are immediately taken “out of” the market in the hands of the sellers. It is an exchange. This is why the place it happens is called a “stock exchange.” The stock market is not an air balloon into which money goes in or out and expands or contracts that balloon. Nor is it a water balloon that is expanded by pouring in “liquidity.” Prices are not driven by the amount of money that buyers “put in” or sellers “take out” (as those dollar amounts are identical). Prices are determined by the relative eagerness of the buyer versus the seller."
http://www.hussmanfunds.com/wmc/wmc070312.htm
So, to answer your question about 401K contributions, there must be some other investor (maybe someone needing to sell stock to buy a car, or perhaps they're already in retirement and are selling stock for living expenses) that's pulling money out of the market.
This point is really not "academic" and it's not at all useless to the average investor. It proves that if a person's goal is to hire a manager who can "beat the market", either through market timing or security selection, then the person needs to have a special skill in selecting such a manager. I'm *not* saying it's impossible to find active managers who can beat the market, just that it's been proven that it's very difficult to find these people, and that in the aggregate active managers do worse than passive managers due to their larger fees.
Let's consider two strategies you discuss frequently on your blog: 200-DMA and under-weighting sectors whose market cap has grown too large (e.g., recent examples are financials and tech stocks). It should be obvious that investors *as a whole* cannot follow your 200-DMA rule, right? Same goes for under-weighting "bubble sectors" - for every smart active manager who under-weighted financials during the recent crisis, there's another dumb active manager who over-weighted them. That really is a mathematical certainty.
- aagold
ooh, a lot of meat on the bone here, i will try to take a closer look later. sorry
I will say one thing for now that is almost tongue and cheek. Karl Popper is (relatively) famous for noting that positive outcomes cannot prove a theory they can only support it. It only takes one negative outcome to disprove a theory. There are enough active managers to disprove the theory of indexing.
Wow can you get more disingenuous than that, Roger? Because some number of active managers beat the index every year that "disproves the theory of indexing"? Sooo.... because the index beats some number of active managers, does that "disprove the theory of active management"?
Fact: aggregate of assets under passive indexed management will outperform the aggregate of assets under active management.
Fact: it is extremely difficult if not impossible to pick out "skilled" active managers. In fact there's only the sketchiest of evidences that such skill (as opposed to luck) exists at all.
Fact: the financial management industry of which you are a fine representative is deeply interested in discrediting indexing in favor of active management so they can charge higher fees in exchange of selling hopes of beating the market (which will, on average, be false hopes).
I don't blame you for trying to perpetuate the mythical advantages of active management -- your living depends on it and what's a little white lie in exchange for a comfy job, right? It's the countless retail "traders" who are convinced they can beat the market that are truly mind-bending. A lot of them are actually smart enough to understand the simple math proving the inherent disadvantage of active management. Yes still they keep at it, inspired by the stories of the few that make it big and, of course, blissfully unaware of the millions that fizzle out.
Just for fun, read some day-trading forums over the course of a few of years. At any point in time there's one or several star traders who got several big calls right in a row and now have a legion of followers. They post daily, over a wide range of topics. Over the following few months they get things wrong and are forgotten and a new set of "stars" appears. And that cycle repeats over and over and over. But the day-trading crowds only grow more convinced of how easy it is to beat the market, if only they did A, B, and C. Because, look, there are those star traders who made tens of thousands just in the last week.
All the while professional financial managers such as yourself laugh all the way to the bank by skimming 1+% of AUM annually, regardless of what Mr. Market does. Active management is the equivalent of the lotto -- a tax on stupid. All the best.
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