active vs passive?

guymo

This has become a very broad-ranging thread but I wanted to butt in with a couple of points about what I understand of the academic theories behind value investing versus broad index investing, and on where above-market returns might come from.

The point made by the advocates of broad index investing is that the efficient market hypothesis tells you there cannot be better than market returns without taking on additional risk. The capital asset pricing model (CAPM) is a model that attempts to explain how risk is rewarded with return.

We know from recent research that cap-weighted indexes have been easy to outperform, with essentially any other weighting of the components: see http://www.cassknowledge.com/research/article/evaluation-alternative-equity-indices-cass-knowledge for quite a bit on this.

Why is that? The CAPM would say that the *risk adjusted* returns of these alternatively weighted indices are expected to be the same as the cap-weighted index. That is, investors are being rewarded for taking on extra risk, usually in the shape of heavier weighting of smaller companies. This risk is the cost that leads people to maintain that there is "no free lunch" in investing.

But Fama and French's famous "three factor model" (for which Fama won the Nobel memorial prize) says that the CAPM is wrong: that there is additional return to be had from small companies and from value investing, that is not explained by extra risk.

The source of these additional returns (the "size premium" and "value premium") is not well understood. I think Fama and French now believe that the CAPM does explain the returns associated with small companies, but not the value premium. Fama and French's 2006 paper "The Value Premium and the CAPM" (Journal of Finance vol LXI no 5) presents more recent work on this.

There is not really a consensus on whether the value premium exists, and whether it will continue to exist in the future is anybody's guess. But suppose it does and will. How can we capture it?

Maybe we can capture it by looking at simple data for the stocks under consideration, such as the book/market ratio or price/earnings multiples. These lead to alternative indexing strategies and, as we know from the above, that will likely give higher returns. Maybe Ryan and Meb Faber are right and one can go as far as to use CAPE on a regional basis to select geographical areas in which to invest --- again this looks like chasing the value premium, and perhaps there will be returns from that, unexplained by the CAPM.

Malkiel remains cautious about these proposals. He gives some explanation for his position in "The Efficient Market Hypothesis and Its Critics"
(Journal of Economic Perspectives, Volume 17, Number 1, Winter 2003, Pages 59–82). In particular he refers to research that shows that dividends yield, and price-earnings, do appear to be correlated with future returns, with an R^2 of around 0.4 --- but then he shows how trying to use these data to decide how to invest would have been disastrous from 1987-2002.

His conclusion is worth reading:

Such results suggest to me a very cautious assessment of the extent to which stock market returns are predictable on this basis.

And this would seem to be the crux of the matter. It's not the case that there is no evidence of ability to outperform the market. There are well identified factors that many researchers believe will give above-market returns for no additional risk. But they are by no means uncontroversial. A cautious assessment is called for, particularly if it is your own long-term wealth that is at stake.

bowlhead99

Ryan_Futuristics wrote: »

So for me, if we can't take the long-term uptrend as an inevitability, buying at anything other that fair value might not work out as well as it has previously

A fair value for an asset, in generally accepted accounting parlance, is the value at which the asset would be exchanged between a willing buyer and an unconnected willing seller. Effectively, the marketplace.

There can sometimes be macro or micro factors creating temporary disconnects between what one might consider to be "fair values" of some individual companies and the market price which eventually get resolved providing some buying or selling opportunities in terms of market timing.

But by the time you "zoom out" to regional level and look at five years instead of five days or five months, then broadly the market probably does its job (especially in developed markets) and at zoomed out level with millions of market participants one would have to say those markets are fairly valued, taking into account each of the various local conditions that may be relevant.

For example, corruption / governance issues, political instability, low prospective GDP growth, demographics and growth of GDP in nearby economic neighbours is going to hold back some companies in some economies from being valued at 20x recent years earnings. Those factors are less relevant in a developed western economy like USA compared to Russia.

So, it seems completely "fair" to value high growth companies in high growth economies (e.g.)with newly liberated energy reserves, at a higher value than low growth companies in low growth warmongering countries like Russia who are finding it difficult to monetise their Siberian oil reserves and don't have a wealthy population driving growth in domestic consumer production and consumption.

I can see what you are trying to say, that some parts of the world look "cheap" when you look at how much people will pay for a certain amount of annual historic income compared to what they previously paid in that economy or in other economies elsewhere.

But there will be reasons for that. You seem to be short on real analysis of those reasons, just inferring that the prices must not be fair values if they differ from some historic average and warning that people paying over fair value will get burned while they should instead take plenty of other opportunities to buy below fair value. If something is cheap because it is risky, that doesn't make it "below fair value". Likewise, paying what the market has determined to be fair value for a high quality product does not mean you are paying over the odds.

Your red/amber/green scale shows some entire countries and regions to avoid and some to embrace. That assumes that everything will converge on amber within some reasonable time frame, but it may not hold true; there are many ways it could pan out.

You also imply that one should not buy a mixed set of assets because you will end up with a diversified portfolio containing holdings that are "at all sorts of different points in their cycle". But that is exactly what traditional investing logic tells us to do - hold uncorrelated assets for long periods and rebalance between them from time to time. To try to buy a lot of assets which based on your theory are all at the bottom of their economic cycles and exit them at the top to find the next ones at the bottom, no doubt has the potential to make bigger returns but it is beyond the capability of newbie investors - and even experienced investors who lack crystal balls

Cash-Cows

Ryan_Futuristics wrote: »

I have about 15-20% of my portfolio in multi-asset funds - I think of them as good, solid, long-term performers, and great for getting started

The problem I've sometimes mentioned is outlined here:

Vanguard Lifestrategy has a lot going for it. Shame you have to buy it all at once
http://simple-living-in-suffolk.co.uk/2014/02/vanguard-lifestrategy-buying-at-once/

When you buy a multi-asset fund, you're buying stocks and regions at all sorts of different points in their cycle (some assets at the bottom of their cycle, waiting to rise, others in the middle, and many that are probably about as stretched on valuation as they're likely to get)

Despite the popular narrative going around at the moment, the best way to avoid losing money in the markets has always been to buy cheap ...

If you wanted to build a Lifestrategy portfolio, you'd probably be buying mainly the European and Emerging parts this year, while adding more gradually to the UK allocation, and only very slightly to the world index

Bonds may not be good value for a while, so you might hold a small amount of short-duration bonds and put some of that money into P2P lending(?), and maybe high interest savings accounts

It's a consideration ... In theory, even if takes longer to build the complete portfolio, buying the expensive parts now probably won't benefit you (especially as the US's dividend is so low)

Are you not trying to time the market, the very thing the passive investor doesn't do. After a period of hold you just rebalance so that would sort out say bonds if they fell on the medium term.

Rollinghome

ChopperST wrote: »

In a few words;

Money breeds money. Save and invest rather than earn and spend.

Seems that not everyone is impressed. One reviewer says that he paid 30p for his copy when his library threw it out and that wasn't a good investment. Nor here, here or here suggesting Kiyosaki the author has gone bankrupt.

Seems there'll always be those seeking the secret to wealth and others willing to sell it to them.

Ryan_Futuristics

Rollinghome wrote: »

Ah, I see. I seem to recall you saying in an earlier post that the US hadn't been at reasonable level for entry during the time you've been investing.

From that, as the S&P was below 700 only just a few years ago, should I assume that you're just out of your teens now and you've become interested in investing in just the last few months?

Well have fun but I saw you also say that that you're not in work at the moment, so unless there's some reason why you can't work, don't forget that finding a job is a more reliable route to riches than small time investing. Believing otherwise is usually little more than a fantasy.

Have to confess have never read Rich Dad Poor Dad, though I was given a copy some years ago, but I hope it would have a similar message. Anyone daft enough to take seriously the title of chapter 7 "Don't work for money" is likely to be disappointed.

Well during the 2008 crash, I don't think the thought to buy a US tracker would have crossed my mind ... I'd say I was a very good saver, but a typically basic investor

Actually the chapter you quoted is apt ... I think the full quote is along the lines of: You can't get rich working for money, you have to make money work for you ... Every wealthy person knows this - assets have done much better than wages these decades (hence the rich/poor divide)

Work is the one of the worst ways imaginable to make money - I work because I'm doing something I'm interested in, but much of my capital has come from short-run businesses ... I've got enough capital not to need to work, but not quite enough to live comfortably in London and not work ... Hence the decision to get my finances functioning more efficiently

Ryan_Futuristics

bowlhead99 wrote: »

A fair value for an asset, in generally accepted accounting parlance, is the value at which the asset would be exchanged between a willing buyer and an unconnected willing seller. Effectively, the marketplace.

There can sometimes be macro or micro factors creating temporary disconnects between what one might consider to be "fair values" of some individual companies and the market price which eventually get resolved providing some buying or selling opportunities in terms of market timing.

But by the time you "zoom out" to regional level and look at five years instead of five days or five months, then broadly the market probably does its job (especially in developed markets) and at zoomed out level with millions of market participants one would have to say those markets are fairly valued, taking into account each of the various local conditions that may be relevant.

For example, corruption / governance issues, political instability, low prospective GDP growth, demographics and growth of GDP in nearby economic neighbours is going to hold back some companies in some economies from being valued at 20x recent years earnings. Those factors are less relevant in a developed western economy like USA compared to Russia.

So, it seems completely "fair" to value high growth companies in high growth economies (e.g.)with newly liberated energy reserves, at a higher value than low growth companies in low growth warmongering countries like Russia who are finding it difficult to monetise their Siberian oil reserves and don't have a wealthy population driving growth in domestic consumer production and consumption.

I can see what you are trying to say, that some parts of the world look "cheap" when you look at how much people will pay for a certain amount of annual historic income compared to what they previously paid in that economy or in other economies elsewhere.

But there will be reasons for that. You seem to be short on real analysis of those reasons, just inferring that the prices must not be fair values if they differ from some historic average and warning that people paying over fair value will get burned while they should instead take plenty of other opportunities to buy below fair value. If something is cheap because it is risky, that doesn't make it "below fair value". Likewise, paying what the market has determined to be fair value for a high quality product does not mean you are paying over the odds.

Your red/amber/green scale shows some entire countries and regions to avoid and some to embrace. That assumes that everything will converge on amber within some reasonable time frame, but it may not hold true; there are many ways it could pan out.

You also imply that one should not buy a mixed set of assets because you will end up with a diversified portfolio containing holdings that are "at all sorts of different points in their cycle". But that is exactly what traditional investing logic tells us to do - hold uncorrelated assets for long periods and rebalance between them from time to time. To try to buy a lot of assets which based on your theory are all at the bottom of their economic cycles and exit them at the top to find the next ones at the bottom, no doubt has the potential to make bigger returns but it is beyond the capability of newbie investors - and even experienced investors who lack crystal balls

Well my process is simply to adjust my asset allocations to maintain a strong trend towards cheaper assets ... In a way it's just a less clean version of what Meb Faber does always holding the cheapest half dozen regions

Essentially, looking at all the brilliant analysis and data we have available to us today, I find it easier to have faith in the correlation between valuation and returns than I do growth in the developed markets

From a brilliant piece I was reading earlier (actually a criticism of CAPE, but one I already factored into my valuation system):


"Looking out over the long-term, it’s going to be very difficult for US investors to receive the “normal” 10% nominal annual equity returns that they have received historically. Literally everything will have to go right. Profit margins and returns on equity will have to stay elevated, contrary to the tendency of mean-reversion. Multiples will also have to stay elevated, which means that interest rates will have to stay low. But low interest rates are a consequence of weak economic growth and weak inflation. How are companies going to consistently produce strong earnings per share (EPS) growth–the kind that would be needed to underpin 10% total returns for shareholders over the long-term–in an environment of weak economic growth and weak inflation?

"Up to now in the current recovery, and really over the last 10 years, profit margin expansion and share buybacks have been the primary drivers of EPS growth for U.S. equities. They are the reasons that strong EPS growth has been possible amid the persistent softness in economic growth and inflation (softness that has depressed the corporate top-line, but that has also provoked zero interest rates and an elevated P/E multiple). Can profit margin expansion and share buybacks continue to be robust drivers of EPS growth, indefinitely, even as shares become more and more expensive for corporations to buy back, and as the income imbalances between capital and labor, the rich and everyone else, get closer and closer to the limits of economic and societal stability? There are good reasons to think not."

http://www.philosophicaleconomics.com/2014/11/dilution-index-evolution-and-the-shiller-cape-anatomy-of-a-post-crisis-value-trap/


A simple conclusion I draw from my valuations is that you should simply be out of equities now - I think what you're seeing is the effect of too much money sloshing around the markets with nowhere to go (and this level of stimulus is completely uncharted territory - we're out in Saturn's rings, when the furthest we've been before is the local Tescos)

From studies I read on CAPE, 15-18 years seems to be how long it takes markets to fully revert to mean ... Actually from the extremes of over and under-valuation we see today (historically unusual) I think QE's only exaggerated market inefficiency

Really what it comes to for me is that it's better to hold cash than an asset that's likely to lose value (diversification or not) ... I'd rather rebalance between two strong performers than two that average out to mediocre

Valuation's the only reason I think you can do this effectively - I don't understand why any macro investor, or macro investing study, would try to achieve this without it

bowlhead99

Ryan_Futuristics wrote: »

A simple conclusion I draw from my valuations is that you should simply be out of equities now - I think what you're seeing is the effect of too much money sloshing around the markets with nowhere to go (and this level of stimulus is completely uncharted territory - we're out in Saturn's rings, when the furthest we've been before is the local Tescos)

In recent weeks there's been growing speculation that the European central bank may, belatedly, follow the U.S., Japan and the UK by embracing quantitative easing. If the ECB goes down this path, experience suggests that the policy would work partly by pushing up equity values. So, all eyes on the ecb to see what they will do next - take the historic step? Not take it? Or, all eyes on the market to see what it thinks the ECB will do next. Choosing deflating cash instead of QE'd equities could be an expensive mistake.

From studies I read on CAPE, 15-18 years seems to be how long it takes markets to fully revert to mean ... Actually from the extremes of over and under-valuation we see today (historically unusual) I think QE's only exaggerated market inefficiency

So with markets at what you think are peaks, perhaps two decades to revert to mean? And then, because you don't want to buy at "mean" but would prefer to buy on a dip below mean... how much longer until you would be fully back in the market? I may be a bit short on lifetime and patience if I spent an entire generation or two out of the markets; missing the dividends and years of"mediocre" returns,to instead take the return from cash.

Really what it comes to for me is that it's better to hold cash than an asset that's likely to lose value (diversification or not) ... I'd rather rebalance between two strong performers than two that average out to mediocre

Valuation's the only reason I think you can do this effectively - I don't understand why any macro investor, or macro investing study, would try to achieve this without it

Your problem is that you are sticking steadfast to your belief that you can value a market better than all other market participants who say the current price is a fair price, all things considered. You believe that the price is wrong and we just need to ignore the market for 18 years until the price is right. Anyone who buys now is ignoring valuation and you don't understand why they would ignore valuation. I would counter that they are performing valuation exercises but simply coming up with a number that you don't agree with. Given there are millions of them, perhaps it is the contrarian who is wrong.

Someone like Buffett says that the average person should use a set of simple indexes as it is cheap and uncomplicated and certainly suitable for his family (who can afford to lose millions )after he's gone. However what he does in practice for BH investors is time the market after researching the hell out of individual companies to find the ones with appealing prices for what they offer. That takes some skill but his team seem good enough. But simply broadening the brush to go from researching a company and its customers and business plan and board, to valuing a whole market on one or two average metrics and deciding whether to use the market or abandon it for 15-18 years, seems like quite a ballsy call.

Mistermeaner

http://www.trustnet.com/Fundswire/News/vanguard-lifestrategy-60-equity-fund-no-longer-a-top-quartile-performer/566647/?fe=1&utm_source=FE%20Trustnet%20Alerts&utm_medium=Email&utm_content=Fundswire%20Alert%20Mail&utm_campaign=Fundswire%20Alert

Fuel for the fire

jimjames

bowlhead99 wrote: »

Your problem is that you are sticking steadfast to your belief that you can value a market better than all other market participants who say the current price is a fair price, all things considered. You believe that the price is wrong and we just need to ignore the market for 18 years until the price is right. Anyone who buys now is ignoring valuation and you don't understand why they would ignore valuation. I would counter that they are performing valuation exercises but simply coming up with a number that you don't agree with. Given there are millions of them, perhaps it is the contrarian who is wrong.

Whilst I agree on the futility of timing markets and staying out for 18 years waiting for the correct value, 1999/2000 was a time when it seemed fairly clear that prices were overvalued especially for companies never having made a profit. Some did come good like Google but others fell by the wayside.

Going by value, Woodford managed to get some decent companies so it can be possible to stay in the market but not buy the outrageous valuations.

TheTracker

ggb1979 wrote: »

http://www.trustnet.com/Fundswire/News/vanguard-lifestrategy-60-equity-fund-no-longer-a-top-quartile-performer/566647/?fe=1&utm_source=FE%20Trustnet%20Alerts&utm_medium=Email&utm_content=Fundswire%20Alert%20Mail&utm_campaign=Fundswire%20Alert

Fuel for the fire

Typical fluff story. It wouldn't want to be measured in 3 year terms. And when compared with other comparable funds it would only expect to be a media performer in the long term. It is in the second quartile. Fees don't appear to have been accounted for either.