Question to passive investors - does it really return?

BananaRepublic

Malthusian wrote: »

I think you may have misunderstood what "efficient" means in the context of the economic term "efficient markets". An "efficient market" is one that instantly takes all available information into account in setting the price of the good. It has nothing to do with whether the price being paid for the good is objectively sensible or not, or whether prices are stable or not.

For illustration, consider two markets in which bushels of wheat are being sold at $5 each, one of which is in a financial centre with high-speed broadband, thousands of commodities traders and 24-hour news feeds, and the other of which is in a remote mountain kingdom where the Internet is banned and news can only come the old fashioned way, from travellers on horseback. One day there is a massive crop failure which makes wheat twice as scarce as it was before. In the city market the price of wheat will react instantly to the news - by the time anyone's read the news of the crop failure, the price of wheat will have already doubled to $10. In the remote mountain market, however, no-one's heard of the failure yet so they're still trading wheat at $5 even though the true value of the wheat is $10. The first traveller to come in from the outside may tell them the news, or he might keep it to himself and make a killing by buying all the wheat he can at $5. Eventually the news will filter through and the mountain kingdom merchants will also sell at $10, but it takes longer for the price of their wheat to adjust itself to the true value. The city centre market is very efficient whereas the remote mountain market is inefficient.

Mainstream stock markets are extremely efficient because shares are being traded thousands of times a day and the price instantly adjusts to news, sentiment or anything else that may affect it. The important thing for this discussion is that it is nonsense to say things like "I've sold off my UK holdings because I believe prices are vulnerable to the impact of Brexit" as fund managers do constantly. This doesn't make any sense. Everyone already knows that the UK may exit Europe and everyone has an opinion on what this will mean for the value of UK companies. And all their beliefs are already factored into current share prices.

To justify buying or selling UK holdings because of Brexit, the only reason that would make sense is "I've sold off my UK holdings because I know more than everyone else about the probability of Brexit and/or I know more than everyone else about what effect this will have on UK share prices - oh but by the way this special insight into the UK electorate and/or economy does not consist of anything I would be obliged to declare to the market under insider trading rules."

It's nonsense. This special insight claimed by active fund managers does not exist.

It is sometimes said that it is better to be wrong and to go with the flow, than to be right and go against the flow. A large part of the reason for this is that if you go with the flow, and it is revealed that you are wrong, you can say "Well, we all got it wrong" and it is hard to single you out. But if you go against the flow, and you get it wrong, you stand out. This I believe is commonplace in the financial world.

Regarding Brexit, Bowlhead makes good points. In a real sense the UK market is a bet. It is probably underpriced if Brexit does not come about, and overpriced if it does. The current fear is holding back investment, and a non Brexit would cause a small surge of exuberance. A Brexit would herald a period of uncertainty, and a drop in the short term. So to say that the market has priced in the outcomes is untrue, it reaches a compromise based on the two possible outcomes.

TheTracker

BananaRepublic wrote: »

So to say that the market has priced in the outcomes is untrue, it reaches a compromise based on the two possible outcomes.

When one says the market has priced in outcomes, one means it has priced in the risk of such outcomes. Markets price in the risk of all manner of outcomes. Its the reason we are rewarded, slightly in favour, for taking such risk. There is a risk AAPL will earn less than the analysts expect. There is a risk of war in Ukraine. There is a risk Tesla will meet a disrupting challenger. There is a risk MSFT will continue to decline in the face of newer companies. Every day we collectively judge these risks and they set prices. On the wider scale, there is a risk Small Caps have had their day, there is a risk EM is undervalued, etc etc.

Its entirely feasible that the market (the universe of investors) is inaccurately judging the risk, either because the likelihood or the impact is not accurate. Look at the GFC. But if you knew these in advance, you'd make even more money with a big short. So unless you have some level of information that everyone does not, or you have a better level of perception personally than the collective wisdom of the universe of investors, its best to stay put. Remain rather than leave, if you will!

DrSyn

talexuser wrote: »

A bad example if wanting to promote passive, HI soared after the tech bubble burst. I first put 6k in 1995 in a Acc Pep and it is the only fund I have never swapped out of since then. Much better return then any equivalently close tracker.

The OP said they could not understand how an index fund could beat an active fund and then mentioned HI specifically.

All I was trying to do, was to explain to the OP the style of investing used by HI (value investing), was out of fashion during the tech bubble period. During that time the PE's of some companies went up to speculative levels and good companies with good dividends where ignored.

Like you, I to found HI a good investment.

BananaRepublic

TheTracker wrote: »

When one says the market has priced in outcomes, one means it has priced in the risk of such outcomes. Markets price in the risk of all manner of outcomes. Its the reason we are rewarded, slightly in favour, for taking such risk. There is a risk AAPL will earn less than the analysts expect. There is a risk of war in Ukraine. There is a risk Tesla will meet a disrupting challenger. There is a risk MSFT will continue to decline in the face of newer companies. Every day we collectively judge these risks and they set prices. On the wider scale, there is a risk Small Caps have had their day, there is a risk EM is undervalued, etc etc.

Its entirely feasible that the market (the universe of investors) is inaccurately judging the risk, either because the likelihood or the impact is not accurate. Look at the GFC. But if you knew these in advance, you'd make even more money with a big short. So unless you have some level of information that everyone does not, or you have a better level of perception personally than the collective wisdom of the universe of investors, its best to stay put. Remain rather than leave, if you will!

You ignore judgement, and argue as if there is some collective wisdom. In reality it is not a group of people, each with the same objective facts, taking mechanical decisions based on rigid mathematical principles. Anyway, I'm curious how you explain consistent outperformance by a small number of star fund managers.

bowlhead99

BananaRepublic wrote: »

An issue with buying into companies as they enter the index is that it takes no account of why they enter and you are in a sense buying after past success. Thus a surge in financials might mean buying into some new entrants at a high price, then selling a year on when they exit at a lower price.

But as mentioned, the proportion of the index that the new entrant represents when you 'buy it after past success' is going to be 0.2% in the case of a FTSE100 tracker and under 0.01% in a FTSE UK All-Share tracker. So, you are hardly committing any money at all to the new entrant.

Even if the company was rising fantastically rapidly and entered the FTSE100 at a £6bn valuation instead of the usual £4-5bn valuation - because the index constituents are only determined every 90 days and it grew massively since the last determination when it was excluded from the index - that is still only 0.3% of your 100-company portfolio. So, yes, buying that new entrant might be at an overvaluation (if the fair price is £3bn and not the £6bn you paid), but this is peanuts as a proportion of the fund. If the value sinks back to £4bn after a year, you will have to sell it when it's only worth £4bn which is less than you paid. The cost of that terrible forced error over the year? 0.1%

That's a month or two's management fee for an active fund, so hardly something to fear or feel you can't afford. As we agree, the massive allocation to the giants of the index gives concentration risk which I don't like at all, but this idea of having to splash out loads of new cash on new entrants doesn't hold water. And when someone leaves the index, he was such a tiny proportion of your portfolio it's almost irrelevant.

TheTracker wrote: »

The problem with this hypothesis is that you must test the reverse.

If the said fund manager is so confident that the upside and downside risk do not match the current price that he will exit a position, as essentially you are hypothesising...

It is not so much that the manager thinks the price is 'wrong'. He just might not want the potential volatility, and can avoid it where the dumb index can't.

If the price used to be 10 and could be 10 if we bremain, but could fall to 5.5 if we brexit, but bremain is acknowledged as more likely than brexit, the market would not be pricing half way between 10 and 5.5, it would be closer to 10. Like maybe 8.5. So the upside freebie in a correction once the result is known, is 1.5, but the downside loss would be 3. The 1.5 is more likely than the 3 which is why the market is pricing at 1.5 vs 3 instead of 2.25 vs 2.25.

You're thinking that I was saying the active manager is claiming he knows 1.5 vs 3 is the wrong odds and that's why he sells up. But those odds are reached by consensus of thousands of market participants, so that would be a bold claim. The real claim is that the active manager knows the types of deals his investors want, and they don't want to play 'lose 3 or win 1.5' on a coin toss, because losing the 3 is 35% of the current 8.5, which is a game many don't want to play on a coin toss, if preserving capital is anywhere in their list of objectives.

So, even though they acknowledge that the 1.5 win is more likely, so the price of 8.5 is completely fair, the manager may feel that this sort of volatility in the last week of June will not be welcomed. The market says the fair value is 8.5 and the price is already 8.5 so the misprice is probably zero and the expected return from this unpredictable external event is 0.0. But that 0.0 is just the expected return, while the actual return will be either +1.5 or -3.0.

As a consequence, the manager may choose not to play. By saying he can choose not to play, I'm not saying that in this situation he has a sixth sense, some 'edge' which would allow him to take a market annual return of 7% and turn it into 7.5%. Just that he could take an event with an EV of 0.0 and swap it for a different event with an EV of 0.0 elsewhere that didn't have such a crazy volatility and would be welcomed by the investors. Meanwhile the tracker must keep the brexit-sensitive stock and will definitely either win a bit (likely) or lose a lot (less likely).

Malthusian says it is a nonsense for the fund manager to announce he is going to exit the stocks on the grounds that they're vulnerable to brexit, because the manager doesn't know what the brexit result will be. But my contention is that he does know they'll swing wildly one way or another, and doesn't like the idea of that so he quite rationally exits them, fully knowing there is no magic extra expected value from that choice.

then he must also have the confidence that, given an efficient vehicle to do so, his real opportunity is to short the stock. The march from short to long is a continuum, and there is only a small friction at the zero point. Thus the market sets prices based on real expectations.

Yes, if he has a mandate from his investors to allow him to indulge in such practices he could turn his opportunity into one in which he has a small chance of gaining a lot or a large chance of losing a little. If the odds aren't 'wrong' he might consider that, because it changes the profile from something where if he's wrong he makes unacceptable losses, to something where if he's wrong he makes acceptable losses. It would of course mean that he is signing up to a bet which he's more likely to lose than win, and nobody likes those bets

TheTracker

BananaRepublic wrote: »

I'm curious how you explain consistent outperformance by a small number of star fund managers.

I believe there are managers who can 'beat the market' regularly, and you might call them star fund managers. Just like in any field, there is a great spread of talent and there are undoubtedly those who can discern opportunities regularly.

But there are caveats.

First, the field in which these experts play is a turbulent one, filled with randomness and confounding factors. The star manager may be correct that a fund is wrongly valued and will go up in time, but he can't foresee that the CEO will go under a bus tomorrow, or some internal scandal will erupt, or it will be a competitor that discovers the next oilfield, not this one. This volatility introduces noise into any radar that looks for star managers.

Look at football, a medium amount of noise means it is difficult to pick a star manager season by season. Was it the players? the draw? a refereeing decision? the weather? How much of this seasons performance by leicester was down to the coach? But over maybe 5-10 seasons it becomes clearer and the stars do stand out. Now consider a form of football where we introduce randomness, and at the full time whistle we add a random amount of points to each team, from 1 to 10. And that we don't have visibility of the performance before this random intrusion, we just see the final result 8 goals to 9. Now its remarkably difficult to pick out a star from just 5-10 seasons, we might need 20 or 30. (as an aside, it is even more difficult to pick it out with individual sports like tennis, where we don't have a team to average out performance).

By the time we've had those 20 or 30 years to identify the star, its too late to capitalise on it.
- The market may have changed so much in those 20 years that the skill is no longer relevant (I wonder if having some super ability to spot the future of oil companies is as useful for 2015-2035 as it was for 1980-2000);
- the manager may be close to retirement and we investors don't have time to stick with him long enough to overcome the future noise, as he won't be practising long enough;
- the method that the manager used was most likely a form of beta that is now common knowledge (a charge/accolade levelled toward buffett for instance).

I reckon a good 90% of people labelled star managers are no such thing, but artefacts of noise. And that there are many more true star managers languishing in the mid table, drowned by noise.

I haven't dragged up the right figures here, but for illustration studies show that the number of consistent performers we see in the industry over time is slightly more than the number of consistent performers we'd see by chance, enough to know they exist, but not to decide who they are.

If I'm wrong, and star managers do exist with more clarity than I propose, then we have to ask why the phenomenon is so much more prevalent in the UK. They don't have a star manager concept in Japan, the US, Australia, Germany, not like the one in the UK anyway.

Such is the competition today that I don't think gut feel / instinctive star managers will be that important going forward. Now that we know most of them were successful for exploiting a beta factor before it was common knowledge, the race moves to the refinement or discovery of further beta. The 'star managers' in the US are not public faces, but hyper intelligent programmers and academicians burrowing away in data, renumerated to a level that they don;t really care who the public face of the fund is on trustnet.

One of the sources of noise is you, the monday morning quarterback, the retail investor. If you get off the field and let the experts play we'd reduce the noise. Instead, be satisfied to be a spectator, a passive investor, where the rewards come from watching the experts, not hopping on the field to kick the ball sideways.

Malthusian

Anyway, I'm curious how you explain consistent outperformance by a small number of star fund managers.

There are thousands of fund managers in the world and it is a statistical inevitability that a small number of them will outperform the market over a sustained period of time.

Suppose I take a hundred rats, and I give each of them a FTSE 100 portfolio, and in each of their cages I put a stock ticker and two buttons. Every time they press the button marked 'Buy' they buy whatever stock is on the stock ticker and every time they press the button marked 'Sell' they do likewise.

After a year I will have roughly 50 rats that will have beaten the index in 2016. The other rats I dispose of. After two years I will have roughly 25 rats that have beaten the index in both 2016 and 2017. After five years I will have around 3 rats that have beaten the index every single year. According to those who follow the cult of the star manager, these rats have demonstrated a special insight into the markets, and we should all invest our money with them.

I mean, I could protest that they're just rats, but you can't argue with that past performance record, can you.

In real life, of course, we don't unceremonially dispose of failed fund managers - we just close their funds and merge them into more successful ones.

talexuser

I think the efficient market theorem is somewhat let down by the herd theory. In the same way Dunstonh mentions many poor active funds are just closet trackers with high charges, those managers feel safer following the herd. Maybe the next big danger here is China where there might now be a huge number of relatively unsophisticated investors who at the first sign of a sell off will try to pile in and trigger the stops every day as recently happened.

Malthusian

I think the efficient market theorem is somewhat let down by the herd theory.

How exactly? As long as the whims of the herd-followers are reflected near-instantaneously in the market price then the efficient market hypothesis stands.

I'll say it again, the efficient market hypothesis has absolutely nothing to do with whether the price an efficient market sets is objectively sensible or socially desirable or anything like that.

grey_gym_sock

Malthusian wrote: »

How exactly? As long as the whims of the herd-followers are reflected near-instantaneously in the market price then the efficient market hypothesis stands.

I'll say it again, the efficient market hypothesis has absolutely nothing to do with whether the price an efficient market sets is objectively sensible or socially desirable or anything like that.

that's not quite how i read EMH. surely it implies that information is immediately reflected in prices in some kind of rational way.

if a wheat crop has failed, markets might rationally respond by raising the price of wheat. but, for instance, could they rationally respond by reducing the price of wheat? only if there's a suitable explanation - e.g. perhaps many people will decide that, after yet another failure of a wheat crop, wheat must be cursed, so they will refuse to eat it at any price; in which case, those people may be irrational in their eating preferences, but the market's pricing (which can be partly driven by those irrational people's participation in the market) is perfectly rational.

or what if the market decided that, when a wheat crop failed, then the price of any stock beginning with W will be changed to $10,000 minus the previous price? providing that happens immediately - let's say, because some people irrationally believe it's the right thing to happen, and other people know that there are many people who believe that, so they anticipate the price moving in this way - then can EMH still hold? i'd say: not unless there is some explanation why these price moves actually reflect the true value of each W company. you could come up with some convoluted explanation for that - e.g. that when people "know" that the price of Woo-Hoo Inc "should" jump from $900 to $9,100, they will rush out and buy lots of Woo-Hoo's products, until a sensible person would have to agree that Woo-Hoo Inc is now worth about 10X more than before. but if there is no such explanation, then these price moves are inconsistent with EMH.