Sunday, October 09, 2005

Happy Anniversary, You’re Perfect, Now Change—Part II

In 2002, a film titled “A Beautiful Mind” won four Oscars, including Best Movie of the Year. It depicted the 25-year struggle with schizophrenia that afflicted John Forbes Nash (played by Russell Crow). Nash was an instructor of mathematics at Massachusetts Institute of Technology, whose studies relating to game theory won him a Nobel Prize, surprisingly in economics, in 1994.

Game theory is defined as “a mathematical method of decision making in which a competitive situation is analyzed to determine the optimal course of action for an interested party, often used in political, economic, and military planning.” The simplest way to think of this is to imagine yourself as an interested party playing a game—say poker—trying to decide what your next move will be. The concept has application over a far ranging group of subjects such as evolutionary biology, international relations, sociology, psychology, engineering, and computer science.

It is estimated that some 2.5 million MBA’s and economists have been taught the subject, and few major business decisions are made today that do not utilize this method. It is interesting to note, in 1985, it was recognized that the Babylonian Talmud—a compilation of ancient law and tradition established during the first five centuries A.D., which serves as the basis of Jewish religious, criminal and civil law—anticipated the modern theory of cooperative games. Game theory was refined over the past three centuries, but it was not formalized until 1944 by John von Neuman and Oskar Morgenstern.

Game theory posits that there are three kinds of games: a positive sum game where on average, the players win; a negative sum game where on average, the players lose; and a zero sum game where on average, players break even. Investing is generally accepted by almost all experts to be a zero sum game wherein half of active investors will outperform a specific benchmark such as the Dow Jones Industrial average, or the S&P 500 Index, and half will underperform.

If you listen to Garrison Keillor’s wonderful radio program on Public Radio on Saturdays and Sundays, you might recall him jokingly claiming that in the imaginary town of Lake Wobegon, “The women are strong, the men are good looking, and all the children are above average.” Obviously, to produce an average, half must be above and half must be below—it is not possible for all children to be above average. In that same vein, John Rekenthaler, director of Morningstar has stated, “We can’t all be above average investors. If you survey investors, probably 80 percent say they are better than average. But, at most, only 50 percent can be.”

Rekenthaler continues, “That means that success and failure offset each other. For every investor who wins, there will be one who loses. And since active management is costly (management fees, transaction costs, etc.), the average return of all active investors will be less than the average return of all passive investors. This conclusion is based on simple arithmetic, and is not debated by investors from either camp.”

In a widely admired recent series of articles actually written for investment professionals, W. Scott Simon, criticizes the traditional usage of active investing by the vast majority of stock brokerage firms and most other investment professionals: “The investment information system, composed of the media, mutual fund families, stockbrokerage firms, investment advisory services, and other entities, derives vast sums of money by encouraging investors to believe that they can beat the market. Hopes of finding the next hot stock tip, identifying the next winning mutual fund, or crowning the next investment guru saturate this world that many investors live in and from which they get their information about investing. This system is enormously powerful in how it affects the emotions of investors (both amateurs and professional) and how it impacts their investment decision making.”

Simon writes further: “No amount of hope and luck…or work and skill…can change the mathematical certain fact that active investing in all financial markets…is a zero sum game. This law of nature may seem unfair to active investors.” Simon goes on, “Investors may disagree in their beliefs about this market being efficient or inefficient or that stock being inefficiently priced. There can be no room for disagreement, though, about the fact that active investing in all financial markets is a zero sum game where most active investors are condemned to underperform after costs. Those who would disagree with this just can’t do simple arithmetic.”

It is for that reason that Meir Statman, professor, and expert in Behavioral Finance at Santa Clara University differs somewhat on the belief that active investing is a zero sum game. Using the game of roulette as an analogy he says, “All the money in a gaming casino comes from the pockets of the players, right? Some win some lose, but the total amount in the pockets of the players at the end of the evening is less that the amount they brought in with them. The house takes a cut on each spin of the wheel, paying out less in winnings than it collects in bets. So roulette is a negative sum game, and so is your non-index mutual fund.” The “house” in the case of investing is the consortium of mutual fund companies that takes its cut in the form of the various expenses that ultimately produce some of the highest profit margins of any American industry. This parallelism cited by John Bogle comes to the same conclusion: “...just as gambling in the casino is a zero sum game before the croupiers rake in their share…and a loser’s game thereafter, so beating the stock and bond markets is a zero sum game before the intermediation costs, and a loser’s game thereafter.”

Splitting hairs between zero sum and negative sum is really not too productive. The point is there are numerous academic studies that suggest in most cases, passive index beating performance by active managers can be attributed to luck. Burton Malkiel, finance professor at Princeton and the author of the seminal book, a Random Walk Down Wall Street, maintains that there are very few managers who consistently outperform the index over long periods. But it is virtually impossible to predict in advance which the ones who will win are—in addition; the past record of the fund is not predictive. As an example, the top funds of the 80’s as a group, underperformed in the 90’s.

Confirmation of Professor Malkiel’s position can be found merely by considering the data cited earlier in Part I of this series whereby passively managed index funds consistently outperform the average actively managed fund over the long term. However current shorter-term data is also confirmatory, wherein three and five-year periods ending June 30th, 2005 are evaluated. To cite a few extreme examples, for the three-year period, the S&P 500 Index beat 74.5% of actively managed large cap funds and did so by 66.8% for the five-year period. Likewise, the S&P mid cap 400 Index outperformed 79.1% and 80.8% of mid cap mutual funds over the same respective periods. The S&P Small Cap 600 Index outperformed 76.8% and 72.7% of small cap funds over the two periods.

Viewing all nine of Morningstar’s Style Boxes—Large Cap, Mid Cap, and Small Cap, each broken into Growth, Blend, and Value—produce similar data results over the same three and five year periods. With one exception, the Index outperforms its actively managed peer group of funds over both time periods from a low of 55.5% to a high of 90.7%. The S&P Barra 600 Small Cap Value Index outperformed only 42.8% of its active peer group over the three-year period; however, it did outperform 60% over the five-year period. Thus, the index funds outperformed in 18 of the 19 style box comparisons. Any argument favoring actively managed mutual funds is difficult to justify.

In another stroke of serendipity, the night before this article was submitted for publication, the on-line site of Smart Money published an interview with one of the very few money managers I have any faith in or respect. His name, William Bernstein, may be familiar to my readers since I have not only mentioned him before, but a few years ago I reviewed an excellent investment book he had written titled, The Four Pillars of Investing. He is a Neurologist, turned investor, who is a very strong advocate of passive investing and, of course, index funds.

He responds to the question, “Why do you think it’s so impossible to beat the market?” as follows: “Markets are efficient enough that if you decide you want a certain asset allocation, you decide to invest passively. It‘s difficult to beat that performance at the market level. Indexes will beat three quarters of active managers. If you look at a global portfolio, if you actively manage each of 10 asset classes, (similar to the Morningstar style boxes mentioned above), chances are you will lose. To win in one asset class you can be lucky and beat the index. But, if you are an investor, you need to beat the benchmark in at least seven or eight of the asset classes if you’re investing in 10 to 15 asset classes. The chances of doing that are close to zero.” It should be pointed out that Dr. Bernstein assumes (and strongly advocates) the desirability of diversifying across a wide group of index funds representing various asset classes.

The title of the interview article is Monkey Business. That is based on the author, one Lisa Scherzer relating the often-cited analogy explaining randomness and probability: “Take 1000 chimpanzees, have them flip coins 10 times in a row, and some of them are bound to get heads all 10 times.” Are those chimps skillful or lucky? The answer should be obvious. Yet, most investors fail to see the relevance of this to stock picking. If you replace the chimps with actively managed mutual fund managers, some of them will outperform an index. Most investors would praise these managers as skillful or talented—William Bernstein disagrees. Ms. Scherzer writes: “The author and investment advisor puts them on a par with that of the coin flipping simians.”

So, if investing in passively managed index funds is as “perfect” as the above headline implies, and as the facts seem to confirm, what are the changes that challenge a concept that has withstood numerous other challenges over the past 30 years? What must be clearly understood is that it is not the notion of passive investing that is being contested. The challenger, Electronic Traded Funds, or ETF’s are actually passively managed index funds with functionalities that differ from, but provide a number of benefits lacking in traditional index funds.

Knowing more about these advantages inherent to ETF’s (as will be described in next month's article), should provide investors with a different outlook, and with additional ammunition to insure that unlike the simian-like “lucky” mutual fund manager, skill will triumph.

As a point of information, Part I of this series, that appeared last month, was sent by a friend to John Bogle. Mr. Bogle graciously responded with a personal email to me that read: “Thanks for remembering the 30th anniversary of ‘Bogle’s Folly.’ Your comments about me were far too generous…but nice anyway. Please send me your next article when it is available.” This is the second time that Mr. Bogle has read an article from Viewpointe and responded favorably.


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