"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
When someone picks active management over passive, they are really betting that they can beat, and hence are not, average. It's difficult for people to swallow their hubris, even when simple arithmetic shows them that they are (collectively) wrong.
So if you want to beat the market, your chances are still better in the passive group...
Now, this doesn't take into account getting away with insider trading, of course. If you can get away with insider trading, then you can beat the market just fine.
More importantly, it also doesn't take into account that there are investment opportunities that are not as directly (i.e., without intermediary layers which extract some of the returns) available to passive investors, so that the passive/act groups aren't splitting the same universe of alternatives. (E.g., passively investing in any given index fund is on average better than actively investing restricted to stocks in that index, and you can probably even extend that to passively investing in index funds in generally being better than actively investing in investments that directly held by any combination of index funds, but not every investment vehicle in the market is directly held by index funds.)
Is this really true? I think it's only true if you replace average with median (e.g. in [1,2,3,10] only 10 is above the average).
> [I]f all of the "passive" half have a different random subset, then about half will by definition do "above average", and the other will do "below average". While in the "active group", less than half will do "above average" because they pay part of their gain to fund managers.
So, if all the passive investors have pick a random "large enough" subset of stocks, one would expect the distribution to approach the normal distribution, with roughly half to either side of the arithmetic mean.
Similarly, as you point out, on the "active" side, one might see more outliers - and perhaps the selection isn't really uniformly random.
So, it would probably be a stretch to claim that half will be above average "by definition", even if one includes the expected distribution, while note perhaps entirely wrong.
Also, as I understand it, Berkshire gets to implement management changes (if it deems them necessary) as it wishes, since it owns whole companies, and so the improvements they see could also come from better management of a business rather than picking better businesses. So arguments about average or above average stock picking ability seem less relevant here. (It could well be that Buffett has average management-picking ability, but is one of a relatively small number of market participants who both can and do exercise it, thereby getting an outsize result.)
ISTR a study a few years ago that said the only way you can know for certain that a fund manager is above average is on something like 30+ years of data. There's too much random variation.
I think it was the same article that said the baseball season would need to be several hundred games before you could definitively choose the best team in a given season.
Perfect example: Buffett has always touted value as a great investment strategy, but he completely missed the cocktail of global trade, speed, and scale that have driven Amazon, Google, Uber, Netflix, Apple, etc. to grow revenue and profits so rapidly.
Looking back, I think this shift into a world where it's possible for a company to go from zero to hundreds of millions/yr in net revenue over a span of 4-5 years (Uber) is really going to be seen as some kind of historical turning point in business, on par with the invention of the printing press, or electricity. Companies used to take a century to accomplish growth that's now possible in less than a decade.
Which is all to say, over a long enough timespan, you're talking about a pretty deep and complex philosophical question, what it means to be a "good investor" in the face of so much change, risk, etc. To be honest, I'm not sure it's something that's knowable at all.
Different individuals on the active side have wildly differing returns. The guy who invests in the hedge fund with 200% returns doesn't care about the 20, 2 fee structure he has to pay on his investment because he's made so much more than the passive guys. There will be large losers and large winners, but you have to pay table stakes (fees) to play and have your shot at winning those big returns.
Buffet is talking his book - a hugely diversified portfolio that basically represents and relies on the strength and growth of the American economy, as well as US government-mandated oligopolies like insurance.
This was the argument made by Protege Partners, when betting against Buffett in the great "index funds vs hedge funds" long bet [0]. It turns out that the index funds fared better — and they're mainly used for long-term investment, where the short-term macroeconomic ebbs don't have an impact on the overall return.
Of course the variance on the active side will be higher, but there are as many losers as they are winners, and much of it is due to simple randomness. Unless you're confident that you know more than other investors (for many people, including myself, we probably don't [1]), index funds, or "hugely diversified portfolios" are the way to go. Basically, no hedge fund is making those 200% returns you're speaking of, and even if some fund were, empirically it's more likely to be just noise. Look at the result so far of Buffett's bet on hedge funds. It speaks volumes.
[1] https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effec...
Truth is that the starting time of an investment determines your results far more than whether you pick active or passive investing.
Word of warning: on a long term graph, today does not look like a good time to start investing, in fact looks like a really good time to sell and stay on the sidelines. This is not affected by passive vs active investing.
Could you expand on what you mean here? Do you mean, that for every day, "today does not look like a good time to start", or do you mean that on this May 4th, 2016, you expect that investments made today, will seem like a bad investment on May 4th 2066? (Or whatever is considered a "long term graph")?
Also if you look at long term history you'd conclude something similar : the US has had a very long (if somewhat disappointing) economic recovery since 2008. We're due a bust.
And finally, the playbook from earlier recessions does appear to be unfolding : manufacturing production has dropped by a lot, and services has flatlined. This is very much like the start of previous recessions. Next up is bad loans to commodity producers (ie. miners) and manufacturers actually going bad (meaning banks declaring losses), then a few defaults, then panic, then recovery.
I would expect index investments made today will seem like bad investments in 10 years. I would never dream of predicting 50 years out. To be fair, I would have told you the same a year ago (not about the recession playbook, but probably everything else listed in this post).
High based on what metric? When I look at this graph, it looks like it's been relatively flat for the last half decade: http://i.imgur.com/3gIwjbh.png
http://finance.yahoo.com/echarts?s=%5EGSPC+Interactive#{"ran...
It's up 53% over that 5 year period, for a CAGR of 8.9% (excluding dividends).
Yes, actually, it is. That's the whole point.
The economy will stagnate. Eventually the entire portfolio the room holds will be money losing companies, burning up the country's capital.
The half of the room who are active investors contribute greatly to the economy's long term growth. They could either have negative long run returns as passive investors, or positive long run returns that are less than passive investors.
Index funds are weighted by capitalization. So whether GM's capitalization goes up or not is actually irrelevant: what's relevant is the ratio of its capitalization to the size of the total capitalization of all companies in the market, and how that changes.
Setting that point aside, here's some basic math that shows why this analysis is completely wrong and why GM's market cap will go down. Let's say today, I am the CEO of GM, and I issued 1 million new shares, bringing the total up to 1 Billion outstanding shares. I dump them on the market, when the price was $50. The price drops some amount, because shares are being sold.
How much money did I, as CEO of GM, raise? At most $50 million
How much could market cap possibly have gone up? Exactly the amount that was raised: at most $50 million
How much could market cap possibly have gone down? Drop in stock price * 1 Billion
So market cap increase is precisely equal to the amount of capital provided by investors, which is finite and won't run away into a vicious cycle as suggested by the poster. Market cap decrease can be... well... 100%, all the way to zero. And the more shares issued, the more downward pressure on market cap... as the effect of crossing the bid-ask spread on market capitalization gets amplified.
I'm sorry, that's an invalid assumption. Especially in a world with only passive investors.
GM has been losing $1 billion a quarter for 10 quarters. GM's stock price is $30 as it has been since 10 quarters ago, market capitalisation $40B. It is running out of cash building unprofitable products. The underwriter calls various index funds, telling them there will be a capital raising of $10B, at $28 per share, representing a ~5% discount, and as a result of that, GM's weighting in the index is going to be re-weighted upwards at the next index balance in three weeks, so they might as well sell other (more productive) stocks, which will be weighted downwards, and buy GM at a discount. The capital raising is "oversubscribed" because of this arbitrage opportunity. As a result of the discount, the stock price of GM falls from $30 to $29.50 ($2 times by roughly 25%). GM's stock price falls 0.16% per quarter, and can sustain this rate indefinitely because of passive investors.
In a stock market with active investors, GM's fall in stock price would be a lot more than 50 cents.
Passive investors represent inertia that will keep the current ratios of market capitalisation between companies listed on the stock exchange constant, even if those ratios are suboptimal economically. As a result of the stunted capital allocation, the economy will begin to shrink, over the long run, as it continues to support unprofitable companies by depressing the share prices of the more productive companies, since, ironically, those more productive companies raise much less money than the unprofitable ones, and those capital raisings funded by selling the other companies that aren't raising money.
It's like going into a casino and arguing that the casino is losing because you see one guy hit a jackpot on the slot machine.
But you aren't. That's who he was speaking to and speaking about. Average investors.
[1] See figure 3: https://wealth.barclays.com/wealth-management/en_us/home/tho...
It may make more sense selfishly to be in the low-energy group, but the overall returns might be lower the more people go that route.
A flawed car analogy: A driver and passenger will both travel the same distance, but the driver spends a lot more effort per mile.
So it might both be better for each individual to be low-energy yet better for everyone if people were more active.
It's an interestingly complex problem.
In your analogy, I'd say investors are car leasing companies, and it's unclear if they provide a value that can't be just as well provided by the driver(s) buying their cars outright. It would mean that the driver(s) would have to be on more equal footing to the investors, though (they'd have to be able to afford the car).
All counted, isn't it great when incentives align almost perfectly with the global optimum?
Passive investors achieve the average return. Active investors receive some distribution of return but obviously it must range from some above to some below average. 1/x investors get a worse than average return, despite their efforts. For simplicity, let's say that 1/2 of the investors 'win' and half 'lose'.
That losing half would do better if they moved to passive investments, allowing the top half to make the real gains. Now, we're back in the same situation. Does this not continue on until it's selfishly best for everyone to be a passive investor, even though overall that might be worse?
Ways I think I might be wrong:
- The maths doesn't really work quite that way once the balance shifts away from 50% each side. It may be possible that some proportion of active investors will always make more profit than the passive investors. I don't think this is right but if it is then it'd entirely break the reasoning.
- Changes that happen from one step to the next. The winners now own more capital and therefore we don't see the same converging series. I don't think that matters other than prolonging the outcome, but I'd not be surprised if I'm wrong on this count, I've not thought it through fully.
(I'm trying to be more cautious about making overly bold claims and so am trying to point to things I know might invalidate what I'm saying, if it seems annoying then let me know)
Put transaction costs there, and you get an adversarial system. Now the top investors will try to convince the others of their own incompetence. Didn't do the math, but the outcome is probably bad.
Now, fill the market with real humans and irrationality will make sure enough incompetent investors will be active to let a big enough amount of competent ones make a win. Stable again.
I'm really unconcerned about index funds.
[1] A spherical cow in vacuum.
If you own all of the stock in the US, and no-one actively trades in any single stock, how do you know how much one sort of stock is worth against another piece of stock?
I think this eventually drives trading of individual stocks, as the market looks to set prices/trade things this that it thinks are over/under valued.
So I think that it's true that on average an active investor will make less money than a passive one, it's the active one's doing the work/generating the value, as well as giving money to the passive investors!
(presuming rational actors, laws are obeyed etc etc)
If this stuff interests you, I recommend reading the previous post (http://www.philosophicaleconomics.com/2016/05/passive/), which discusses this exact topic.
And if they put money in from their monthly paycheck, they're placing a buy order.
As long there is a reasonably good balance of buyers and sellers of mutual funds, the underlying securities will find equilibrium.
There is no "correct" price aside from the price set through the market.
(1) the initial split was formed by splitting each company into halves between the two groups, and
(2) no new companies were ever formed, or, if they are, they are from initiation split ownership exactly 50/50 between actives and inactives.
Which kinds of begs the question, how much passive investment can there be, and what is the limiting factor, if not a Grossman-Stiglitz model where 'arbitrage ' (in this context market-making, market-timing etc.) makes prices boundedly efficient, and less arbitrage means higher spreads, less liquidity, less pricing efficiency.
There must be a 'Bernstein peak' and mixed strategy equilibrium, where if you have too much active, expenses are too high, and if you have too little active, liquidity suffers and costs from spreads and volatility are too high.
There is no real danger that so many people are going to turn passive that it won't work; there are plenty of people out there who think they can do better (and always will be, given human nature), despite the evidence that they won't.
No, it assumes that all assets are passively investable, and each asset is half held by passive investors and half held by active investors. Under any other set of assumptions (particularly, if its just a 50%/50% split of initial market value across all but not each individual investment), the equal-returns conclusion does not hold.
I believe he meant that active fund managers may be able to get positions or create/use instruments that are not available to the general public.
Read some of the other comments in this thread and you'll see it's not common knowledge either.
This Planet Money episode talks about it in detail.
http://www.npr.org/sections/money/2016/03/04/469247400/episo...
An excerpt from the transcript [0] follows:
What I’d like you to do is for a moment, imagine that in this room, you people own all of America. All the stocks in America are owned by this group. You are the Berkshire 18,000 (or whatever it is) that have somehow managed to accumulate all the wealth in the country. Let’s assume we just divide it down the middle. On one side, we put half the people…half of all the investment capital in the world, and that capital is what a certain presidential candidate might call ‘low energy’. In fact, they have no energy at all. They buy half of everything that exists in the investment world – 50 percent – everyone on this side. Now half of it is owned by these ‘low energy’ people. They don’t look at stock prices. They don’t turn on business channels. They don’t read the Wall Street Journal. They don’t do anything. They are a slovenly group that just sits for year after year, owning half of America’s business. What’s the result going to be? The result is going to be exactly average as all American business does because they own half of all of it. They have no expenses – nothing.
What’s going to happen with the other half? The other half are what we call the ‘hyperactives’. The hyperactives’ gross result is also going to be half, right? The whole has to be the sum of the parts. This group, by definition, can’t change from its half of the ultimate investment results. This half is going to have the same gross results. They’re going to have the same results as the ‘no energy’ people but they’re also going to have terrific expenses because they’re all going to be moving around, hiring hedge funds, hiring consultants, and paying lots of commissions, et cetera. As a group, that half has to do worse than this half does. The people who don’t do anything have to do better than the people that are trying to do better. It’s simple.
[0] https://www.biznews.com/global-investing/2016/05/02/berkshir...