INVESTMENT INTELLIGENCER

Warren Buffett: Buy Low-Cost Index Funds

The Oracle delivered some secrets of intelligent investing in a press conference following the Berkshire Hathaway annual investor meeting:

• Buy low-cost index funds, which will outperform the majority of other investors (the vast majority).
• Avoid hedge funds.

Buffett also said he hoped that Berkshire would outperform the S&P by a couple of percentage points (which wouldn't be surprising, given the value effect).  He added that he would be "amazed" if Berkshire did any better than that.

Mauboussin: Why the Market is Smarter Than You Are

Most people who write about the wisdom of crowds offer colorful anecdotes about crowd intelligence but don't explain why groups are smarter than individuals.  In a recent piece, Explaining the Wisdom of Crowds, Legg Mason strategist Michael Mauboussin solves this mystery.

Drawing on a book by Scott Page (The Difference) and some of his own experiments at Columbia Business School, Mauboussin first observes that, in order for crowd wisdom to prevail, several conditions must be met:

• The group must be cognitively diverse (the individuals in the group must have different approaches to analyzing and solving problems).
• There must be a way to aggregate each individual's opinion into a collective view (such as a stock market).
• There must be incentives: rewards for being right, punishment for being wrong.

In most cases, the stock market easily satisfies all three conditions.  (Mauboussin has argued in the past that part of what happens during bubbles is that there is reduced cognitive diversity, as most investors begin to think and invest alike). 

Mauboussin then describes three distinct types of situations in which groups are wiser than individuals. In the first, the "needle-in-the-haystack," a subset of the group knows the correct answer, but the majority does not (Mauboussin uses the example of the audience on Who Wants to Be a Millionaire).  Here, the crowd's "best guess" is superior because the subset of people who know the answer ensure that the correct answer is the most popular choice (everyone else's guess is random).

In the second and third cases, which are closer to the situation in the stock market, no one in the crowd knows the correct answer, so it must be estimated.  (In the stock market, no one knows what stocks are worth because the valuation process is subjective and because the key variable--future cash flows--is unknown).  In these cases, Mauboussin attributes the crowd's wisdom to Page's "diversity prediction theorem," which states the following:

Collective error (the difference between the correct answer and the group's average estimate) = average individual error minus prediction diversity (the dispersion of the individual estimates).

Mauboussin invokes his Columbia experiments--"guess the number of jelly beans in the jar" and "predict the Oscar winners"--to show how this theorem works.  He also summarizes the theory's implications, all of which apply to investing:

1. A diverse crowd will always predict better than the average individual.  Not sometimes.  Always. 
2. Collective predictive ability is driven by average individual accuracy and diversity.  In other words, a crowd composed of simpletons who think the same way will be less intelligent than one composed of independent-minded geniuses or experts.
3. The group is often smarter than not only the average individual, but the smartest individual.

The last point is critical for investors.  Because of our innate overconfidence, we quickly dismiss the fact that a diverse crowd is always smarter than the average individual.  (Most of us think we're above average).  What is far harder to dismiss is the fact that the crowd is often smarter than all individuals. 

In instances in which the crowd is not smarter than all individuals, moreover, the individuals who beat the crowd usually change with each successive prediction (which gives the investment media a parade of new gurus and "fallen stars" to write about).  Just because you are occasionally right when the market is wrong, in other words, doesn't mean you usually will be. 

Costs Matter: Vanguard Wins Again

Low-cost fund leader Vanguard had another strong year in 2006, with 78% of its funds beating their peer-group averages.  Over longer periods--three, five, and ten years--the percentage is even higher: more than 80%.

This performance, of course, has nothing to do with superior stock-picking and market timing--and everything to do with costs.  The industry-wide average mutual fund expense ratio was 1.27% of assets in 2006.  The average Vanguard fund expense ratio was 0.21%.  Since 1975, moreover, Vanguard's average expense ratio has dropped to one-quarter of its original level--while the industry-wide average has risen.

Given Vanguard's consistently strong performance, it is no wonder that it now manages more than $1 trillion of assets and is the second largest fund firm in the world.  What is a wonder is why more fund companies haven't copied Vanguard's "secret formula."

Actually, it's not a wonder.  Most other fund companies are for-profit corporations, many of them publicly held.  For-profit corporations, especially publicly-owned ones, have impatient shareholders to please.  And for impatient shareholders, even a three-to-five year time horizon is eternity.

In Search Of: A New Name For "Passive"

One of the many reasons "passive" investing gets dissed is that its name--"passive"--is both misleading and deflating.  Who wants to be "passive"?  The folks who do well in life are active, the ones who have gumption, the ones who get up off the couch and make things happen.  "Passive" investing, moreover, isn't passive--it's active.  Smart passive investors actively determine which types of stocks they want to invest in, actively screen the market to find such stocks, and actively manage their portfolios to make sure they contain only such stocks (and in the proper proportion). 

So smart passive investors, the ones who wouldn't mind earning some respect in addition to superior returns, are forever searching for a new term to describe what they do.  Alas, to date, none has been found.

"Indexing" doesn't work, because "indexing" suggests that the passive investor is simply trying to match the performance of the S&P 500, Russell 2000, or other index.  And now that such strategies are popular, the style suffers from herding, index-reconstitution, and other problems (even thought it still outperforms most active strategies).

"Rules-based investing" doesn't work because...well, because it's boring and vague.

"Factor-based investing" doesn't work because it's mystifying.

"Dimensional investing" doesn't work because...ditto.

"Quantitative" doesn't work because it has already been coopted by "quants."

The latest suggestion, "Equilibrium-based investing", put forth by DFA's Weston Wellington in a recent article, doesn't work because it doesn't mean anything that couldn't just as easily apply to the "active" world.  (Although it is arguably better than "passive").

So the search continues.  One thing is certain, however.  If passive investing continues to be called "passive," those who advocate the strategy will continue to operate at a major marketing disadvantage to their "active" competitors.  In fact, given the inherent connotations of the words "active" and "passive," it is almost certain that the nomenclature was devised by a traditional stockpicker.

Fama and French Dish, Diss, and Disagree

In this Journal of Indexes (JOI) interview (download below), two of the world's smartest investors weigh in on the strategies that have made Dimensional Fund Advisors one of the most successful fund firms in the world.  Better known as finance professors, Eugene Fama and Ken French helped design DFA's stock-selection and fund-management techniques.  In this interview, Fama and French revisit their original conclusions, poke fun at the arrivistes who have since claimed to have discovered their ideas, and, once again, show why traditional stock-picking is almost always for the birds.

Notable points:

• Fama and French now disagree about the cause of the "value effect"--the phenomenon in which value stocks have outperformed growth stocks over the long term (for more on the value effect, see this post).  French no longer believes that this outperformance represents "distress risk" and, instead, thinks there is some "mispricing" involved (investors underestimating the prospects for value stocks and overestimating them for growth stocks).  Fama, ever the efficient market man, begs to differ.

• Both men are shocked that commentators believe that today's hot product--"fundamental indexing"--is actually something new.  The academic literature, they point out (and DFA), has described the strategy for 15 years.  The advantage of "fundamental indexing" is merely that it captures the value effect.  As French puts it: "It's not even another way [of doing this.]  It's the same way.  I have a friend who calls [fundamental indexing] value investing for clients who don't understand ratios."

• On the "dividend-weighting" strategy used by Jeremy Siegel and WisdomTree: This, too, is nothing new.  Dividends are just another way of sorting stocks to capture the value premium.  Unfortunately, using dividends as the value screening metric is inferior to using book-to-market ratios.  How do Fama and French know this?  Because they've tested all the value metrics.

• Fama still thinks the market is efficient, but French now concedes that some people can probably beat it.  Returns are so random, however, that he just doesn't have enough information to figure out who they are (implication: neither do the rest of us.)

• On whether the value/growth mean-reversions can be timed (Specifically, as I asked in this post:  Can investors use the ratio between value and growth to predict the performance of each asset class?)  According to French, there's no evidence that this works.

• On ETFs: Great tools, as long as they're cheap and passive.

• On behavioral finance: Investors make the mistake of assuming that, now that they know some of the mistakes investors make, they won't make those mistakes.  Unfortunately, they'll probably just make others.

Download fama_french_journal_of_indexes_3_07.pdf

Will the "Value Effect" and "Size Effect" Persist? Do They Even Exist?

In my "dumbest column of the year" post, I suggested that DFA and other smart investors have capitalized on the "value effect" to design better passive funds.  Astute readers pointed out that the value effect is a theory, not a fact, and that it might soon disappear--leaving those who bought "value tilted" or "fundmental-weighted" funds holding an underperforming bag.

This is a complex topic, one that still produces violent arguments in the halls of academia and elsewhere.  Fama, French, DFA, and others attribute some of the superior long-term performance of value and small stocks over large growth stocks to higher risks: stocks get cheap because the companies are in distress (or riskier), and rational investors demand a higher return.  If this view is correct, the effects should persist over the long term, even if they disappear for decades at a time.

One contrary view, held by John Bogle and others, is that the value effect is merely a short-term trend that, like other such trends, will eventually become over-bought.  Having "discovered" that value stocks outperform growth stocks, this theory goes, investors will bid up the prices of value stocks, and this will reduce or eliminate future higher returns (or, more pertinently, result in lower returns relative to growth stocks). 

Common sense and analyses of past data suggest that the latter view--temporary phenomenon--is certainly valid over periods that most investors consider long-term: 1-5 years.  Other analyses, however, show that the value effect has, on average, been persistent over many decades and in many markets, validating the former theory, too.  The same can be said for the size effect.

In the coming weeks, I will assemble some of the most important work on this topic (and please feel free to weigh in with studies, thoughts, and comments, either in the comments section or via email).  For today, I will simply highlight some excellent charts produced by Index Funds Advisors.  These show the frequency with which small and value stocks have outperformed large and growth stocks (scroll down to the bar charts, Figs 9-9 through 9-16), as well as the relative performance of small vs. large over selected time periods (Fig 9-17).  The charts show that:

• Small value outperformed large growth in 58% of 1-year periods from 1927 to 2006.
• Small value outperformed large growth in 97% of 20-year periods over the same 80 years.
• Large value outperformed large growth in 58% of 1-year periods and 92% of 20-year periods.
• The "size effect" showed perfect decile by decile performance correlation over 80 years (smallest 10% outperform second-smallest 10%, etc.)  Over shorter--but still long--periods, however, this performance has completely reversed.
• From 1965-1968, 1975-1983, 1992-1993, and 2002-2006, the smallest 10% of stocks wildly outperformed the largest 10%.
• In all the interim periods, small stocks got absolutely crushed.

These charts illustrate why both camps in the "persistent" versus "temporary" camp have an important point.  Over the truly long-term (80 years), the value and small effects appear to be undeniable.  Over interim periods long enough to feel like eternity, however, small and value stocks get overextended and experienced painful reversion to (and beyond) the mean.

Should investors try to take advantage of either pattern? Both?  Should investors "tilt" portfolios toward value/small, but also try to time the mean-reversion by changing ideal portfolio weights depending on relative valuation?  The latter would depend on whether the mean-reversion can be meaningfully predicted...

Dumbest Column of the Year

When you first stumble across this recent column from MSN Money, it seems that the writer (Tim Middleton) might just be playing an early April Fool's joke on his readers.  After reading the the rest of the text, however, it's clear that he isn't--and this means that the joke really is on them.

"Just Beating The Market is Too Easy," the headline says. "Jack Bogle founded Vanguard Group on one simple premise: Indexing beats active management because indexes are less fallible than human managers. So how come this year everything -- small funds, large funds, gold funds, technology funds, energy funds, health-care funds and even utility funds -- is beating the S&P 500 Index?..."

Having hooked readers with a misleading question, Middleton goes on to explain part of an answer, which is that the S&P is primarily composed of large-cap U.S. stocks, while all of the funds above invest in distinct industry sectors or different asset classes altogether.  Some industry sectors and some non-domestic-large-cap asset classes have in fact beaten the S&P so far this year (and will again next year, and the year after that, and so on)--a fact that merely demonstrates why investors are wise to diversify among multiple asset classes.  What this year's performance does not even begin to demonstrate is what Middleton apparently finds so obvious that he is comfortable dismissing a half-century's worth of academic research with a wave of his hand: that passive investing, a.k.a., indexing, guarantees mediocrity and that, for those willing to show a bit of gumption, trouncing index funds is a piece of cake.

The only way to conclude that Middleton's argument is anything short of moronic is to assume that he equates "beating the market" with "beating the S&P 500" and that all "index funds" are designed to track the S&P 500.  If one makes these two leaps, one might agree that simply buying an S&P 500 fund is not the best-possible solution for most investors.  Even in this scenario, however, Middleton would still have some explaining to do (such as how he can conclude that buying the Vanguard S&P 500 fund guarantees "average" performance when almost every study in the past 50 years has shown that the vast majority of funds of any kind have lagged the Vanguard fund and that the fund has therefore delivered excellent performance.)

As the end of the column makes clear, however, Middleton is not content to just trash one of the best-performing mutual funds of all time: He wants to condemn the whole indexing movement.  To wit:

...over longer periods, indexes do not compare favorably with above-average mutual funds, and they are shamed by really good ones. Here are examples:

Middleton then lists four indices--the S&P 500, the S&P Mid-Cap, the S&P Small-cap, and the MSCI EAFE International--followed by the "average" fund for each asset class and a couple of funds that have beaten the indices.  In every case, not surprisingly, the "average fund" lagged the appropriate index in most of the time periods shown.  Also not surprisingly, the top performers beat the indices.

So where's the error?  As usual, in the omissions. 

First, because Middleton has demonstrated after the fact that some funds beat their benchmarks, he wants his readers to believe that such funds would have been easy to identify ahead of time.  Half a century of academic research suggests otherwise.

Second, although Middleton concedes (via the chart) that the "average" fund in each asset class lagged the index, he implies that investors still have a really good chance of picking a fund that beats the index.  In reality, they have, at best, about 1 chance in three (and that's if they switch funds every year; if they are smart enought to invest for the long term, their odds are far lower).  Middleton also ignores the fact that if investors fail to pick an index-beating fund, they will not get the index return.  Instead, they will get a below-market return--sometimes WAY below market.  As a result, choosing an actively managed fund has a negative expected outcome.

Third, despite beating the majority of professional money managers, the indexes that Middleton ridicules are not the state of the art.  Since the mid-1990s, fund firms like Dimensional Fund Advisors and others have capitalized on the discovery that "value" stocks tend to outperform "growth" stocks--and, therefore, that indexes "tilted" toward value tend to do better than those that include a mix of value and growth.  Like Middleton's after-the-fact winners, the smartest passive investors have trounced the S&P 500.

[Update: Some astute readers have pointed out that the "value effect" may not persist, especially now that so many investors have discovered it (see comments).  Bogle himself takes this position.]

Is it possible to pick funds that beat the market, as Middleton suggests?  Yes, it's possible.  It's also unlikely, difficult, and risky (which, in most cases, makes it un-intelligent).  And far from guaranteeing mediocrity, a diversified portfolio of low-cost index funds guarantees exactly what MSN's Middleton urges his readers to strive for: a solidly above-average return.

Thanks to David Boyum for passing on the link.

Some Cramer Fans Now Beating Market

Over at Mad Money Machine, Paul Boyer (an erstwhile Jim Cramer devotee) is running a trading game in which 25 people try to use the famous speculator's insights to beat a passive index portfolio managed by Index Funds Advisors.  Earlier this year, the contestants were accomplishing a wildly improbable feat, in that every single one of them was lagging the index.  In recent weeks, however, the contestants have rallied, and now 6 out of 25 are beating the index.

The contest is just a game: None of the contestants are playing with real money, which might encourage them to take more risk than they would in the real world.  One could also quibble with the low transaction costs charged to the contestants, as well as the zero-value placed on the time they must spend watching the show and placing the trades.  (The index's performance, on the other hand, includes not only transaction costs but a double-layer of advisory fees).  Lastly, since it was primarily last week's market crash that thrust a handful of contestants into the relative black, it might have been cash reserves, not stock picks, that boosted the relative performance (actively managed funds often do well in down markets, because their cash reserves don't depreciate). 

This said, the current breakdown between the game's leaders (25%) and laggards (75%) is closer to what one would expect to see under normal circumstances.  In most markets, about half of stocks beat the market average and half lag, so dart-throwers have about a 50% chance of beating the market in any given period. The earlier performance, meanwhile, in which ALL of the Mad Money Machine contestants were lagging, was a spectacularly unlikely outcome--one that suggested that Cramer's picks were significantly worse than the market average.

On Benchmarks

Capital Research & Management is one of the smartest, best-run, and most successful mutual-fund management firms in the business (Capital runs the American Funds).  In yesterday's WSJ story on mutual-fund streaks($), however, a Capital vice president appeared to invoke some weak logic when explaining a fund's performance relative to that of the benchmark:

"We don't manage the fund with the objective of trying to beat the benchmark," says Drew Taylor, a vice president at Capital Research & Management Cos., which oversees the American Funds. The objective, instead, is to deliver, "over long periods of time, current income and growth to shareholders."

There is no shame in trying to provide "current income and growth to shareholders."  But it does matter how the fund performs relative to the appropriate benchmark.  Given the wide availability of low-cost passive funds designed to track almost every conceivable benchmark, the only reason for fund customers to pay higher fees for active stock-picking services is to try to beat appropriate benchmarks.  If an active fund fails to do this, it has cost the fund-holder money relative to the cheaper passive product, no matter how much "income and growth" it has generated. 

The fact that most mutual-fund buyers don't understand this allows many fund companies to fall back on an intellectually weak defense ("It's okay that we lagged the benchmark, because we weren't trying to beat it.")  This, in turn, allows the active fund industry to continue to coin money while its stock-picking services actually subtract value from most clients' portfolios. 

There is no fraud or subterfuge here: Most active fund companies are just taking advantage of fund-customers' ignorance to set low success hurdles for themselves.  But because the vast majority of active funds underperform low-cost passive funds, the most client-oriented move for most fund managers would be to fire themselves and put their clients in passive funds.  For obvious reasons, few will do so.

UPDATE

As I noted at the top of this piece, Capital has one of the best records in the business.  One reader (see comments) suggests that most of its funds have, in fact, beaten the benchmarks, and with far lower volatility.  If this is true, the firm has accomplished what the vast majority of fund managers cannot, and therefore deserves every bit of its reputation. 

DFA's Davis: Why Most Mutual Funds Lag

In this summary paper, Dimensional Fund Advisors's James Davis reviews the academic research on equity mutual-fund performance from 1969 to 2001.  With some minor exceptions, the research shows the following:

• The vast majority of actively managed funds lag passive benchmarks.
• Some fund managers do have above-average stock-picking skill, but usually not enough to allow them to overcome the costs of their own trading and compensation.
• Almost all fund performance can be explained by four "factors": the market's performance, the relative size of the stocks in the portfolio, the relative valuation of stocks in the portfolio, the relative "momentum" of stocks in the portfolio.  These factors have little to do with traditional "stock-picking."
• The market is not perfectly efficient, but its inefficiencies are not large or regular enough to exploit consistently.

In short, the vast majority of mutual funds lag the market.  They do this not because their managers are stupid but because beating the market is hard.  Fund buyers who want to give themselves the best chance of success should therefore choose among low-cost passive funds.