A case against active fund management - Part 2

In my previous article, I wrote about how majority of the fund managers fail to beat the market but continue to charge high management fees which erodes the wealth of millions of average investor. In this article, my focus is to shed some light on why fund managers fail to outperform the market based on the evidence from years of academic research and the best course of action for an average individual investor.

Why do stock (asset) prices move?

This question has been the focus of academic research since 1860s. According to the academic research, at any given point of time, stock (asset) prices reflect all the available information. Prices of the equities react to new information, which is by nature random and therefore price movement are also random. This hypothesis is known as Efficient Market Hypothesis (EMH). This does not imply, that stock prices will not move up and down. When new information becomes available, market will react to it and the price of the stock will be accordingly adjusted (whether up or down) making it fairly valued.

Based on EMH, we arrive at the conclusion that it's near impossible to buy undervalued shares or sell shares for inflated prices. This, in turn, implies that it is extremely difficult to outperform the market either through smart stock selection or market timings.

A common question posed by opponents of EMH is how does one explain the dot com bubble of 2000 and its subsequent bust, housing bubble of 2005-2006 and then GFC in 2009. It is important to note that EMH is after all, a model, and like any model it is not perfect. The stock market is forward looking. In my humble opinion, the stock prices not just reflect all the available information but the interpretation and expectation (sentiment) based on the available information of all participants. Since stock market is forward looking, markets go up and down in anticipation of a recession or slower economic growth based on the interpretation and expectation (sentiment) derived from the new information. Most of the time, the expectation is more or less close to the reality . At times, when the unrealistic expectations gets the better of the investors it results in significant bubbles and bust. It is important to realise though, that, these are not an everyday event.

Warren Buffet acknowledges that markets are efficient most of the time about most things and believes that there are exploitable “pockets of inefficiency” (Source: Tap dancing to work and Emory's Goizueta Business School and McCombs School of Business at UT Austin). Shrewd investors, who have the ability to not be swayed by the unrealistic expectation (both optimistic and pessimistic), can produce returns that outperform the market by a wide margin. Based on the quantitative evidence, such investors form a very tiny fraction (about 1%) of the investing community and odds of identifying such fund managers at the outset are extremely low.

Within the last decade, the frequency of trading has increased by 100 fold from 20,000 trades per second a decade ago to 1.8 million trades a second. The number of investors have also increased in number. In the US alone, there are 14 times more mutual funds today, then there were in 1979. With every trade, investors give their estimate of how much a stocks is worth based on their interpretation and expectation (sentiment) of the available information. This implies that the price of every stock is the very latest, best estimate of the entire market. That's how efficient markets have become (if not totally efficient, very very efficient at least).

Capital asset pricing model
Capital asset pricing model (CAPM) is a model to determine the prices of an capital asset in an Efficient Market. This depends on two things, the risk of holding the asset when markets fall and secondly, the expected returns. CAPM also introduced a concept called, market beta, a measure of the volitity of an asset or portfolio in comparision to the market as a whole. This allows assets to be categories by market risk, size, value, profitability and investments. In other words, the return you expect from a security is related to the risk of holding it when markets fall.

By the same logic, small company stocks are more volatile (risky) when compared to larger stocks and if held for long period of time, should deliver higher returns.

Another characteristic of financial markets is that the prices of different assets go up and down at different times. Hence, it pays for an investor to be diversified as it reduces the risk. Ideally, an investor should hold all the available securities in the market.
What does all of this mean for the ordinary investor?
Investing is counter-intuitive in the sense that when we look at the other products and services that we buy as consumers, higher prices usually equates to better product or service but not so in case of investing.
Based on the evidence, we should be very wary of investors who say they can beat the market on consistent basis. Because markets are fundamentally efficient, consistent out performance is near impossible. The ordinary investor should therefore invest in passive funds that track the market performance at very low cost. 
I would like to sum up this article in the words of the best active investor of all times, Warren Buffet (who himself does not believe in EMH and says that if it was true he and Charlie Munger would not exist) endorses index investing, 'When the dumb investor realises how dumb he is and he buys index funds, he becomes smarter than the smartest investors'. More recently, Buffet gave these instructions to the trust, 'Put 10% of the cash in short term govt bonds and 90% in a very low-cost index funds. The long term results from this policy will be superior to those attained by most investors - whether pension funds, institutes or individuals - who employ high-fee managers'.

This is not the first time Buffet has endorsed passive investing, in his letter to shareholders in 1996 he said - 'If you invest in an index fund, you are virtually guaranteed to outperform the vast majority of investors, both institutional and individual.'

If you look in the mirror and see Warren Buffet or Charlie Munger or Peter Lynch, go ahead and pick individual stocks, for the rest of us, sticking to a cost low-cost diversified index fund (or ETFs) will generate very satisfying returns over long period of time!

Like always would love to hear stories from my readers.

2 comments :

  1. Hi

    Visiting your site for the first time from Singapore :)

    You can't say it any better. Too little people spend too much time who makes it at the top end. Sometimes, you can say that it's not all worth it. The ETFs are there to assist everyone and they should definitely use that as a platform to boost their returns on investment.

    There's a catch though with some ETFs which Andrew Hallam highlighted in his book. The US death tax is one of them where the heirs will be heavily penalized on it. Just something to consider.

    Cheers.
    B
    http://www.foreverfinancialfreedom.blogspot.com

    ReplyDelete
  2. This comment has been removed by a blog administrator.

    ReplyDelete

Related Posts Plugin for WordPress, Blogger...