The myth of alpha?


in Economics

I have mentioned the value of low-fee index tracking funds before. This article, from this week’s Economist, is sure to rile up some mutual and hedge fund managers. It basically accuses them of being con-men, getting people to pay them high fees with misleading promises of high returns.

The existence and magnitude of alpha remains disputed.

{ 37 comments… read them below or add one }

. March 15, 2008 at 11:06 pm

Under the normal rules of capitalism, any industry that can produce double-digit annual growth should soon be swamped by eager competitors until returns are driven down. But in fund management that does not seem to be happening. The average profit margin of the fund managers that took part in a survey by Boston Consulting Group was a staggering 42%. In part, this is because most fund managers do not compete on price. Instead, they persuade their clients to select their funds on the basis of past performance, even though there is little evidence to show that this is a good predictor of future success. Nor can investors be sure that the intermediaries who sell the funds—brokers, advisers and bankers—will steer them in the right direction. These middlemen often get a cut of the fund managers’ fees, so they have little interest in recommending low-cost alternatives.

Hence the clients get engaged in a costly game of chasing the best performers, even though by definition they are bound, on average, to lose it: after costs, the average manager inevitably underperforms the market. Figures from John Bogle of Vanguard, an American fund-management group, neatly illustrate the point. Over the 25 years from 1980 to 2005, the S&P 500 index returned an average of 12.3% a year. Over the same period, the average equity mutual fund returned 10% and the average mutual-fund investor (thanks to his regrettable tendency to buy the hottest funds at the top of the market) earned just 7.3%, five percentage points below the index.

. June 9, 2008 at 1:45 pm

Warren Buffett recently bet an ambitious hedge fund operator $1 million that they won’t beat the returns of S&P 500 after their extremely hefty fees are accounted for. Buffett claims investors will do as well with a no-load index fund over the ten years of the bet. He has long been critical of the performance claims of hedge funds, and his bet is intended to put his money where his mouth is.

. December 9, 2008 at 11:31 am

FOR American and European savers it has been a lost decade. After two booms and two busts, stockmarkets have earned them nothing, or less, in the past ten years. Low interest rates have made bonds and bank deposits unrewarding too. Were it not for the tax relief they receive, contributors to personal pension plans would have been better off keeping their money under their mattresses. It will be little consolation to Westerners that savers in Japan have known this empty feeling for far longer.

As a result, saving seems like pouring money into a black hole (see article). Any American who has diligently put $100 a month into a domestic equity mutual fund for the past ten years will find his pot worth less than he put into it; a European who did the same has lost a quarter of his money.

. October 15, 2009 at 10:56 am

“Mutual funds, until recently, didn’t even disclose how they voted the proxies of shares they owned. When asked why not at a forum I was part of several years ago, the general counsel of one of the largest mutual fund companies tried to explain that it would be too expensive to make such disclosure. The answer was patently ridiculous, and it hid the much more important reason for nondisclosure: Mutual funds rarely if ever want to vote in opposition to management because mutual funds want to be included among the list of 401(k) options the company chooses for its employees. Mutual funds make money by increasing the size of the portfolios they manage, and if management knocks them off the 401(k) list, they will lose that revenue stream. This basic conflict of interest has neutered mutual funds. They are not meaningful checks on corporate mismanagement.”

. February 7, 2010 at 11:54 am

Index Funds, Dowdy to Some, Get a Notable Endorsement

Published: February 5, 2010

FOR the wealthy, index funds have an image problem. They are considered the economy cars of the investing world: they’ll get you there but not in style and you’re always worried they may break down. Anyone at a serious level of wealth, the thinking goes, needs the equivalent of a luxury sedan, with strategic stock choices, hedge funds, private equity, real estate.

Burton G. Malkiel says this is all hogwash.

Best known for his classic investment treatise, “A Random Walk Down Wall Street,” Mr. Malkiel has just published “The Elements of Investing” with Charles Ellis, an investment consultant (Wiley, 2009). The book, an unabashed homage to “The Elements of Style” by William Strunk Jr. and E. B. White, is focused on the cleanest, simplest ways for people to invest their savings. He argues that while people of modest means are hurt by not saving regularly, wealthy people lose out by chasing the latest, greatest investment.

Mr. Malkiel, a professor of economics at Princeton University, has long advocated index funds. What’s striking now is his belief that the wealthiest would have fine returns without the volatility and high fees if they simply used indexes to diversify their money across asset classes.

. February 23, 2010 at 12:37 pm

“Shocked, the government asked for a review of the fund’s active-management approach by Mercer, a consultancy, and for a report by three business-school academics—Andrew Ang, William Goetzmann and Stephen Schaefer from Columbia, Yale and London respectively. The three professors found that for all their stock-picking and do-gooding, the fund’s managers could just as well have thrown darts at a board. Taking the crash into account, the oil fund’s performance was essentially indistinguishable from that of a passively managed index fund. “The evidence points to the fact that over time, managers do not provide extra profits,” says Espen Sirnes of the University of Tromso.

How then did the fund manage to beat its benchmarks before the crisis? The professors argue that this was not because of clever share selection but because it took on extra risk by, for instance, investing in securities that are not easily traded or buying bonds of companies that might go bankrupt. They argue that instead of trying to beat the markets, the government should simply have the fund track an index tweaked to take on a bit more risk because of its very long investment horizon. “

. May 10, 2010 at 10:01 am

“The need to go through a fund of funds to reach specific managers has also diminished as cash-hungry funds have become more approachable. The across-the-board collapse in returns during the crisis has weakened the appeal of diversification, too. Funds of funds have typically charged investors 1% of assets and 10% of gains, on top of fees of 2% and 20% levied by individual funds in the portfolio. Some investors question what those fees are buying them.”

. May 18, 2010 at 1:39 pm

“What should you invest in? First off, don’t make the mistake of believing that you need a broker or adviser to pick your investments for you. Studies show that paying others to make these decisions for you generally costs more than you gain from it — if you gain anything at all.

If you want to learn about stocks and bonds, do some research at the American Association of Individual Investors website, or borrow a stack of books from the public library. But I’d encourage you to instead consider index funds, which are mutual funds designed to track the movement of the stock market (or a section of the stock market). For example, Vanguard’s VFINX fund is designed to mirror the movement of the S&P 500 index. Some people argue that index funds don’t make sense because they can never beat the market. While that’s true, they still perform better than 80% of investors (professional or otherwise) over long periods of time. If you don’t believe me, maybe you’ll believe Warren Buffett, the most successful investor the world has ever seen. He advocates index funds for most investors, having once said, “I believe that 98 or 99 percent — maybe more than 99 percent — of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs.” “

. June 14, 2010 at 3:40 pm

Who’s the patsy?
Even sophisticated investors have just been chasing returns

May 27th 2010

Some of this faulty decision-making may also reflect the underlying rationale of hedge-fund investments. Take pension funds. For decades they used their bargaining power to force down the fees they paid to conventional, active fund managers. So it seems rather odd that they should have signed up for hedge funds which charge annual management fees of 2% plus 20% of any returns.

Another rationale for the move into alternative assets (as hedge funds and private equity are known) is that returns are uncorrelated with those on other assets. But Mr Montier points out that the correlation of returns from different hedge-fund styles (which invest in a wide range of assets, from corporate bonds through to equities) has risen from around 0.3 in 1993 to 0.8 in 2009. Given that 1 would represent perfect correlation, that implies most hedge-fund styles are rising and falling in near-unison. As Mr Montier remarks: “It would appear as if all the hedge funds are doing exactly the same thing—riding momentum or selling volatility.”

It is all reminiscent of the “search for yield” in the past decade, which saw investors ignore risk as they piled into structured products linked to subprime mortgages. This chase for higher returns may not prove quite so disastrous. But it is more likely to reward hedge-fund managers than their clients.

. August 10, 2010 at 4:16 pm

The financial industry has done so well for itself, in short, because it has been given the licence to make a leveraged bet on property. The riskiness of that bet was underestimated because almost everyone from bankers through regulators to politicians missed one simple truth: that property prices cannot keep rising faster than the economy or the ability to service property-related debts. The cost of that lesson is now being borne by the developed world’s taxpayers. “

. August 23, 2010 at 3:32 pm

“Mr Morris argues that private-equity managers have charged excessive fees and overstated returns by using misleading measures of their internal rate of return. In addition, he says, the returns they do achieve are due to factors, including high leverage and the overall movement of the stockmarket, for which private-equity managers cannot claim credit.

Similarly private-equity managers will often realise their investments by refloating firms on the stockmarket. To the extent that the market has risen in the interim, the managers (and their investors) will make a profit. Investors would not dream of paying a performance fee to traditional fund managers merely for matching the market return, yet they cheerfully reward private-equity managers for the same feat.

But the authors propose a very simple measure, first suggested by Paul Myners, a minister in Britain’s last Labour government. The idea could be dubbed the “inertia benchmark”. Clients would look at the performance of the manager’s portfolio over the past year and compare it with the return that would have been achieved had he done nothing at all.”

. October 21, 2010 at 5:06 pm

So should you be dialing your broker with instructions to mimic the trades of insiders that the study identifies as opportunistic? Insiders are required to report trades to the SEC within a couple of days of a transaction, so if you were closely following SEC filings you’d get almost the same boost to your portfolio as insiders. (Even if it took a little longer to get the information, you’d still make out pretty well—Cohen and his co-authors find that the superior performance of stocks purchased by insiders continues for months afterward.) You’d of course also need information on insiders going back a few years to figure out whether the trades you’re observing are routine or opportunistic. Probably not an option for the average day trader, but no problem for the Goldman Sachs and Morgan Stanleys of the world. But if enough investors were to act on the information in this study, all the buy orders would quickly drive up prices in response to opportunistic purchases, wiping away any benefit of following insider trades in the first place. (On the other hand, if the authors had kept their findings to themselves and used their formula to buy and sell stock, they might have profited handsomely from it.)

The insider himself—the one who gets to make the very first trade—still walks away with his extra 10 percent. However, by providing an effective means of screening out irrelevant insider actions, this exercise in “forensic economics” can help the SEC and other regulators focus their efforts where—statistically speaking—the likelihood of misconduct is greatest.

. November 15, 2010 at 1:27 pm

Pay at investment banks
Mutiny over the bounty
Investment banks have cut pay a bit but shareholders are still getting a raw deal

Nov 4th 2010

IT IS a year since the investment-banking industry committed reputational suicide by paying bumper bonuses just a few months after the worst financial crisis in living memory. That move helped destroy investment bankers’ credibility with the public and many politicians. Outside finance, even red-blooded capitalists cringed in embarrassment. Bonuses were paid from profits buoyed by public subsidies—either directly through bail-outs or by central-bank interventions and implicit government guarantees. They also were paid at the expense of rebuilding capital buffers. In 2009 the typical firm’s wage bill was equivalent to between a quarter and half of its core capital. Investment banks, it seemed, were not being run in the interests of the economy or even of their owners, but for their staff. It was financial mutiny.

Some firms that did badly still booked pay costs that pushed their investment-banking units into the red—most notably UBS. Its chief financial officer was brutally honest to analysts. “We are a living example of a bank that experimented with not paying people and it didn’t come off very well in 2008. And as a consequence we know that we are bound to pay people, to some extent, regardless of the performance of the bank.” More marginal firms, including Nomura (which bought bits of Lehman Brothers), seem to struggle to make decent returns in any conditions.

. February 13, 2011 at 9:35 pm

Boneheaded bonuses

SIR – It was distressing to read another perpetuation of the myth that we have to pay bankers obscenely huge sums of money to attract the best talent (“Do the maths”, January 15th). I wonder what the evidence for this assertion really is? There are examples of particular bankers leaving a particular bank and taking clients with them, but this is a short-term glitch, not a long-term woe.

Trading isn’t hard. Computers do much of the work, and unless we break the culture of paying ridiculous bonuses for being “lucky”, the banks will continue to laugh in the face of politicians and regulators. Japanese housewife traders have led the way in showing us that frankly, it isn’t rocket science.

Roger Moffat
Former derivatives trader

* SIR – The management boards at most banks have completely forgotten who is providing their business with capital in the first place and is thus the ultimate risk taker: the equity shareholder. Paying out huge compensation packages to bankers affects returns to shareholders. It is equity investors who must do something about this, especially where gross incompetence on the part of the bank is concerned.

Albert Trayner
Pitlochry, Perthshire

. February 14, 2011 at 9:21 pm

Vexed in the City
When businessmen issue new shares, they are prey to smooth-talking bankers

THOSE who think that City pay is unrelated to “talent” must concede that investment bankers at least have a gift for lifting hefty sums from corporate clients without embarrassment. Britain’s executives, it seems, are all too easily seduced by the smooth patter, tailored suits and solicitous manners of their brokers. A report by the Office of Fair Trading (OFT) published on January 27th said the high fees charged for helping firms raise fresh equity capital in part reflects an imbalance in know-how between finance types and less savvy businessmen. There are enough banks to ensure that competition in underwriting deals ought to be vigorous, says the OFT. The reason charges are so high is that firms issuing equity often fail to drive a hard bargain with their bankers.

Shareholders moan that banks levy fat fees to underwrite “rights issues” even though the risk of a deal failing is minimal. In a rights issue, a firm seeks extra funds from its investors in proportion to their current shareholding. To entice those investors to take part, the issuer offers new shares at a lower price than its existing shares are changing hands for. The trend in recent years has been towards ever-larger discounts: 15% might be typical in the 1990s, but 30% or higher is now common.

Why do executives pay up? Rights issues are rare, so businessmen are not well-placed to judge the appropriate fee. Price is not the main concern when the life of the firm might be at stake: around two-thirds of British equity issues in 2009 were to shore up firms’ finances. So equity underwriting is often a “distress” purchase, like a funeral. Buyers are inexperienced, under pressure to act quickly, and have little time to consider terms. Discretion, competence and a talent for hand-holding are prized of underwriter and undertaker alike. Haggling over fees seems almost distasteful, especially for squeamish Brits who tend to pay what is asked and resent it later.

. February 14, 2011 at 9:22 pm

No stopping them
For all the efforts to combat it, Somali piracy is posing an ever greater threat to the world’s shipping

THE first successful pirate attack of 2011 could scarcely have come more promptly. In the early afternoon of January 1st, monitors at the Maritime Security Centre-Horn of Africa, based in Northwood near London, picked up distress signals from the MV Blida.

Somali pirates had hijacked the Greek-operated, Algerian-flagged 20,586-tonne bulk carrier, its crew of 27 (mainly Algerian and Ukrainian) and its cargo of clinker. The ship was some 150 nautical miles south-east of the Omani port of Salalah and heading for Dar es Salaam in Tanzania. Four days later the Blida’s Ukrainian captain sent word that the ship was berthed off the Somali coast near the pirate lair of Garacad. The crew, he said, was safe and unharmed but the pirates had yet to start haggling with the owners over the ransom.

The Northwood centre was established in late 2008 as part of Operation Atalanta, a European Union (EU) naval initiative against Somali piracy. It works with the Royal Navy’s UK Maritime Trade Operations office in Dubai as a reporting hub for pirate activity and as a communications hub for the multinational naval forces in the area. The seizure of the Blida was the fourth attack on New Year’s Day; the other three were unsuccessful, thanks to evasive action and other protective measures.

Since then attacks have been running at the rate of more than one a day. According to the International Maritime Bureau, which posts live data on raids, Somali pirates hold 33 vessels and 758 hostages. In January alone the bureau recorded 35 attacks. The raiders took seven ships and 148 new hostages. The United Nations estimates the annual cost of piracy in the Indian Ocean at between $5 billion and $7 billion. Later this month, as the monsoon ends and the seas calm, attacks will multiply and the numbers of ships and hostages held will rise (see chart).

. March 18, 2011 at 11:23 pm

Investment banking
The big squeeze
Can investment banks make high enough returns on equity to exist?

Feb 17th 2011 | from the print edition

FOR financiers, closing an investment bank is like parting with a Porsche: life is too dull without it. Yet a cull is needed. Most bulge-bracket firms made billions of dollars of profits in 2010, but not enough to compensate shareholders for the far larger amounts of capital they now have invested. Three big firms— Barclays, Credit Suisse and JPMorgan Chase—this week outlined how their investment-banking units can still make a respectable return on equity (ROE) over the medium term.

The problem they face is that these divisions will be clobbered by the new Basel 3 rules. The required capital ratio will rise, as for most types of banking. But investment-banking units will also see a dramatic rise in the amount of risk-weighted-assets (RWAs) that this charge applies to. The result is that the absolute capital required under the new rules could be double that under the old ones. Taking the banks’ forecasts of their RWA under the new regime, and assuming a core capital ratio of 10%, the investment-banking units of Barclays and Credit Suisse made ROEs of about 10-11% last year, while JPMorgan’s division earned a slightly less paltry 13.5%.

. March 30, 2011 at 8:45 pm

Another problem is that diversification means more than simply a willingness to invest across a wide range of asset classes. It also requires taking a separate stance from the herd. Some asset classes (particularly illiquid ones) can be subject to a “rowing boat” effect. Mortgage-backed securities were a classic example. Everyone rushes into them, so the price rises sharply and investors pat themselves on the back for their shrewdness. Then something happens to change sentiment. As everyone tries to rush out of the asset, the boat capsizes. The additional returns achieved during the boom turn out to be illusory.

Martin Leibowitz of Morgan Stanley has analysed the characteristics of endowment portfolios over the past ten years. He looked at three portfolios: a classic 60/40 US equity/Treasury bonds split; a Yale-like portfolio with seven separate asset classes; and a portfolio with international diversification but without the illiquid private-equity, hedge-fund and real-estate portions. What is remarkable about these portfolios is how closely correlated they all are with the S&P 500. Even the Yale-like portfolio had a correlation of more than 0.9 (where 1 is a perfect fit).

Those results ought to weigh on the minds of those planning to follow the Yale example. After all, institutional investors are able these days to invest in the main asset categories for very low fees of just a fraction of a percentage point. Handing over an annual fee of 1-2%, plus a 20% performance fee, to an alternative-asset manager throws away that advantage. As 2008 showed, the asset managers get rich but the investors still get clobbered.

. June 7, 2011 at 5:49 pm

Messrs Levitt and Miles divided participants into two groups. The first included those who, based on lists of the top players in 2009 and the results of previous tournaments, could be thought of as “high-skilled”; the second was everyone else. If poker were truly a game of luck, then the winnings of the 12% of entrants marked as specially gifted ought not to have differed significantly from those made by the rest.

But the opposite proved to be true. Those who had done well before did well in 2010, too. Whereas ordinary players made a loss of 15.6%, the skilled made a return on investment of 30.5%, suggesting that poker is after all a game of skill. The economists say that similar tests of persistence in returns have also been used to detect whether mutual-fund managers have genuine expertise. In contrast to the case of poker, they point out, those tests have tended to find “little evidence of skill in this domain”.

. June 7, 2011 at 6:27 pm

And like any self-respecting religion, finance has its doctrinal schisms as well. Active fund managers are a bit like the medieval Catholic church, offering eternal salvation to those willing to pay the appropriate sum, which are known in modern parlance as performance fees rather than indulgences. The active-investment sect has its elaborate rituals and language, with a liturgy (“information ratios” and “alpha generation”) as baffling to the layman as the Latin mass was to the medieval peasant. Clients are supposed to listen to their presentations in a reverential hush, trusting that all the mumbo-jumbo will deliver superior results.

The passive fund managers, or index-trackers, are akin to early Lutherans. Investors have no need for priestly intermediaries between them and the market, say the index-trackers. All they require is the full text of those companies that are included in the benchmark.

. November 9, 2011 at 1:03 pm

Intelligence? Talent? No, the ultra-rich got to where they are through luck and brutality.

By George Monbiot. Published in the Guardian 8th November 2011

If wealth was the inevitable result of hard work and enterprise, every woman in Africa would be a millionaire. The claims that the ultra-rich 1% make for themselves – that they are possessed of unique intelligence or creativity or drive – are examples of the self-attribution fallacy. This means crediting yourself with outcomes for which you weren’t responsible. Many of those who are rich today got there because they were able to capture certain jobs. This capture owes less to talent and intelligence than to a combination of the ruthless exploitation of others and accidents of birth, as such jobs are taken disproportionately by people born in certain places and into certain classes.

The findings of the psychologist Daniel Kahneman, winner of a Nobel economics prize, are devastating to the beliefs that financial high-fliers entertain about themselves. He discovered that their apparent success is a cognitive illusion. For example, he studied the results achieved by 25 wealth advisers, across eight years. He found that the consistency of their performance was zero. “The results resembled what you would expect from a dice-rolling contest, not a game of skill.” Those who received the biggest bonuses had simply got lucky.

. December 15, 2011 at 9:21 pm

MANAGERS of hedge funds like to think of themselves as seers, skilled in predicting where the market will go next. But today they are staring blankly at their liquid crystal screens and wondering where it all went wrong. The average hedge fund has fallen by around 9% this year; the S&P 500 has fallen by just 3.4%.

. January 20, 2012 at 7:28 pm

. February 3, 2012 at 10:58 am

TOTAL hedge-fund assets under management ended 2011 a smidgen over $2 trillion, according to Hedge Fund Research, having fluctuated around that figure throughout the year. Net capital inflows were over $70 billion, half of which was allocated to relative-value strategies (mostly based on fixed-income instruments). The tough economic climate prompted investors to adopt a risk-averse attitude and seek quality assets. Relative value was the best-performing strategy, but even so it only managed to eke out a return of 0.5% (net of fees). Total returns in the composite index fell by over 5% in 2011, the second-worst year since records began in 1990. Equity hedge, macro and event-driven indices declined by 8.3%, 3.8% and 2.8% respectively. They attracted net inflows of $27.9 billion.

. August 24, 2012 at 3:39 pm

The remarkable tendency for individuals to rely on expert advice, even when the advice clearly has no useful component, was neatly illustrated in a recent academic paper* about an Asian experiment. Undergraduates in Thailand and Singapore were asked to place bets on five rounds of coin flips. The participants were told that the coins came from fellow students; that these would be changed during the process; that the coin-flipper would be changed every round; and that the flippers would be participants, not experimenters. Thus there was a high likelihood that the results would be random.

Taped to the desk of each participant were five envelopes, each predicting the outcome of the successive flips. Participants could pay to see the predictions in advance, but they saw them free after the coin toss had occurred.

When the initial prediction turned out to be correct, students were more willing to pay to see the next forecast. This tendency increased after two, three and four successful predictions. Furthermore, those who paid in advance for predictions placed bigger bets on subsequent coin tosses than those who did not.

Paying for financial advice might not seem quite as bizarre as paying for coin-toss predictions, but there are some similarities. Nobody can reliably forecast the short-term outlook for economies or stockmarkets; Warren Buffett, the world’s most successful long-term investor, thinks it is not worth trying to do so. But plenty of economists and strategists earn a good living doing just that. The average active-fund manager fails to beat the stockmarket index; no reliable way has been found for selecting above-average managers in advance. Yet investors are still willing to pay for the services of active managers.

. October 8, 2012 at 12:58 pm

IN A world marked by high-frequency trading and billionaire fund managers, Jack Bogle ploughs an increasingly lonely furrow. He founded the mutually owned Vanguard group in 1974, with a remorseless focus on keeping costs down. Through its index funds, investors can own a diversified portfolio for a fee that is a fraction of a percentage point a year.

Mr Bogle is now 83, and his latest book* echoes many familiar themes (he even reprints a section of this column). But those themes are worth repeating, because they are too often ignored. Investors spend so much time chasing hot asset classes and hot fund managers that they end up buying high and selling low, all the while incurring transaction costs. In Mr Bogle’s words, “investors need to understand not only the magic of compounding long-term returns, but the tyranny of compounding costs.”

Although the cost of an individual transaction has fallen a lot over the past ten years, the volume of trading has risen in tandem—so much so that Mr Bogle reckons Wall Street’s total commission revenues have doubled over the past decade. In aggregate, this reduces investors’ returns.

Small investors face a “double agency” problem. Their money is entrusted to mutual-fund managers who place the proceeds with corporate executives. Those mutual-fund managers are pretty poor stewards, rarely voting against the actions of executives. And they have an incentive to expand the amount of funds they manage, even though such expansion has not benefited their existing investors. The assets of the mutual-fund industry have risen from $5 billion in 1960 to $6 trillion at the start of this year, but the annual expense ratio of the average equity fund has risen from 0.5% to 0.99%. If economies of scale have been achieved, they have not been passed on to the individual investor.

. October 8, 2012 at 1:18 pm

The secrets of Buffett’s success
Beating the market with beta

Sep 29th 2012 | from the print edition

IF INVESTORS had access to a time machine and could take themselves back to 1976, which stock should they buy? For Americans, the answer is clear: the best risk-adjusted return came not from a technology stock, but from Berkshire Hathaway, the conglomerate run by Warren Buffett. Berkshire also has a better record than all the mutual funds that have survived over that long period.

Some academics have discounted Mr Buffett as a statistical outlier. Others have simply stood in awe of his stock-picking skills, which they view as unrepeatable. But a new paper* from researchers at New York University and AQR Capital Management, an investment manager, seems to have identified the main factors that have driven the extraordinary record of the sage of Omaha.

Understanding the success of Mr Buffett requires a brief detour into investment theory. Academics view stocks in terms of their sensitivity to market movements, or “beta”. Stocks that move more violently than the market (rising 10%, for instance, when the index increases by 5%) are described as having “high beta”, whereas stocks that move less violently are considered “low beta”. The model suggests that investors demand a higher return for owning more volatile—and thus higher-risk—stocks.

. November 5, 2012 at 1:47 pm

VANGUARD is the investing world’s answer to Walmart. Founded in 1975 in response to research showing that few mutual funds performed well enough to justify their fees, it was the first company to sell index funds, which seek to match rather than exceed the market’s return, to ordinary retail investors. To ensure that its managers charge the lowest expenses possible, it is owned by the shareholders in its funds. By competing relentlessly on price, it has driven down fees across the industry.

. July 26, 2013 at 3:36 pm

When a company’s share price rises faster than the rest of the market, this means that it has a bigger weight in a traditional index. When its share price falls, its weight reduces. A strategy that attempts to match the cap-weighted index is thus buying high and selling low; put another way, it has a big exposure to the most expensive stocks. That makes it easier for alternative indices to outperform over the long run.

. December 8, 2013 at 7:57 pm

Fama not in the Vanguard

SIR – Regarding the recent Nobel prizes in economics, it is just not so that Eugene Fama’s efficient-market hypothesis “led to the development of the index-tracking industry” (“A very rational award”, October 19th). When I founded Vanguard 500, the world’s first index mutual fund, in 1975 I had never heard of Mr Fama. Years later I studied his work demonstrating that stock prices are efficiently priced and concluded that his notion was wrong.

Sometimes markets are efficient, sometimes they are not, and it is not possible to know which is which. In fact, it was Paul Samuelson who inspired the creation of our pioneering fund. It was not abstract theory that provided the justification for the index fund, but the compelling evidence that money managers as a group cannot beat the market; they must lose to the market by the amount of the fees and costs charged by active fund managers.

Gross return in the stockmarket, minus the costs of investing, equals the net return that investors as a group must share. It is the cost-matters hypothesis that holds universally. The brute evidence provided by the data meets the standard you cited in another article: Trust, but verify.

John Bogle
Founder of the Vanguard Group
Valley Forge, Pennsylvania

. September 13, 2014 at 12:57 am
. April 25, 2016 at 5:25 pm

Since forecasting is so hit and miss, he thinks, the practice of giving prizes to the best forecasters “makes as much sense as it would to award the Fields Medal in mathematics to the winner of the National Lottery”.

. July 15, 2016 at 7:59 pm

A 25-year-old saver who invests in a pension for 40 years on an annual charge of 1% will take a 25% hit on the average dollar deposited in their pot, irrespective of returns; for those who pay 1.5% a year, the loss is 38%. The total fees on the average Vanguard tracker are 0.08% a year.

. July 15, 2016 at 8:06 pm

Ask any employee for the secret of Vanguard’s success, and they will point to its ownership structure. The firm is entirely owned by the investors in its funds. It has no shareholders to please (and remunerate), unlike the listed BlackRock or Fidelity, a privately owned rival. Instead of paying dividends, it cuts fees. Mr Bogle’s rationale for this set-up is simple: “No man can serve two masters.” The incentives of the firm and its customers are completely aligned, he says. Competitors implicitly agree. “How are we supposed to compete when there’s a non-profit disrupting the game?” complains one.

. January 2, 2017 at 7:35 pm

British mutual-fund fees are too high
The British mutual-fund industry is not sufficiently competitive

Launch enough funds (around 36,000 are available across Europe) and some are bound to be successful. Asset managers simply bury their failures. Of the equity funds available to British investors in 2006, only about half are still around in 2016; the others were merged or liquidated. As the report remarks: “This may give investors the false impression that there are few poorly performing funds on the market.”

In chasing performance, investors are pursuing a chimera. The FCA finds, like others before it, that active managers underperform the index after costs (see chart). And it finds little evidence of persistence in outperformance. It looked at the best-performing quartile of funds over the 2006-10 period and examined how they performed in the next five years. Just under a quarter stayed in the highest quartile, exactly what chance would suggest. More than one-third of the stars of 2006-10 slipped to a bottom-quartile ranking—or were closed or merged.

It is hardly surprising that, if investors seem unconcerned by cost, charges stay high. But it makes a big difference to their wealth. Over 20 years, the FCA calculates, an active manager’s charges can eat up a third of an investor’s return.

. June 30, 2017 at 1:50 pm

Customers have removed about $2.5trn from active funds since 2000 and placed a similar amount into passive ones. About two-fifths of the global industry’s equity assets are managed passively, up from close to zero in 2000, according to Inigo Fraser-Jenkins of Sanford C. Bernstein, a research firm.

This has been a huge jolt for the asset-management industry, because fees on passive funds are up to 80% lower.

. June 30, 2017 at 1:51 pm

Sheer luck is as good as past returns in predicting future performance

Performance does not persist, as the latest data from S&P Dow Jones Indices show clearly.

Suppose you had picked one of the best-performing 25% of American equity mutual funds in the 12 months to March 2013. In the subsequent 12 months, to March 2014, only 25.6% of those funds stayed in the top quartile (see chart). That result is no better than chance. In the subsequent 12-month periods, this elite bunch is winnowed down to 4.1%, 0.5% and 0.3%—all figures that are worse than chance would predict. Similar results apply if you had picked one of the best-performing 50% of all funds; those in the upper half of the charts failed to stay there.

Perhaps this is an unfair comparison; fund managers cannot be expected to outperform every year. But clients do hope they can deliver superior returns over the long run. So S&P Dow Jones Indices ran the numbers in a different way. Suppose you had picked a fund with a top-quartile performance in the five years to March 2012. What proportion of those funds would be in the top quartile over the subsequent five years (to March 2017)?

The answer is just 22.4%: again, less than chance would suggest. Indeed, 27.6% of the star funds in the five years to March 2012 were in the worst-performing quartile in the five years to March 2017. Investors had a higher chance of picking a dud than a winner.

The industry’s answer to this problem is to launch a lot of funds. Some of them are bound to be near the top of the charts and can be trumpeted in adverts; the losers can then be killed off. Almost 30% of the worst-performing (bottom quartile) equity funds over the five years to March 2012 had been merged or liquidated by March 2017.

It should not be a surprise that the average fund fails to beat the index. The “iron law of costs” is that, in aggregate, professional fund managers own most of the stockmarket. Thus their performance is highly likely to resemble that of an index that tracks the overall market. But the index does not incur costs or fees; fund managers do. Thus the average fund manager must underperform the market, after costs.

The average fund manager runs a portfolio for only around four-and-a-half years. So if you pick a fund based on its record, the chances are that a new person is in charge. The old saying that “past performance is no guide to the future” is not a piece of compliance jargon. It is the truth.

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