Thursday, March 17, 2011

Buffett, Bogle, and the Invisible Foot

From Warren Buffett's 1983 Berkshire Hathaway (BRKashareholder letter:

"...consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on low-priced stocks) and if the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company's net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the 'frictional' cost of transfer. (And this calculation does not count option trading, which would increase frictional costs still further.)

All that makes for a rather expensive game of musical chairs. Can you imagine the agonized cry that would arise if a governmental unit were to impose a new 16 2/3% tax on earnings of corporations or investors? By market activity, investors can impose upon themselves the equivalent of such a tax."

Later Buffett goes on to say...

"These expensive activities may decide who eats the pie, but they don't enlarge it.

(We are aware of the pie-expanding argument that says that such activities improve the rationality of the capital allocation process. We think that this argument is specious and that, on balance, hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy.)"

Consider that this was written during a time when trading volumes were quaint by comparison to today (although partially offset by today's lower commission costs).


Let's look at the trading volumes and resulting frictional costs of S&P 500 Index ETF (SPY) in our modern context. John Bogle recently pointed out the SPY turns over 10,000%/year.

"Well, the ETF has got to be one of the great marketing ideas of the recent era. I think it remains to be seen whether it’s one of the great investment ideas of the recent era. The trading volumes are astonishing. Standard & Poor’s 500 SPDR (SPY), the biggest one, turns over 10,000% a year, and I think 30% turnover is too high. What does one say about 10,000%?"

So take that turnover rate and assume a .05% average commission cost (for example: $ 10 of commissions...$ 5 for the buyer and $ 5 for the seller on a $ 20,000 average purchase amount of SPY). Using these simplistic but I think meaningful assumptions, what's the rough annualized frictional costs for the average participant in the SPY during a calender year based upon current behavior?

It comes out to a little over 5% per year plus the modest .09% fund expenses:

$ 10/trade x 10,000% percent annual turnover + $ 20,000 x .09% = $ 1,018

That's $ 1,018 of expenses per year on the $ 20,000 purchase amount or just over 5%.

In other words, if these assumptions are even close to correct, the average participant in SPY would make only 4% if the S&P 500 went up 9% per year going forward. This, of course, does not apply to participants wise enough to just buy and hold the SPY. Yet, for the average participant, 4% would in fact be the approximate per annum return (again, based upon current typical market participant behavior).

Only those involved in the hyperactive trading of SPY bear the costs. Those that buy and hold do not (they pay a mere $ 18/year on $ 20,000 invested plus a modest commission expense).

Under the above scenario, buy and hold behavior would seem to provide a 5%/year advantage over the average participant in that fund (those driving that 10,000% turnover volume).

If correct, more than half the returns of that ETF is being drained off in the form of commissions. What Jeremy Grantham calls a "raid" of the balance sheet.

Taking money that would be capital and converting it to income (in the form of salary, commissions, bonuses etc to your favorite broker).

Now, in this case the frictional costs are not being caused by raising fees but the effect is the same. Instead, the frictional cost is caused by investor behavior itself (well, actually trader behavior or whoever plays the "rather expensive game of musical chairs").

The fact is a quality ETF like the SPY (if traded minimally) can be an incredibly convenient low frictional cost way to invest.

Now, the above admittedly is a bit of a Fermi Estimate. The question: Is that estimate, at least, in the ball park of being correct? Let's look at a broader set of ETFs that were tracked by Vanguard and referenced by John Bogle in this interview:

Bogle said among the pitfalls are that ETFs "turn over at a fantastic rate and they reflect the public appetite for performance chasing."

When Vanguard tracked the returns on 175 ETFs recently, said Bogle, it found investors fell about six percent short per year of the actual index the ETFs were designed to track—adding up to a 30 percent gap over five years.

So much like my Fermi guesstimate above, it's likely that a good portion of that performance gap comes from all the frictional costs associated with trading ETFs so frequently.

Charlie Munger said the following in a 1998 speech to the Foundation Financial Officers Group:

"Human nature being what it is, most people assume away worries like those I raise. After all, five centuries before Christ Demosthenes noted that: 'What a man wishes, he will believe.' And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary."

Just like the study of Swedish drivers, many probably think they will chase the performance of the SPY at just the right time and end up above average. The evidence suggests otherwise and by definition the total return of investors as a whole can be no larger than the total return of the fund minus frictional costs.

Newton's 4th Law.


Long BRKb

Related posts:
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again
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