Wednesday, June 29, 2011

Buffett, Bogle, and the "Invisible Foot" Revisited

"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." - Warren Buffett in the 1983 Berkshire Hathaway (BRKaShareholder Letter

The casino-type markets Buffett was referring to back in 1983 seem quaint in size and complexity compared to now.

With Buffett's "invisible foot" in mind, consider this interview with John Bogle from earlier this year where he provided some thoughts on the frenetic turnover of ETFs:

"'Spiders,' the S&P 500 ETF [SPY], turns over 10,000% a year. That's a lot of turnover. And even the big emerging market ETFs are turning over, I think at around 3,000% a year. And even the more cautious funds are turning over at 2-300% a year...And we know in fact that if you look at all of the ETFs that are out there--there are about 175 of them that have been out there for five years--and you calculate the returns as it happens in that particular five-year period, the average returns of all of those indexes together that they were tracking is about +3% a year, and the returns of the investors in those ETFs was -3% a year."

Compounded that costs investors 30% or so over five years. A well-designed system of capital formation/allocation efficiently helps money meet a good idea with minimal frictional costs. We've steadily gone backwards in this regard in my view*.  In recent years, the lower costs per transaction have been much more than offset by the increased costs of hyperactive trading.

In the past few decades, the average holding period of marketable securities has gone from being measured in years to a few months. One big equity rental system.

Related post: Buffett, Bogle, and the Invisible Foot

Q: "So who's watching the governance practices of the business? Is the business being well run? Are resources being intelligently allocated?"

A: "Who cares, I'm only going to own shares in the company for 15 minutes."

There may not be a precise number that you can put on what it costs (in potential wealth creation not realized) to have most owners of equity uninterested in the long run performance of the actual business itself. That doesn't mean there are not some very real, terribly important, and hard to quantify costs beyond the explicit ones Bogle notes above.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in this speech at UC Santa Barbara

Well, just because you can't put numbers on wealth not created or destroyed resulting from a system increasingly oriented toward share-renters over share-owners doesn't make the costs less real. Maybe a few less corporate scandals this past decade would have occurred if the owners were keeping a closer eye on who was minding the store. You can't quantify precisely but you know those scandals had real costs.

A short-term renter doesn't lose much sleep over how well the caretakers of the underlying asset are looking out for its long run future.

Seriously, how carefully did you drive your last rental car? It's a completely different context but worry much about the underlying asset? Short-term renting changes behavior whether it's a car or a business.

Equity shares aren't trading cards. They're partial ownership of some mostly rather useful assets. For those that think these costs don't reduce value (wealth) because they happen to be tough to quantify I have a nice, well-maintained, rental car to sell them.

"Not everything that counts can be counted, and not everything that can be counted counts." - Sign hanging in Albert Einstein's office at Princeton

Now, getting back to the easier to quantify explicit frictional costs. Jeremy Grantham made the point that frictional costs like this actually "raid the balance sheet" of investors.

Now, in this case the frictional costs** are not driven by raising fees but the effect is the same. Instead, the additional frictional costs come from investor behavior itself (well, actually trader behavior). Taking money that would be capital and converting it to income (in the form of salary, commissions, bonuses etc). Potential investment dollars becomes mostly consumption.

I prefer to own equities directly, but a quality ETF can be an incredibly convenient low frictional cost way to invest.

That doesn't mean trading them excessively makes sense.

Adam

Long BRKb

Related posts:
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Despite the lower per transaction cost (some would say because of the lower per transaction cost). Take the 10,000% turnover rate that Bogle mentions above for the "Spiders" (SPY), 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%. A bit of a Fermi Estimate but not far from the actual performance gap, noted by Bogle above, experienced by investors in those 175 ETFs. So it's not hard to see what drives most of the underperformance...excessive trading costs.
** These dollars don't disappear, of course. After sloshing around the economy for a while some will eventually become savings and investment again. It's just seems an expensive and inefficient way to go about capital development.
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