Wednesday, June 29, 2016

Bogle: Arithmetic Quants vs Algorithmic Quants

From a recent speech by John Bogle:

"As I see it, the plain and simple, well-armed, lightly-dressed, unencumbered shepherd is the index fund, a portfolio holding all 500 stocks in the Standard & Poor’s 500 Index. The David approach to investing, then, is 'buy a diversified portfolio of stocks operated at rock-bottom costs, and hold it forever.' The index fund relies on simple arithmetic, a mathematical tautology that could be calculated by a second grader: gross return in the stock market, minus the frictional costs of investing, equals the net return that is shared by all investors as a group. Taking the lion's share of those costs out of the equation is the key to successful long-term investing.

In contrast, many (most?) Goliaths of academia and quantitative investing believe the contrary: the application of multiple complex equations—the language of science and technology, of engineering and mathematics (yes, STEM), developed with computers processing Big Data, and trading stocks at the speed of light—make our Goliaths far stronger and more powerful than are we indexing Davids. The question posed in my title is essentially, 'who wins?'—the arithmetic quants or the algorithmic quants."

In the early days, when the hedge fund Goliaths* were individually smaller in size and part of a much smaller industry (assets of $ 120 billion in 1997), annualized returns were impressive: 11.8 percent vs 7.2 percent for the S&P 500 from 1990 to 2008.

By 2008, the Goliaths had $ 1.4 trillion in assets that have now grown to roughly $ 2.8 trillion and their relative performance has suffered a bunch: 5.3 percent vs 13.5 percent for the S&P 500 from 2009 to 2016.

Will there prove to be, in the long run, any advantage to all this additional complexity? Is the additional size the main cause of the more recent underperformance?  Is it the additional competition from capable individuals entering what is, if nothing else, a potentially rather lucrative profession? Or is it the addition of less capable managers entering the industry? For Bogle this all just reflects what is an inevitable reversion to the mean. The extra muscle and heavy armor -- in terms of industry assets -- has certainly led to huge compensation for the Goliaths.
(Bogle estimates ~$ 84 billion in annual fees while The New York Times reported that the top 25 managers alone were paid an average of $ 465 million in 2014.)

In any case, not unlike the classic battle, all that additional muscle and armor didn't make the Hedge Fund Goliaths a more formidable opponent to the indexing Davids; instead, it appears -- at least based upon the more recent results -- to have made them vulnerable to a much simpler and low cost approach.

Huge frictional costs -- roughly 3 percent per year or more according to Bogle -- are, of course, a meaningful factor but, with a greater than 8 percent annualized gap since 2009, it comes down to more than just those costs. Keep in mind that in the early days the drag of these heavy frictional costs also existed.

The range of outcomes is also a concern. Over the past 5 years, according to Bogle, individual hedge fund returns have been between -91 percent to 157 percent.

Yikes.

These Goliaths may perform much better in the future, of course. There's, as always, just no way to know. Yet I think it's fair to ask whether such long-term outcomes deserves so much time, talent, and capital especially when much less costly, simple, and effective alternatives exist.

If nothing else, over the long haul, the headwind coming from all the frictional costs is no small thing for most to overcome. Some exceptional managers no doubt will overcome those costs -- whether through pure chance or skill or a bit of both -- but that doesn't change the reality that a hedge fund with typical fees must outperform by ~3 percent each year just to keep up with the indexing Davids.

Adam

Related posts:
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
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

* It's worth noting the wide variety of investment and trading strategies employed by hedge funds. Still, what most have in common is vastly greater complexity and cost.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, June 7, 2016

Berkshire 2016 Meeting: Charlie Munger Highlights - Part I

The following are excerpts of comments made by Charlie Munger at the 2016 Berkshire Hathaway (BRKa) shareholder meeting:

On Ignorance
"...looking back, I don't regret that I didn't make more money or become better known, or any of those things. I do regret that I didn't wise up as fast as I could have — but there's a blessing in that, too. Now that I'm 92, I still have a lot of ignorance left to work on."

So, for those who are a bit younger than Mr. Munger (and also similarly did not "wise up" as fast as they'd have liked), I guess this way of thinking potentially offers an even bigger opportunity for them. Well, at least it possibly could for the person who hasn't become convinced they already have most things figured out and, as a result, focus their efforts on confirming it.

"If others examined themselves attentively, as I do, they would find themselves, as I do, full of inanity and nonsense. Get rid of it I cannot without getting rid of myself. We are all steeped in it, one as much as another; but those who are aware of it are a little better off -- though I don't know." - Michel de Montaigne

To me, it's through the "though I don't know" that Montaigne adds a crucial element of healthy doubt (though I, as well, certainly don't know!); much like Munger, it seems a humble recognition that no matter how long and hard one attempts to better understand the world, the work is ultimately incomplete, and to a great extent this comes down to inherent limitations of the human mind.

And those who might be very smart and capable aren't exempt from it; the question is whether they think they are, in fact, entirely or mostly exempt. In other words, individuals convinced they already don't have much "ignorance left to work on" seem rather guaranteed to possess a whole lot more of it than they realize.

On Retailing & the Internet
"...I would say that we failed so thoroughly in retailing when we were young, that we pretty well avoided the worst troubles when we were old. I think net Berkshire has been helped by the Internet. The help at GEICO has been enormous and it's contributed greatly to the huge increase in market share. Our biggest retailers are so strong that they'll be among the last people to have troubles from Amazon."

What comes across loud and clear during the meeting is how much Jeff Bezos and Amazon comes into play in their thinking when it comes to retail businesses (and, who knows, maybe one day even some of their other businesses).

On the Health Effects of Carbonated Soft Drinks
"...every person has to have about eight or ten glasses of water every day to stay alive...and it improves life to add a little extra flavor to your water -- a little stimulation, and a few calories if you want to eat that way. There are huge benefits to humanity in that and it's worth having some disadvantages. We ought to almost have a law...where these people shouldn't be allowed to cite the defect without also citing the advantage. It's immature and stupid."

Munger says those who choose to look at only the downside without also weighing the benefits are making an "inexcusable" error.

On Microeconomics vs Macroeconomics
"Well, there could hardly be anything more important [than microeconomics]...Business and microeconomics are sort of the same term. Microeconomics is what we do and macroeconomics is what we put up with."

Considering how little Berkshire relies on macro factors in their investment decision-making it's notable, as a contrast, just how much time and energy is expended by a whole bunch of market participants -- as well as the many economists, consultants, and analysts who advise and opine -- on macro-oriented forms of analysis.

"It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident." - Charlie Munger at the University of Michigan

Here's a comprehensive transcript of what was said at the Berkshire meeting by both Warren Buffett and Charlie Munger.

Also, here's a transcript focused specifically on what Charlie had to say.

Adam

Long position in BRKb established at much lower than recent prices
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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