"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 (BRKa) Shareholder 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.
---
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 are never a recommendation to buy or sell anything.
Showing posts sorted by relevance for query invisible foot. Sort by date Show all posts
Showing posts sorted by relevance for query invisible foot. Sort by date Show all posts
Wednesday, June 29, 2011
Tuesday, January 3, 2012
Six Stock Portfolio Update
Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
Intrinsic Value: The Six Stock Portfolio
The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM), Pepsi (PEP), Lowe's (LOW), and American Express (AXP).
Stock | Total Return*
WFC | 44.4%
DEO | 110.5%
PM | 135.6%
PEP | 38.5%
LOW | 31.6%
AXP | 162.5%
The total return for the six stocks combined is 87.2% (including dividends) since April 9, 2009. By comparison, the S&P 500 SPDR ETF (SPY) is up 54.0% (also including dividends) over that same time frame.
While the S&P 500 is down since I last updated this portfolio, the six stocks as a group continued to build on their gains. As a result, the portfolio's performance advantage expanded further. That certainly won't be the case in every period considering the concentration.
Unfortunately, none of these are selling at the kind of discount to intrinsic value I'd require to buy more shares.
Hopefully that will change.
The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).
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 Shareholder Letter
The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a concentrated portfolio of high quality businesses that can outperform over the long-haul.
Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.
Buffett on Helpers and "Frictional" Costs
My view is that many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & "frictional" costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.
This six stock portfolio is clearly very concentrated by most standards but this approach to investing rejects the idea that vast diversification is needed.
I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.
In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this speech to the Foundation Financial Officers Group
We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
Clearly, many investors need to diversify holdings a bit more. As always, one of the most important things is to always stay well within one's own limits as an investor. Depending on background and experience, low expense index funds may make more sense for some than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.
Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.
The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on an absolute basis, especially when risk-adjusted, relative to the market as a whole over a period of 10 years+.
It's worth noting the unusual allocation of this portfolio.
When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment.
Consumer staples were, of course, thought to be too defensive (lately, unfortunately, they've become a bit too popular...the substantial discounts to value that were available for many stocks in this sector have quickly disappeared) while many financial and housing stocks were in rough shape and in many ways continue to be so.
In part true, certainly, but you don't get bargains on good businesses when the outlook is sunny. Also, I consider the idea that one needs to jump in and out of stocks (or ETFs) based upon what the hot sector is to outperform is, to be kind, not a very good one (more a recipe to make mistakes and generate unnecessary fees and commissions).
Most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's (KO), Pepsi's, and Philip Morris International's of the world are not defensive in the long-run.
(Okay, this has received more than its fair share of coverage on this blog but the fact is many consumer staple businesses, though each has a unique set of risks, often do not get enough respect as long-term offense while instead getting overplayed as short-term defense.)
Stocks in the consumer staples sector are, especially when bought well, often a lower risk way to outperform. For most of the time I have been making this point they've been priced from between extremely cheap to attractive. While not necessarily expensive now, most of these are no longer extremely cheap, either. So there are some great stocks in this sector to own for the long haul but the price paid still matters and the bargains, among consumer staples, have all but disappeared.
The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair or better price. We'll see how the portfolio continues to perform.
In any case, this simple example is designed so it's easy for anyone to check the results over time. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses bought with a margin of safety can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.
Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.
In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.
So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).
Keep in mind that even though the stocks I chose have done well versus the S&P 500, I still don't consider a little less than three years a meaningfully long enough time frame to measure performance.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* Total return is calculated using the closing price on December 31, 2011 compared to the closing price on April 9, 2011 (the date these stocks were first mentioned) plus dividends. I've used the closing price on April 9, 2011 (instead of something like average intraday price) even though it reduces the calculated total return slightly. The benefit is that it makes the calculation simpler and easier to confirm. In other words, better market prices were available intraday April 9, 2011 (and in subsequent days) so total returns could have been improved with some careful share accumulation. In any case, as always the comparison with the S&P 500 is apples to apples.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500.
"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle
Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear.
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable to cheap prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is to get a handful of them at a fair price and then let the businesses and time work.
------------
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
Intrinsic Value: The Six Stock Portfolio
The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM), Pepsi (PEP), Lowe's (LOW), and American Express (AXP).
Stock | Total Return*
WFC | 44.4%
DEO | 110.5%
PM | 135.6%
PEP | 38.5%
LOW | 31.6%
AXP | 162.5%
The total return for the six stocks combined is 87.2% (including dividends) since April 9, 2009. By comparison, the S&P 500 SPDR ETF (SPY) is up 54.0% (also including dividends) over that same time frame.
While the S&P 500 is down since I last updated this portfolio, the six stocks as a group continued to build on their gains. As a result, the portfolio's performance advantage expanded further. That certainly won't be the case in every period considering the concentration.
Unfortunately, none of these are selling at the kind of discount to intrinsic value I'd require to buy more shares.
Hopefully that will change.
The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).
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 Shareholder Letter
The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a concentrated portfolio of high quality businesses that can outperform over the long-haul.
Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.
Buffett on Helpers and "Frictional" Costs
My view is that many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & "frictional" costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.
This six stock portfolio is clearly very concentrated by most standards but this approach to investing rejects the idea that vast diversification is needed.
I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.
In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this speech to the Foundation Financial Officers Group
We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
Clearly, many investors need to diversify holdings a bit more. As always, one of the most important things is to always stay well within one's own limits as an investor. Depending on background and experience, low expense index funds may make more sense for some than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.
Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.
The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on an absolute basis, especially when risk-adjusted, relative to the market as a whole over a period of 10 years+.
It's worth noting the unusual allocation of this portfolio.
When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment.
Consumer staples were, of course, thought to be too defensive (lately, unfortunately, they've become a bit too popular...the substantial discounts to value that were available for many stocks in this sector have quickly disappeared) while many financial and housing stocks were in rough shape and in many ways continue to be so.
In part true, certainly, but you don't get bargains on good businesses when the outlook is sunny. Also, I consider the idea that one needs to jump in and out of stocks (or ETFs) based upon what the hot sector is to outperform is, to be kind, not a very good one (more a recipe to make mistakes and generate unnecessary fees and commissions).
Most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's (KO), Pepsi's, and Philip Morris International's of the world are not defensive in the long-run.
(Okay, this has received more than its fair share of coverage on this blog but the fact is many consumer staple businesses, though each has a unique set of risks, often do not get enough respect as long-term offense while instead getting overplayed as short-term defense.)
Stocks in the consumer staples sector are, especially when bought well, often a lower risk way to outperform. For most of the time I have been making this point they've been priced from between extremely cheap to attractive. While not necessarily expensive now, most of these are no longer extremely cheap, either. So there are some great stocks in this sector to own for the long haul but the price paid still matters and the bargains, among consumer staples, have all but disappeared.
The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair or better price. We'll see how the portfolio continues to perform.
In any case, this simple example is designed so it's easy for anyone to check the results over time. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses bought with a margin of safety can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.
Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.
In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.
So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).
Keep in mind that even though the stocks I chose have done well versus the S&P 500, I still don't consider a little less than three years a meaningfully long enough time frame to measure performance.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* Total return is calculated using the closing price on December 31, 2011 compared to the closing price on April 9, 2011 (the date these stocks were first mentioned) plus dividends. I've used the closing price on April 9, 2011 (instead of something like average intraday price) even though it reduces the calculated total return slightly. The benefit is that it makes the calculation simpler and easier to confirm. In other words, better market prices were available intraday April 9, 2011 (and in subsequent days) so total returns could have been improved with some careful share accumulation. In any case, as always the comparison with the S&P 500 is apples to apples.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500.
"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle
Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear.
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable to cheap prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these six. The point is to get a handful of them at a fair price and then let the businesses and time work.
------------
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
Tuesday, April 12, 2011
Six Stock Portfolio Update
Portfolio performance since mentioning on April 9, 2009 that I like these six stocks as long-term investments if bought near prevailing prices at that time (or lower, of course).
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM, Pepsi (PEP), Lowe's (LOW), and American Express (AXP).
Stock |Total Return*
WFC | 70.9%
DEO | 83.0%
PM | 90.2%
PEP | 33.4%
LOW | 37.6%
AXP | 172.4%
Total return for the six stocks combined is 81.2% (including dividends) since April 9th, 2009 while the S&P 500 is up 63.2% (also including dividends) over that same time frame. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.
The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).
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 Annual (BRKa) Shareholder Letter
The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a stable/concentrated portfolio of high quality businesses that can outperform over the long-haul.
Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.
Buffett on Helpers and "Frictional" Costs
Many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.
This six stock portfolio is clearly very concentrated by most standards but the Buffett/Munger approach rejects the idea that vast diversification is needed.
I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.
In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group
Clearly some, depending on background and experience, may need to diversify holdings a bit more. For others, low expense index funds may make more sense than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.
As always, one of the most important things is to always stay well within one's own limits as an investor.
Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.
The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on a risk-adjusted basis relative to the market as a whole over a period of 10 years+.
It's also worth noting the unusual allocation of this portfolio. First of all, there is not/has not been exposure to the hot sectors (commodities these days and surely something else down the road) and no attempt to do so. When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment. Staples too defensive. Financials and housing a mess. All partly true but shares of a good businesses usually aren't cheap when the macro environment looks great.
Not to beat a dead horse but most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's, Pepsi's, and Philip Morris International's of the world are not defensive in the long-run. They are often a lower risk way to outperform.
(Okay, maybe I've beaten this one dead but the best consumer staple businesses, while each having a unique set of risks, often do not get enough respect as long-term offense instead getting overplayed as short-term defense.)
The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part, left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair price. We'll see how it continues to perform.
In any case, this simple example is designed so it's easy for anyone to check the results over time using this blog. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.
Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.
In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.
So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).
Keep in mind that even though the stocks I chose have done well versus the S&P 500 I don't consider a mere couple of years as a meaningfully long enough time frame to measure performance.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* As of 4/11/11.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500.
"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle
Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear.
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these 6. The point is to get a handful of them at a fair price and then let time work.
---------
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
While I never make stock recommendations each of these, at the right price, are what I consider attractive long-term investments for my own capital.
The portfolio is made up of the following stocks: Wells Fargo (WFC), Diageo (DEO), Philip Morris International (PM, Pepsi (PEP), Lowe's (LOW), and American Express (AXP).
Stock |Total Return*
WFC | 70.9%
DEO | 83.0%
PM | 90.2%
PEP | 33.4%
LOW | 37.6%
AXP | 172.4%
Total return for the six stocks combined is 81.2% (including dividends) since April 9th, 2009 while the S&P 500 is up 63.2% (also including dividends) over that same time frame. This is a conservative calculation of returns based upon the average price of each security on the date mentioned. Better market prices were available in subsequent days so total returns could have been improved with some careful accumulation.
The above is a relatively low turnover and concentrated portfolio of high quality businesses. It is, in part, meant to be an example of Newton's 4th Law at work (or, alternatively, a way to avoid being tripped by the invisible foot).
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 Annual (BRKa) Shareholder Letter
The approach rejects the idea that trading rapidly in and out of different securities is necessary to create above average returns. Instead, build a stable/concentrated portfolio of high quality businesses that can outperform over the long-haul.
Buying shares at a discount to value (conservatively calculated), low "frictional costs", and the intrinsic value created by the businesses themselves becomes the driver of total returns not some special aptitude for trading or timing the market. In short, the outperformance, if it continues, will come from owning shares of good businesses bought with an appropriate margin of safety combined with little in the way of unnecessary fees, commissions, and related costs.
Buffett on Helpers and "Frictional" Costs
Many equity investors would get improved long-term returns, at lower risk, if they: 1) bought (at fair or better prices) shares in 5-10 great businesses, 2) avoided the hyperactive trading ethos that is so popular these days to minimize mistakes & frictional costs, and 3) sold shares in these businesses only if the core long-term economics become impaired or opportunity costs are extremely high.
This six stock portfolio is clearly very concentrated by most standards but the Buffett/Munger approach rejects the idea that vast diversification is needed.
I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.
In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich. And why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices. - Charlie Munger in this 1998 speech to the Foundation Financial Officers Group
Clearly some, depending on background and experience, may need to diversify holdings a bit more. For others, low expense index funds may make more sense than buying individual stocks. Yet, keeping trading and other frictional costs to a minimum is almost always wise.
As always, one of the most important things is to always stay well within one's own limits as an investor.
Though I could surely be wrong, I consider these six stocks appropriate for my own portfolio (not someone else's) given my understanding of the downside risks and potential rewards. It doesn't make sense for others unless they do their own research and reach similar conclusions.
The above concentrated portfolio of six stocks obviously won't outperform in every period. In the long run, it has a reasonable probability of doing well compared to the S&P 500 due to lower frictional costs and the durable high return qualities of the businesses. While unlikely to outperform the very best portfolio managers**, it's likely to perform well on a risk-adjusted basis relative to the market as a whole over a period of 10 years+.
It's also worth noting the unusual allocation of this portfolio. First of all, there is not/has not been exposure to the hot sectors (commodities these days and surely something else down the road) and no attempt to do so. When I put this together, I intentionally allocated one half the portfolio to consumer staples (DEO, PEP, PM), a third in financials (WFC, AXP), and a housing stock (LOW). At the time, none of these were exactly the hot trade of the moment. Staples too defensive. Financials and housing a mess. All partly true but shares of a good businesses usually aren't cheap when the macro environment looks great.
Not to beat a dead horse but most readers of this blog will know the one thing I've said consistently is that the Coca-Cola's, Pepsi's, and Philip Morris International's of the world are not defensive in the long-run. They are often a lower risk way to outperform.
(Okay, maybe I've beaten this one dead but the best consumer staple businesses, while each having a unique set of risks, often do not get enough respect as long-term offense instead getting overplayed as short-term defense.)
The point is I wanted this portfolio to be made up of businesses that, once shares were bought at the right price, could be, for the most part, left alone to compound in value across multiple business cycles. Some may want exposure to other sectors not represented here which is fine if quality can be had at a fair price. We'll see how it continues to perform.
In any case, this simple example is designed so it's easy for anyone to check the results over time using this blog. If this six stock portfolio*** isn't performing well against the S&P 500 it will be obvious. The idea that a concentrated portfolio of quality businesses can perform well while avoiding the hassle and risks of trading should, at least, be of some interest. Producing results via the increasingly popular hyperactive buying and selling of securities seems inspired by Sisyphus by comparison to me.
Finally, an opportunity may come along where the capital from one of these stocks is needed. My view is under such a scenario the threshold for making changes needs to be high. That hypothetical new investment must have clearly superior economics and relative price.
In addition, if something appears to fundamentally threaten the moat (ie. the effect of the internet on the newspaper biz) of one of these businesses a change may also be warranted.
So I may rarely add or switch some of the stocks in this portfolio but I will only make a change if the situation described above exists (ie. if the core long-term economics of one of these stocks become impaired or opportunity costs of not making a change is extremely high).
Keep in mind that even though the stocks I chose have done well versus the S&P 500 I don't consider a mere couple of years as a meaningfully long enough time frame to measure performance.
Adam
Long position in DEO, AXP, PEP, PM, WFC, and LOW
* As of 4/11/11.
** There's no shortage of evidence that many actively managed equity mutual funds underperform the S&P 500.
"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!." - John Bogle
Also, DALBAR's Quantitative Analysis of Investor Behavior (QAIB) study released in March 2009 revealed that over the past 20 years investors in stock mutual funds have underperformed the S&P 500 by 6.5% a year (8.35% vs. 1.87%). Beyond the performance of the funds themselves, it shows that much of these poor returns come down to investor behavior. The tendency of investors to buy the hot mutual fund that has been going up while selling when the market is going down out of panic or fear.
*** I don't think these are necessarily the six best businesses in the world, but I believe they are all very good businesses that were selling at reasonable prices on April 9th, 2009. At any moment, there is always something better to own in theory but I don't think you can invest that way (as if stocks are baseball cards) and have consistent success. So there are certainly quite a few other shares in businesses that would be good alternatives to these 6. The point is to get a handful of them at a fair price and then let time work.
---------
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 are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
Thursday, October 13, 2016
Bogle & Buffett on Frictional Costs
John Bogle had the following to say in a speech earlier this year:
"Hedge funds (so-called; actually concentrated investment accounts which offer a wide variety of strategies) manage about $2.8 trillion of assets, at a cost equal to at least 3% of assets per year (300 basis points, an informed guess), generating some $84 billion in annual fees."
Vanguard manages roughly $3 trillion with roughly two thirds being index funds. Similar size but naturally much lower costs:
"The costs of supervising these index portfolios come to about $400 million annually, or 0.02% per year (two basis points)—less than 1% of the hedge fund rate. Administering the index funds and handling the accounts of some 15 million index shareholders costs another $1.2 billion, adding 0.06% (six basis points) to bring the aggregate expense ratio to eight basis points."
The ~ 300 basis point "informed guess" is primarily driven by the 2 and 20 compensation structure that is common to hedge funds. The above comments are not unlike those made by Warren Buffett -- in reference to his bet that a low-cost S&P 500 index fund would outperform a basket of hedge funds chosen by experts -- at the Berkshire Hathaway (BRKa) shareholder meeting earlier this year:
"The result is that after eight years and several hundred hedge fund managers being involved, the totally unmanaged fund by Vanguard with very minimal costs is now 40-something [percentage] points ahead of the group of hedge funds. It may sound like a terrible result for the hedge funds, but it's not a terrible result for the hedge fund managers."
Buffett also pointed out...
"We have two [investment] managers at Berkshire. They each manage $9 billion for us. They both ran hedge funds before. If they had a 2/20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million annually each merely for breathing."
And then added:
"It's a compensation scheme that is unbelievable to me and that's one reason I made this bet."
So it comes down to this big difference in frictional costs to explain the results (so far) of Buffett's bet.
Investors in these high-cost funds are betting that, over many years, a capable manager can reliably outrun such a frictional cost headwind and that somehow those investors will be able to correctly pick beforehand who that manager is going to be. As Charlie Munger said at the same Berkshire meeting:
"There have been a few of these managers who've actually succeeded...But it's a tiny group of people...like looking for a needle in a haystack."
The likelihood that a manager will do well ends up much higher than the likelihood those who actually put their capital at risk will do well.
It seems rather obvious that the system would be vastly improved if the opposite were true.
Tortured logic is required to explain why those who are putting their capital at risk shouldn't first be compensated sufficiently before vast sums are drained from their balance sheet.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
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
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.
"Hedge funds (so-called; actually concentrated investment accounts which offer a wide variety of strategies) manage about $2.8 trillion of assets, at a cost equal to at least 3% of assets per year (300 basis points, an informed guess), generating some $84 billion in annual fees."
Vanguard manages roughly $3 trillion with roughly two thirds being index funds. Similar size but naturally much lower costs:
"The costs of supervising these index portfolios come to about $400 million annually, or 0.02% per year (two basis points)—less than 1% of the hedge fund rate. Administering the index funds and handling the accounts of some 15 million index shareholders costs another $1.2 billion, adding 0.06% (six basis points) to bring the aggregate expense ratio to eight basis points."
The ~ 300 basis point "informed guess" is primarily driven by the 2 and 20 compensation structure that is common to hedge funds. The above comments are not unlike those made by Warren Buffett -- in reference to his bet that a low-cost S&P 500 index fund would outperform a basket of hedge funds chosen by experts -- at the Berkshire Hathaway (BRKa) shareholder meeting earlier this year:
"The result is that after eight years and several hundred hedge fund managers being involved, the totally unmanaged fund by Vanguard with very minimal costs is now 40-something [percentage] points ahead of the group of hedge funds. It may sound like a terrible result for the hedge funds, but it's not a terrible result for the hedge fund managers."
Buffett also pointed out...
"We have two [investment] managers at Berkshire. They each manage $9 billion for us. They both ran hedge funds before. If they had a 2/20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million annually each merely for breathing."
And then added:
"It's a compensation scheme that is unbelievable to me and that's one reason I made this bet."
So it comes down to this big difference in frictional costs to explain the results (so far) of Buffett's bet.
Investors in these high-cost funds are betting that, over many years, a capable manager can reliably outrun such a frictional cost headwind and that somehow those investors will be able to correctly pick beforehand who that manager is going to be. As Charlie Munger said at the same Berkshire meeting:
"There have been a few of these managers who've actually succeeded...But it's a tiny group of people...like looking for a needle in a haystack."
The likelihood that a manager will do well ends up much higher than the likelihood those who actually put their capital at risk will do well.
It seems rather obvious that the system would be vastly improved if the opposite were true.
Tortured logic is required to explain why those who are putting their capital at risk shouldn't first be compensated sufficiently before vast sums are drained from their balance sheet.
Adam
Long position in BRKb established at much lower than recent market prices
Related posts:
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
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
Thursday, March 22, 2012
Buffett's Bet Against Hedge Funds, Part II
Yesterday's post about Buffett's bet that hedge funds (or actually funds of hedge funds selected by Protege Partners LLC) would not outperform the S&P 500 over ten years brought the following to mind:
Let's say a hypothetical hedge fund manages $ 5 billion.
That means just the annual 2 percent management fee* (the 2 percent of assets that a typical hedge fund charges investors each year) alone will cost its investors $ 100 million/year. The costs would be more, of course, since a hedge fund will also usually charge investors 20 percent of profits generated (performance fees). There would also be an additional 1.25 percent of assets and 7.5 percent of any gains charged if a fund of hedge funds is involved as noted in yesterday's post.
(As I write this I still find all these fees very hard to believe.)
Now, compare the above to Berkshire Hathaway (BRKa).**
Berkshire Hathaway's market value is $ 200 billion (it's not hard to argue the company is worth more but that's another topic).
So Berkshire is 40x bigger than the above hypothetical hedge fund but Buffett's pay has been and continues to be much more reasonable. For decades, Buffett's compensation has been the $ 100k/year he collects in salary. Buffett does also benefit from personal and home security that Berkshire pays for but otherwise no bonus, stock options, or other forms of compensation.
(Buffett's primary source of wealth has come from the shares he purchased decades ago.)
Quite a contrast and, well, quite a bargain.
What Buffett has been paid during the forty plus years as CEO added together is, in total, less than 5 percent of what the hypothetical hedge fund above would be paid in one year.
Now naturally some of the $ 100 million paid to the hedge fund goes to other operating expenses. So to be completely fair, at least some of the operating costs of Berkshire's headquarters (though much of those costs are presumably related to the operating businesses Berkshire owns outright), including the new investment managers, shouldn't be ignored. That's the only way to make this a true apples-to-apples comparison of frictional costs (though I know of no corporation Berkshire's size with such a small headquarters).
Let's not split hairs. This difference in costs, I think, speaks for itself. Precision not required. Berkshire is built to minimize frictional costs for investors like few other investment vehicles. Add the cost for Berkshire's headquarters (all 19 employees) and the total frictional costs compared to the value of the assets being managed is still lower than any fund in existence by a large margin.
(Consider I'm also ignoring the performance fees that hedge funds charge which are far from inconsequential.)
...frictional costs of all sorts may well amount to 20 percent of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80 percent or so of what they would earn if they just sat still and listened to no one.- From the How to Minimize Investment Returns section of the 2005 Berkshire Hathaway Shareholder Letter
What if Buffett had been charging '2 and 20' fees instead all these years?
Berkshire would be a shadow of itself and its long-term investors, of which it has many, a lot less rich.
We know with Buffett in charge Berkshire has produced ~20 percent returns per year for decades. Due to its sheer size, it will almost certainly not do that well in the future whether Buffett's at the helm or not.
Having said that, the company is made up of a pretty fine set of assets that are likely to compound nicely in value over time.
I'm guessing no matter who is running Berkshire over the coming decades, even if not the compensated at a bargain $ 100k per year rate, that the frictional costs as a percent of value will continue to be lower than just about any fund in existence.
Adam
Long position in BRKb established at less than recent market prices
Related posts:
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
* The article mentioned in yesterday's post noted that, in addition to the '2 and 20' fees hedge funds typically charge (investors are charged 2% of the assets each year in management fees plus 20% of profits generated in performance fees), the funds of funds add another layer of fees. According to the Bloomberg article, on average this is an additional 1.25 percent of assets and 7.5 percent of any profits.
** Berkshire's not a hedge fund, of course, but I think it's worthwhile to make the comparison. Much like a hedge fund, Berkshire is an investment vehicle that attempts to generate satisfactory returns and manage risks. The investor is just charged a lot less for the privilege.
---
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.
Let's say a hypothetical hedge fund manages $ 5 billion.
That means just the annual 2 percent management fee* (the 2 percent of assets that a typical hedge fund charges investors each year) alone will cost its investors $ 100 million/year. The costs would be more, of course, since a hedge fund will also usually charge investors 20 percent of profits generated (performance fees). There would also be an additional 1.25 percent of assets and 7.5 percent of any gains charged if a fund of hedge funds is involved as noted in yesterday's post.
(As I write this I still find all these fees very hard to believe.)
Now, compare the above to Berkshire Hathaway (BRKa).**
Berkshire Hathaway's market value is $ 200 billion (it's not hard to argue the company is worth more but that's another topic).
So Berkshire is 40x bigger than the above hypothetical hedge fund but Buffett's pay has been and continues to be much more reasonable. For decades, Buffett's compensation has been the $ 100k/year he collects in salary. Buffett does also benefit from personal and home security that Berkshire pays for but otherwise no bonus, stock options, or other forms of compensation.
(Buffett's primary source of wealth has come from the shares he purchased decades ago.)
Quite a contrast and, well, quite a bargain.
What Buffett has been paid during the forty plus years as CEO added together is, in total, less than 5 percent of what the hypothetical hedge fund above would be paid in one year.
Now naturally some of the $ 100 million paid to the hedge fund goes to other operating expenses. So to be completely fair, at least some of the operating costs of Berkshire's headquarters (though much of those costs are presumably related to the operating businesses Berkshire owns outright), including the new investment managers, shouldn't be ignored. That's the only way to make this a true apples-to-apples comparison of frictional costs (though I know of no corporation Berkshire's size with such a small headquarters).
Let's not split hairs. This difference in costs, I think, speaks for itself. Precision not required. Berkshire is built to minimize frictional costs for investors like few other investment vehicles. Add the cost for Berkshire's headquarters (all 19 employees) and the total frictional costs compared to the value of the assets being managed is still lower than any fund in existence by a large margin.
(Consider I'm also ignoring the performance fees that hedge funds charge which are far from inconsequential.)
...frictional costs of all sorts may well amount to 20 percent of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80 percent or so of what they would earn if they just sat still and listened to no one.- From the How to Minimize Investment Returns section of the 2005 Berkshire Hathaway Shareholder Letter
What if Buffett had been charging '2 and 20' fees instead all these years?
Berkshire would be a shadow of itself and its long-term investors, of which it has many, a lot less rich.
We know with Buffett in charge Berkshire has produced ~20 percent returns per year for decades. Due to its sheer size, it will almost certainly not do that well in the future whether Buffett's at the helm or not.
Having said that, the company is made up of a pretty fine set of assets that are likely to compound nicely in value over time.
I'm guessing no matter who is running Berkshire over the coming decades, even if not the compensated at a bargain $ 100k per year rate, that the frictional costs as a percent of value will continue to be lower than just about any fund in existence.
Adam
Long position in BRKb established at less than recent market prices
Related posts:
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
* The article mentioned in yesterday's post noted that, in addition to the '2 and 20' fees hedge funds typically charge (investors are charged 2% of the assets each year in management fees plus 20% of profits generated in performance fees), the funds of funds add another layer of fees. According to the Bloomberg article, on average this is an additional 1.25 percent of assets and 7.5 percent of any profits.
** Berkshire's not a hedge fund, of course, but I think it's worthwhile to make the comparison. Much like a hedge fund, Berkshire is an investment vehicle that attempts to generate satisfactory returns and manage risks. The investor is just charged a lot less for the privilege.
---
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, September 4, 2012
Investors Are Often Their Own Worst Enemies
Terrance Odean is the Professor of Finance at the University of California, Berkeley and known for his work on behavioral finance.
This Forbes article covers some of Professor Odean's thinking and summarizes his case that it is the actions of investors themselves that often subtracts meaningfully from long-term returns.
According to Professor Odean, here's a couple (among others) of the greatest sins investors tend to make:
Overconfidence - A tendency to overestimate their own abilities and the likelihood of favorable outcomes.
Excessive trading - The real winner is the middleman.
The following was put together by Forbes:
In Pictures: 10 Ways Investors Sabotage Themselves
In this paper, "Trading Is Hazardous To Your Wealth", Professor Odean and his colleague Professor Brad Barber concluded the following:
"The average household turns over approximately 75 percent of its common stock portfolio annually. The poor performance of the average household can be traced to the costs associated with this high level of trading.
Our most dramatic empirical evidence is provided by the 20 percent of households that trade most often. With average monthly turnover of in excess of 20 percent, these households turn their common stock portfolios over more than twice annually. The gross returns earned by these high-turnover households are unremarkable, and their net returns are anemic. The net returns lag a value-weighted market index by 46 basis points per month (or 5.5 percent annually). After a reasonable accounting for the fact that the average high-turnover household tilts its common stock investments toward small value stocks with high market risk, the underperformance averages 86 basis points per month (or 10.3 percent annually)."
The paper has some useful insights. Excessive trading and the associated frictional costs adversely impacts returns. The above more than suggests that less activity generally wins. It also at least suggests that many (if not most) investors would be better off just buying index funds.*
(And, of course, accumulating shares over time but, most importantly, holding them long-term. Unfortunately, index ETFs are all too easy to trade which seems like an advantage but quickly turns into quite the opposite.)
The paper's focus is instead on the deleterious effects of highly active trading. That less trading leads to superior returns. They think that the excessive trading behavior is at least in part "explained by a simple behavioral bias: People are overconfident, and overconfidence leads to too much trading."
They conclude by saying:
"Active investment strategies will underperform passive investment strategies. Overconfident investors will overestimate the value of their private information, causing them to trade too actively and, consequently, to earn below average returns."
I certainly agree with this. Buying and owning shares of great businesses long-term can be executed as a relatively passive investment strategy (passive in terms of trading, but lots of work otherwise). I can understand why this isn't addressed in the paper but is worthy of consideration.
In other words, index funds are treated by some as THE passive investment strategy alternative for most investors. Is that really the case?
Clearly, the long-term ownership of shares (extremely low portfolio turnover) can't be lumped together with those who engage primarily in making guesses about near or even intermediate term stock market price action.
(Even if those guesses are highly educated in nature and happen to involve sophisticated methods of gambling and speculation.)
Owning shares of the great durable franchises is an alternative to buying index funds. It does require the right skill set and -- getting back to how overconfidence can damage returns -- a realistic (not imagined or optimistic) assessment of one's capabilities.
"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose..." - Charlie Munger in a 1998 speech to the Foundation Financial Officers Group
You can't buy individual stocks without knowing how to judge value consistently well and the discipline/patience to ALWAYS buy at a plain discount.
I'll follow up on this.
Adam
Related posts:
Investors Are Often Their Own Worst Enemies, Part II (follow up)
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
* Index funds were tough to own this past decade plus but that's mostly the result of extreme valuation across many sectors. Stocks in general (though not many individual stocks, of course) were a decade and more ahead of themselves in terms of valuation.
---
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.
This Forbes article covers some of Professor Odean's thinking and summarizes his case that it is the actions of investors themselves that often subtracts meaningfully from long-term returns.
According to Professor Odean, here's a couple (among others) of the greatest sins investors tend to make:
Overconfidence - A tendency to overestimate their own abilities and the likelihood of favorable outcomes.
Excessive trading - The real winner is the middleman.
The following was put together by Forbes:
In Pictures: 10 Ways Investors Sabotage Themselves
In this paper, "Trading Is Hazardous To Your Wealth", Professor Odean and his colleague Professor Brad Barber concluded the following:
"The average household turns over approximately 75 percent of its common stock portfolio annually. The poor performance of the average household can be traced to the costs associated with this high level of trading.
Our most dramatic empirical evidence is provided by the 20 percent of households that trade most often. With average monthly turnover of in excess of 20 percent, these households turn their common stock portfolios over more than twice annually. The gross returns earned by these high-turnover households are unremarkable, and their net returns are anemic. The net returns lag a value-weighted market index by 46 basis points per month (or 5.5 percent annually). After a reasonable accounting for the fact that the average high-turnover household tilts its common stock investments toward small value stocks with high market risk, the underperformance averages 86 basis points per month (or 10.3 percent annually)."
The paper has some useful insights. Excessive trading and the associated frictional costs adversely impacts returns. The above more than suggests that less activity generally wins. It also at least suggests that many (if not most) investors would be better off just buying index funds.*
(And, of course, accumulating shares over time but, most importantly, holding them long-term. Unfortunately, index ETFs are all too easy to trade which seems like an advantage but quickly turns into quite the opposite.)
The paper's focus is instead on the deleterious effects of highly active trading. That less trading leads to superior returns. They think that the excessive trading behavior is at least in part "explained by a simple behavioral bias: People are overconfident, and overconfidence leads to too much trading."
They conclude by saying:
"Active investment strategies will underperform passive investment strategies. Overconfident investors will overestimate the value of their private information, causing them to trade too actively and, consequently, to earn below average returns."
I certainly agree with this. Buying and owning shares of great businesses long-term can be executed as a relatively passive investment strategy (passive in terms of trading, but lots of work otherwise). I can understand why this isn't addressed in the paper but is worthy of consideration.
In other words, index funds are treated by some as THE passive investment strategy alternative for most investors. Is that really the case?
Clearly, the long-term ownership of shares (extremely low portfolio turnover) can't be lumped together with those who engage primarily in making guesses about near or even intermediate term stock market price action.
(Even if those guesses are highly educated in nature and happen to involve sophisticated methods of gambling and speculation.)
Owning shares of the great durable franchises is an alternative to buying index funds. It does require the right skill set and -- getting back to how overconfidence can damage returns -- a realistic (not imagined or optimistic) assessment of one's capabilities.
"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose..." - Charlie Munger in a 1998 speech to the Foundation Financial Officers Group
You can't buy individual stocks without knowing how to judge value consistently well and the discipline/patience to ALWAYS buy at a plain discount.
I'll follow up on this.
Adam
Related posts:
Investors Are Often Their Own Worst Enemies, Part II (follow up)
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
* Index funds were tough to own this past decade plus but that's mostly the result of extreme valuation across many sectors. Stocks in general (though not many individual stocks, of course) were a decade and more ahead of themselves in terms of valuation.
---
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.
Friday, April 28, 2017
Buffett on Bogle
"If a statue is ever erected to honor the person who has done the most for American investors, the hands-down
choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds.
In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have
promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of
added value.
In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me." - From Warren Buffett's latest letter
John Bogle, in a speech last year, noted that:
- Hedge funds, in total, managed at the time something like $2.8 trillion in assets
- Investors in such funds pay out to their managers ~ 3 percent per annum -- what he calls an "informed guess" -- or roughly like $ 84 billion (yes...billion) in fees per year
- Vanguard manages ~$3 trillion in assets -- nearly the same amount as all hedge funds combined -- with two thirds being index funds.
- The cost of managing the ~ $2 trillion of index fund assets = .08 percent of assets per annum = ~ $ 1.6 billion
Quite a difference in costs even after normalizing the $ 2.8 trillion to the size of the index fund asset base. The compounded impact of these extra costs for investors over the long haul is hardly small.
In fact, even a traditional actively managed mutual fund that charges something like "only" 1 percent per annum is an order of magnitude more costly than the typical index fund. Imagine two investors. Both have $ 100k to invest and a 35 year investment horizon. Each have portfolios excluding fees that produce a 6 percent annual return over those 35 years. The only difference is one of the investors is paying 1 percent in annual fees while the other has .08 percent in annual fees.
So how much more wealth would the low fee paying investor have at the end of the 35 year investment horizon?
~ $ 200k
What's worth noting is that here we have someone who's accomplished great success through active investing (Buffett) with high respect and admiration for the person (Bogle) who has been encouraging investors to avoid such an approach for decades.
To understand why this seemingly inherent conflict might exist just consider the frictional costs -- or lack thereof -- inherent to Buffett's approach. Now, imagine if Buffett charged investors something like the 3% in annual fees to manage Berkshire Hathaway's (BRKa) current portfolio -- ~ $ 276 billion of cash and investments at the end of 2016 -- instead of the $ 100,000 salary plus security costs?*
Berkshire would instantly become a very different and very much less valuable investment -- more than $ 8 billion in additional costs tends to do that -- but that'll have to be a subject for another day.
High fees or not, it's just not easy to figure out who'll be able to produce -- over many years/decades and many investing environments -- satisfactory or better results.
Add in the high fees and an already difficult task becomes even tougher.
When it comes to investing -- and often well beyond the world of investing -- it's tough to beat the wisdom of Bogle and Buffett.
Adam
Long position in BRKb eastablished at much lower than recent market prices
Related posts:
Innovators, Imitators, & the Swarming Incompetents
Bogle & Buffett on Frictional Costs
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
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
Howard Marks on Risk
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
* Otherwise, Buffett generally receives no stock options, stock grants or bonuses. Keep in mind that Buffett's $ 100,000 salary covers not only his investment portfolio responsibilities, but also finding and buying new businesses outright, and making sure the many businesses Berkshire already owns outright (which combined have 367,000 employees according to the latest annual report) are run effectively by honest and capable people (among other things).
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.
(6)
In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me." - From Warren Buffett's latest letter
John Bogle, in a speech last year, noted that:
- Hedge funds, in total, managed at the time something like $2.8 trillion in assets
- Investors in such funds pay out to their managers ~ 3 percent per annum -- what he calls an "informed guess" -- or roughly like $ 84 billion (yes...billion) in fees per year
- Vanguard manages ~$3 trillion in assets -- nearly the same amount as all hedge funds combined -- with two thirds being index funds.
- The cost of managing the ~ $2 trillion of index fund assets = .08 percent of assets per annum = ~ $ 1.6 billion
Quite a difference in costs even after normalizing the $ 2.8 trillion to the size of the index fund asset base. The compounded impact of these extra costs for investors over the long haul is hardly small.
In fact, even a traditional actively managed mutual fund that charges something like "only" 1 percent per annum is an order of magnitude more costly than the typical index fund. Imagine two investors. Both have $ 100k to invest and a 35 year investment horizon. Each have portfolios excluding fees that produce a 6 percent annual return over those 35 years. The only difference is one of the investors is paying 1 percent in annual fees while the other has .08 percent in annual fees.
So how much more wealth would the low fee paying investor have at the end of the 35 year investment horizon?
~ $ 200k
What's worth noting is that here we have someone who's accomplished great success through active investing (Buffett) with high respect and admiration for the person (Bogle) who has been encouraging investors to avoid such an approach for decades.
To understand why this seemingly inherent conflict might exist just consider the frictional costs -- or lack thereof -- inherent to Buffett's approach. Now, imagine if Buffett charged investors something like the 3% in annual fees to manage Berkshire Hathaway's (BRKa) current portfolio -- ~ $ 276 billion of cash and investments at the end of 2016 -- instead of the $ 100,000 salary plus security costs?*
Berkshire would instantly become a very different and very much less valuable investment -- more than $ 8 billion in additional costs tends to do that -- but that'll have to be a subject for another day.
High fees or not, it's just not easy to figure out who'll be able to produce -- over many years/decades and many investing environments -- satisfactory or better results.
Add in the high fees and an already difficult task becomes even tougher.
When it comes to investing -- and often well beyond the world of investing -- it's tough to beat the wisdom of Bogle and Buffett.
Adam
Long position in BRKb eastablished at much lower than recent market prices
Related posts:
Innovators, Imitators, & the Swarming Incompetents
Bogle & Buffett on Frictional Costs
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
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
Howard Marks on Risk
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
* Otherwise, Buffett generally receives no stock options, stock grants or bonuses. Keep in mind that Buffett's $ 100,000 salary covers not only his investment portfolio responsibilities, but also finding and buying new businesses outright, and making sure the many businesses Berkshire already owns outright (which combined have 367,000 employees according to the latest annual report) are run effectively by honest and capable people (among other things).
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.
(6)
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.
"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.
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.
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