Author Topic: 3 Reasons Some Sophisticated Investors Don't Buy Index Funds (Joshua Kennon)  (Read 43191 times)

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This_Is_My_Username

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« Reply #1 on: December 29, 2014, 05:01:46 AM »
I love indexing, but I think those points are all true.

1. A Sophisticated Investor Might Not Want to Buy an Index Fund Because He or She May Not Want to Purchase Overvalued Assets

2. A Sophisticated Investor Might Not Want to Buy an Index Fund Because He or She Might Not Want Exposure to Certain Areas of the Economy to Which His or Her Fortune Is Already Tied

3. A Sophisticated Investor Might Not Want to Buy an Index Fund Because He or She Might Want Even Better Tax Efficiency
(i.e. buy all top 200 shares, and then do tax loss harvesting by yourself)

4. Indexing by market capitalisation is stupid - you buy more of XYZ in a bubble, and buy less of XYZ in a trough.  The exact opposite of what should be done.   There are better options:  weighted equally, weighted by profit, weighted by revenue, weighted by dividend payments, etc.

:

I do indexing because I am a lazy piece of shit with a small amount of money.

ScroogeMcDutch

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Joshua Kennon's pieces on indexing vs individual stocks are what gave me the peace of mind to go with indexing for the time being. My rational mind could not wrap itself around humans / individuals being unable to beat the market on the long term. Yet, the amount of depth he shows in analyzing stocks and companies, is a skill I will have to develop, and it will take some time to develop those, with mistakes bound to happen as well.

I do believe I will be able to pick stocks that are good deals with proper analysis, that will beat the market on the long term (10+ years) or match it with a lower risk. What I do not know is if I want to spend that time on it, and indexing is definitely the next best thing for now. The tax efficiency that appears with individual stocks is something that is hard for me to ignore however.

But those are all a bit longer term plans. For next year, I plan to pick one or two individuals stocks and make a purchase of them after analysis, while sticking the rest in good old indexes.

Dyk

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Sounds great, it makes sense on paper.

But I would love to find a 'Sophisticated Investor' in the wild that has beaten the market in the long term.  (And they cannot be selling something .....)
I think it's possible, but I guess anything is.  My questions if we find one are:
- How much effort/time does it take?  (I am a family man, and while you could compute a $/hr. that was spectacular, there are only so many hours in the day as I am still working.)
- How many have tried and failed for each one we find?  This question we will never be able to answer, by default they will be harder to find.

ScroogeMcDutch (love the name).  I am curious, when this year alone 85% of fund managers failed to beat the market (and long term the results are lower) .... what leads you to say:
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I do believe I will be able to pick stocks that are good deals with proper analysis, that will beat the market on the long term (10+ years) or match it with a lower risk.
I am not trying to argue here or pick a fight at all, I am honestly curious, thanks for your feedback!

innerscorecard

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Do you think that some private businesses are ever more successful than others? Do some people do real estate investing better than others? Are you trying to live a more optimized lifestyle than others?

And yet there is the dogma that once something becomes a publicly traded, regulated market, it magically becomes perfectly efficient, so that "only Warren Buffett" can ever beat it.

Your points are good ones. Most who try to beat the market do fail. But a lot do beat it as well. In fact, it's much easier as an individual investor (who has no institutional imperative or bosses or clients to deal with) than as a mutual fund or even a hedge fund. Not that it's easy. You need financial education, and a lot of hard work. And some actual skill.

But it's not all but impossible. That's a convenient and helpful lie to tell to most people, but I believe in telling the truth rather than lies.

Scandium

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That person seems to have a flawed understanding of the argument for index fund. He keeps going on about "sophisticated investors" and how they can do better, but index funds are "good enough" for unsophisticated ones. Except the fact is that throughout history, millions of sophisticated investors have constantly done worse that the index. Over and over and over again. Stock pickers, no matter how sophisticated, always loose to the index eventually.

This is the same fallacy we see in every discussion about stock, that somehow a person reading enough financial statements will somehow predict the (uncertain) future better than someone else reading the exact same financial statements!

Two first ones assume that some knowledge can predict the market movements and reactions. Which simple facts show is not true.
1. overvalued assets
According to who? How do you know? Amazon has been "overvalued" for 15 years now..

2. Overexposure to sector
How does he know a cyber attack will impact tech stocks so badly? Maybe it will be good for them in the end? And for the long term why would you care? Unless you run an oil company this seems like a silly reason to avoid the most broadly diversified investment on the planet, and even if you do I don't think it makes much sense. The largest sector in VTSAX is 18%, so still over 80% in unrelated sectors! And the largest holding (AAPL) is only 3%. Even if you run Apple you'd be pretty darn well diversified.
(And btw tech is only 16% of VTSAX so I think he's pretty dumb to avoid it because he runs some tech business)

3. Is the only one that makes some sense, but even then not by much. You might pay less taxes, but you'll also have less money since you'll loose to the index. So..

YoungInvestor

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I think that the main reason so many hedge/mutual funds lose to the index is mostly due to client considerations: reducing volatility, keeping cash on hand, having to own the "hot" names, people leaving after a crash and whatnot.

I'm sure many portfolio managers would beat the market without these considerations. I know I'll give it a shot, at least.

index

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This is the same fallacy we see in every discussion about stock, that somehow a person reading enough financial statements will somehow predict the (uncertain) future better than someone else reading the exact same financial statements!

I would say a very high % of individual stock pickers do not read financial statements. As an indexer, you read no financial statements. Simply by the act of reading the last few Annual reports you have put yourself at an information advantage to every index investor and likely more that half of individual investors.

Its not divination. You could beat the S&P pretty easily by buying all 500 companies minus the ones where their annual reports and financials clearly point they are losing money.

By indexing you are buying into companies that are clearly bad businesses. You are also buying using market cap to dictate your weighting. Both of these points are real and undisputed. The counterpoint- is it worth your time and the expense to screen out the bad businesses and weight your portfolio more appropriately?

If you have 10k, 100k, or 1M probably not. If you have 10's of millions? Stock picking and concentrated investing is the way the majority of high net-worth individuals, endowments, and wealth funds store their money. They make better risk adjusted returns than you do in your index funds. Should you try and copy them? no.       
 

Scandium

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This is the same fallacy we see in every discussion about stock, that somehow a person reading enough financial statements will somehow predict the (uncertain) future better than someone else reading the exact same financial statements!

I would say a very high % of individual stock pickers do not read financial statements. As an indexer, you read no financial statements. Simply by the act of reading the last few Annual reports you have put yourself at an information advantage to every index investor and likely more that half of individual investors.

Its not divination. You could beat the S&P pretty easily by buying all 500 companies minus the ones where their annual reports and financials clearly point they are losing money.

By indexing you are buying into companies that are clearly bad businesses. You are also buying using market cap to dictate your weighting. Both of these points are real and undisputed. The counterpoint- is it worth your time and the expense to screen out the bad businesses and weight your portfolio more appropriately?

If you have 10k, 100k, or 1M probably not. If you have 10's of millions? Stock picking and concentrated investing is the way the majority of high net-worth individuals, endowments, and wealth funds store their money. They make better risk adjusted returns than you do in your index funds. Should you try and copy them? no.       

If that was true then thousands would do so, and every single mutual fund. That's pretty darn easy! Yet something like 90% of mutual funds underperform the index over a decade. How is this then? Don't have the data for people in their basements with 10-k statements, but I'd be surprised if it was any better. This is just a matter of what the historical data shows, and unfortunately it's not as simple as "reading financial data".

A typical stock picker is a 6-figure salary hedge fund manger working on this 10+ hrs a day. And you think you'd have an information advantage by reading publicly released financial data after you eat dinner every night? 

You also assume that any of this info will tell you how a business will do in the future; that you can clearly tell bad businesses from good and that's only a question of bothering to find out. Data show people can't, and unexpected changes happen.

Yes, you are right the richest of the rich do pick stocks and hedge funds etc, and usually underperform. For example college endowments doing poorly by shuffling funds and managers:
http://www.wsj.com/articles/SB10001424127887324610504578276360954805602

Bob W

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Seems pretty straightforward to me.   So if a relatively bright MMMer were to pick 20 stocks they would obviously pick some nice companies and not pick crappy ones.  Seems like they would beat the market over the long term if they weren't traders and have tax efficiency as well.

One thing neglected in the "sophisticated" investor strategy is the failure to mention in what country and under what structure assets are held.  Sophisticated investors have their money mostly in Panama and buy their ownership units through self directed trusts with no names attached.   Income/capital gains taxes do not come into play and there is little or no inheritance tax.  They generally hold duel citizenship as well.   

Seems like indexing by design requires you to hold crap companies while reducing your ownership of stellar companies.   Since that is their policy.  They will ride the crap company to the bottom and reduce their ownership of great companies as they go up. 

JayGatsby

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Your points are good ones. Most who try to beat the market do fail. But a lot do beat it as well. In fact, it's much easier as an individual investor (who has no institutional imperative or bosses or clients to deal with) than as a mutual fund or even a hedge fund. Not that it's easy. You need financial education, and a lot of hard work. And some actual skill.

But it's not all but impossible. That's a convenient and helpful lie to tell to most people, but I believe in telling the truth rather than lies.

I agree with this. I do believe, as an individual, it is possible to outperform the market. Most investors do NOT read even the most basic things about the companies they are investing in.  If you invest in good companies, do your research, and buy at fair (or better prices), you will do well. This is easier said than done, but it is possible.

I am not willing to invest (or even recommend investments) to others in the fashion I invest and the risk is too high. I love seeing a stock I'm invested in go down by 30%. Since I did my research before buying that stock, I know it is a good company, and not going to go to zero. And that over the long run, I'm a very confident that company will end up significantly higher than my original purchase price. So when I see a stock I own go down 30%? I buy. And buy. And turn over my mattresses in my house for loose change to try and buy one more share. 99% of people do not have the stomach (or understanding of financial markets) to do this. They will sell the stock, and lock in a guaranteed loss. As Charlie Munger says though, he loves volatility in stocks (note: volatility is different from risk. Volatility only creates risk if you sell). It gives an opportunity to start/add to positions in stocks at fair prices.

index

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I would say a very high % of individual stock pickers do not read financial statements. As an indexer, you read no financial statements. Simply by the act of reading the last few Annual reports you have put yourself at an information advantage to every index investor and likely more that half of individual investors.

Its not divination. You could beat the S&P pretty easily by buying all 500 companies minus the ones where their annual reports and financials clearly point they are losing money.

By indexing you are buying into companies that are clearly bad businesses. You are also buying using market cap to dictate your weighting. Both of these points are real and undisputed. The counterpoint- is it worth your time and the expense to screen out the bad businesses and weight your portfolio more appropriately?

If you have 10k, 100k, or 1M probably not. If you have 10's of millions? Stock picking and concentrated investing is the way the majority of high net-worth individuals, endowments, and wealth funds store their money. They make better risk adjusted returns than you do in your index funds. Should you try and copy them? no.       

If that was true then thousands would do so, and every single mutual fund. That's pretty darn easy! Yet something like 90% of mutual funds underperform the index over a decade. How is this then? Don't have the data for people in their basements with 10-k statements, but I'd be surprised if it was any better. This is just a matter of what the historical data shows, and unfortunately it's not as simple as "reading financial data".

A typical stock picker is a 6-figure salary hedge fund manger working on this 10+ hrs a day. And you think you'd have an information advantage by reading publicly released financial data after you eat dinner every night? 

You also assume that any of this info will tell you how a business will do in the future; that you can clearly tell bad businesses from good and that's only a question of bothering to find out. Data show people can't, and unexpected changes happen.

Yes, you are right the richest of the rich do pick stocks and hedge funds etc, and usually underperform. For example college endowments doing poorly by shuffling funds and managers:
http://www.wsj.com/articles/SB10001424127887324610504578276360954805602

This is from another post on why mutual fund managers have a hard time beating the indices:

This was in response to this paper http://papers.ssrn.com/sol3/papers.cfm?abstract_id=869748

Quote
Let's look at at individual investor vs an active mutual fund manager:
 
Transaction Costs and Securities available-
The individual investor can pay as little as $1 per trade on a couple hundred shares or $7 per trade for up to 2k shares. These shares are held at a brokerage. He submits a limit order, and the order is traded electronically. 2k shares represents about 4% of the daily volume of a relatively illiquid stock that trades 50k shares per day.

The fund manager may hold 1M or more shares. That company that trades 50k shares per day, it would take the manager well over a month to establish that position. Does the manager do this?

No, they limit themselves to stocks with more liquidity. This is one of the huge problems with index funds as well. Large well run companies are often not in the indexes because of liquidity ie. Berkshire - 200B at the time and not in the S&P.

If you are a fund manager and want to buy 1 M shares of TWC (an S&P 500 company with good liquidity) it would take you about a week to establish the position. This requires a trader to sit at a desk and manually trade large blocks of shares with other traders. This guy is billing at >$300 an hour. You also cannot say buy or sell XX at $20. These are huge positions. You will buy and sell something between $20-21 after a week your average price may be $20.10 meaning the transaction cost you 0.5% over an individual investor saying sell at $20.

Redemptions-
In 2008 an individual investor holding a IBM had the ability to sell it a buy WFC. (this is an example, it could be any company or group of companies). In this case, the individual investor would have made twice as much money in WFC than in IBM.

In '08 the fund manager was hit with people pulling money out of his fund left and right. He may have wanted to sell IBM to buy WFC, but has to sell IBM to give money back to a client. This is a huge problem for the fund managers and one of the reasons funds with lock up periods - hedge funds - or permanent capital - Berkshire out perform active mutual funds.   

Window dressing-
An individual investor doesn't have to deal with this. They don't answer to clients.

The fund manager has to explain why Apple is their largest holding after the stock tanked from $700 to $450. They often sell a company after a large fall because clients may think: I'm taking my money out, this idiot didn't even predict Apple was going to lose 35%. This is dressing up your quarterly and annual reports to make them look prettier to your clients.

76% of fund manager managed to match the index despite the above working against them and while charging an average fee of 1.08%! I'm not saying this means you should be investing with active managers. I am saying they have a lot working against them and by virtue of matching the market after 2.5% worth of fees (1.08% average fund costs + 1.4% transaction expenses) and having to deal with redemptions and keeping clients happy the majority are actually beating the indices.

Believing indices beat the majority of people shows a fundamental misunderstanding of how the stock market works. The price of the S&P is the sum of what investors are willing to pay for each of 500 companies added together according to market cap. By virtue of this "voting" with money, there is a buyer and seller on every trade. One person wins and one loses. At the end of the day there is approximately a normal distribution of winners and losers. Half of the investors beat the market, half lose to it.



index

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Indexing is not the end all be all, but is good for most people who lack financial literacy. Take a look at what Seth Klareman has to say on indexing:

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Another reason for the trend toward indexing is that many institutional investors and pension funds believe in the effi¨cient-market hypothesis. This theory holds that all information about securities is disseminated and becomes fully reflected in security prices instantaneously. It is therefore futile to try to out¨perform the market. A corollary of this hypothesis is that there is no value to incremental investment research. The efficient-market theory can be expressed, according to Louis Lowenstein, "as a much-too-simplified thesis that one stock is as good as another and that, therefore, one might as well buy thousands of stocks as any one of them."
By contrast, value investing is predicated on the belief that the financial markets are not efficient. Value investors believe that stock prices depart from underlying value and that investors can achieve above-market returns by buying undervalued securities. To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that "in any sort of a contestófinancial, mental or physicalóit's an enormous advantage to have opponents who have been taught that it's useless to even try." I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted.

Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis. Indeed, at the extreme, if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them.

Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers. There are implicit assumptions in indexing that securities markets are liquid, and that the actions of indexers do not influence the prices of the securities in which they transact. Yet even very large capitalization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yes¨terday. In effect, people are willing to pay more for that stock just because it has become part of an index.

By way of example, when Blockbuster Entertainment Corporation was added to the Standard and Poor's 500 Index in early 1991, its total market capitalization increased in one day by over $155 million, or 9.1 percent, because so many fund managers were "obliged" to buy it. Indeed, Barron's has calculated that stocks added to the Standard & Poor's 500 Index outperformed the market by almost 4 percent in the first week after their inclusion.

A related problem exists when substantial funds are commit¨ted to or withdrawn from index funds specializing in small-cap¨italization stocks. (There are now a number of such funds.) Such stocks usually have only limited liquidity, and even a small amount of buying or selling activity can greatly influence the market price. When small-capitalization-stock indexers receive more funds, their buying will push prices higher; when they experience redemptions, their selling will force prices lower. By unavoidably buying high and selling low, small-stock indexers are almost certain to underperform their indexes.

Other perverse effects of indexing are now emerging with increasing frequency. When securities are owned only because they are part of an index and the only stated goal of the owners is to match the movements of that index, the portfolio "manager" responsible for those securities has virtually no interest in influencing the performance of the index. He or she is indiffer¨ent to whether the index rises or falls in value, other than to the extent that fees are based on total managed assets valued at market prices.

This means that in a proxy contest, it makes no real difference to the manager of an index fund whether the dissidents or the incumbent management wins the fight, even though the outcome may make a significant financial difference to the clients of the indexer. (By choosing indexing, investors have implicitly expressed the belief that their vote in a proxy contest could make no predictable financial difference anyway.) Ironically, even if indexers wanted to vote in a direction that maximized value, they would have absolutely no idea which way that would be because index fund managers typically have no fundamental investment knowledge about the stocks they own.

It is noteworthy that the boom in indexing has occurred during a bull market. Between 1980 and 1990 the estimated amount of money managed in indexed accounts increased from $10 billion to about $170 billion, with 90 percent of that amount indexed to Standard & Poor's portfolios. An additional $100 billion or more is believed to be "closet indexed," that is, to track, if not exactly match, the S&P 500 Index. According to Barron's, "No little impetus has been supplied to this melancholy trend by the harsh fact that the S&P has laid waste to the performance of conventional managers during the Eighties, particularly in the past five years. For example, the S&P has beaten the average equity mutual fund in the Lipper Analytical Service, Inc., survey in 24 out of the past 31 quarters."10 The S&P 500 Index has also significantly bettered the broadly based Wilshire 5000 Index since the second half of 1983, outperforming it in twenty-three out of twenty-nine quarters; during that period the compound annual total return for the S&P 500 Index was 12.7 percent compared with 10.7 percent for the Wilshire 5000 Index.

I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. More significantly, as Barron's has pointed out, "A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing."" When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits...

Scandium

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Yes, obviously; in any one year half the people beat the index and half loose to it (before fees). But the people who win/loose changes from year to year. Therefore over a decade 90% loose to the index, which is always the average.

You can throw out all kinds of reasons why indexing is a terrible idea and anyone could do better simply by checking P/E or something and buying stocks, but historical facts show that indexing has won over any long term. Always.

Yes one can do better, but people don't . That's a fact. It has nothing to do with financial literacy or lack thereof. 
« Last Edit: December 29, 2014, 12:02:44 PM by Scandium »

bacchi

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Believing indices beat the majority of people shows a fundamental misunderstanding of how the stock market works. The price of the S&P is the sum of what investors are willing to pay for each of 500 companies added together according to market cap. By virtue of this "voting" with money, there is a buyer and seller on every trade. One person wins and one loses. At the end of the day there is approximately a normal distribution of winners and losers. Half of the investors beat the market, half lose to it.

Eh? i don't think this works intraday. The market can end flat and someone can beat the market by buying at a low. The market can drop and a shorter wins, or the market can rise, be shorted, and then end flat -- shorter wins again. And how do you account for someone who bought yesterday and sold at the high today for a profit but the market drops at the end of the day?

mak1277

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Re: .
« Reply #15 on: December 29, 2014, 12:34:08 PM »
I do indexing because I am a lazy piece of shit...

This, for me too.  I have no interest in spending time managing my investments. 

index

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Yes, obviously; in any one year half the people beat the index and half loose to it (before fees). But the people who win/loose changes from year to year. Therefore over a decade 90% loose to the index, which is always the average.

You can throw out all kinds of reasons why indexing is a terrible idea and anyone could do better simply by checking P/E or something and buying stocks, but historical facts show that indexing has won over any long term. Always.

Yes one can do better, but people don't . That's a fact. It has nothing to do with financial literacy or lack thereof.

You obviously did not read what was posted. First off, the number you keep saying- 90% is something you are parroting or made up. I linked the the study that all of the articles and boggle head discussions cite to explain active mutual fund under-performance. The actual numbers: from 1975 to 2002, 21.3% of funds had returns that lagged the market, 76.6% of funds statistically matched the market, 2.1% of funds reliably beat the market. This is taking into account fees and expenses of ~2.5% (1.4% transaction costs + 1.08% expense ratio).

The FACT that 76.6% of managers matched the market while subtracting ~2.5% from their annual returns for fees and expenses proves that the majority of managers actually beat the index. They just do not do it by a wide enough margin to compensate for their fees and expenses. The argument for indexing is if 97.9% of managers match or under-perform the market, why not just index?

I think equal weight indexing is superior to active management for the individual investor. The belief everyone should index because  90% of people (made up number) under-perform the index is false. If you want to index, index intelligently (try to minimize the weaknesses in vanguard index funds). You don't have to know how to pick stocks to diversify your holdings much more appropriately than VTSAX.

RapmasterD

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<<The FACT that 76.6% of managers matched the market while subtracting ~2.5% from their annual returns for fees and expenses proves that the majority of managers actually beat the index.>>

Right....but as mentioned, the SAME managers do not successfully do this year after year, which puts the onus on the individual investor to know when to hop in and out of funds. And I could be wrong, but I think most investors do NOT do this successfully.

Love and Kisses,
Former investor in active mutual funds who has grown his money a shit ton faster since he started indexing several years ago.

index

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Believing indices beat the majority of people shows a fundamental misunderstanding of how the stock market works. The price of the S&P is the sum of what investors are willing to pay for each of 500 companies added together according to market cap. By virtue of this "voting" with money, there is a buyer and seller on every trade. One person wins and one loses. At the end of the day there is approximately a normal distribution of winners and losers. Half of the investors beat the market, half lose to it.

Eh? i don't think this works intraday. The market can end flat and someone can beat the market by buying at a low. The market can drop and a shorter wins, or the market can rise, be shorted, and then end flat -- shorter wins again. And how do you account for someone who bought yesterday and sold at the high today for a profit but the market drops at the end of the day?

I'm not sure I follow. For every buy/sell there is another person on the other side of the trade. Say you buy in the morning at $10 it goes to $11 at noon and you sell to person B. By the close the stock is back to $10. You made $1, person B lost $1 and the day is recorded as flat. The thing to remember about the market is there is someone on the other side of every trade.

Say you wan to buy VTI. Maybe there are no sellers at $107 but and 107.50 there is a guy with 10 shares that will sell them to you. At 108 there are 9 people who will sell you 10 shares. This is just an anecdote for how stock prices move. In this case, your order for 100 shares of VTI moved the price from 107 to 108 because there were not enough sellers at 107. This same thing happens on a much larger scale in the market. Buyers are constantly bidding what they want to pay and sellers what they will take. If there are more buyers than sellers at a price then the price moves up to find more sellers. The opposite happens when the price is moving down. 

index

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<<The FACT that 76.6% of managers matched the market while subtracting ~2.5% from their annual returns for fees and expenses proves that the majority of managers actually beat the index.>>

Right....but as mentioned, the SAME managers do not successfully do this year after year, which puts the onus on the individual investor to know when to hop in and out of funds. And I could be wrong, but I think most investors do NOT do this successfully.

Love and Kisses,
Former investor in active mutual funds who has grown his money a shit ton faster since he started indexing several years ago.

This is from 1975 to 2002. The SAME managers successfully did this for 27 years. This is not fund hopping. This is if you picked a random active mutual fund in 1975 and kept it for 27 years, you had a 76.6% chance of matching the market after fees and expenses, a 2.1% chance of significantly beating it, and a 21.3% chance of under-performing.

bacchi

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I'm not sure I follow. For every buy/sell there is another person on the other side of the trade. Say you buy in the morning at $10 it goes to $11 at noon and you sell to person B. By the close the stock is back to $10. You made $1, person B lost $1 and the day is recorded as flat. The thing to remember about the market is there is someone on the other side of every trade.

If I buy 200 shares with a basis of $100 and sell them to 2 different people at $101, I'd be up $1/share. If the stock closes at $100 (flat), the 2 buyers would be losers for the day. 1 outperformed, 2 underperformed.

It seems more accurate to claim that the money in any trade is an equal sum game rather than the number of participants. I'm not even sure that's technically true given that there are options and futures leverage and market makers and margin (= additional money added to the market).

space

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This is from 1975 to 2002. The SAME managers successfully did this for 27 years. This is not fund hopping. This is if you picked a random active mutual fund in 1975 and kept it for 27 years, you had a 76.6% chance of matching the market after fees and expenses, a 2.1% chance of significantly beating it, and a 21.3% chance of under-performing.

I'm fairly certain that the study you refer to doesn't factor out survivor bias. What if a fund closes in the 27 year period?

ScroogeMcDutch

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Sounds great, it makes sense on paper.

But I would love to find a 'Sophisticated Investor' in the wild that has beaten the market in the long term.  (And they cannot be selling something .....)
I think it's possible, but I guess anything is.  My questions if we find one are:
- How much effort/time does it take?  (I am a family man, and while you could compute a $/hr. that was spectacular, there are only so many hours in the day as I am still working.)
- How many have tried and failed for each one we find?  This question we will never be able to answer, by default they will be harder to find.

ScroogeMcDutch (love the name).  I am curious, when this year alone 85% of fund managers failed to beat the market (and long term the results are lower) .... what leads you to say:
Quote
I do believe I will be able to pick stocks that are good deals with proper analysis, that will beat the market on the long term (10+ years) or match it with a lower risk.
I am not trying to argue here or pick a fight at all, I am honestly curious, thanks for your feedback!
Thanks Re: Name :D

TL;DR:
I think it may be possible to defeat the index, but don't know if I have the skill and/or information. The same is true for any average investor and is best served with index funds.


This is going to get into a stock-picking vs indexing discussion quickly. I was very careful in my wording as I know this might be considered heresy on this forum, and I do think you need to be very diligent in picking your stocks as well as . There are different types of trying to beat the market. There is a day-trading and derivatives-trading market. That one is, in my opinion, for an individual investor impossible to beat. Anything that's remotely interesting is snagged off the market before you see it on your screen. Then there is the long-term stock market, which is what we are interested in here on MMM. When talking "the index" in the next part, just read S&P 500 as that will do for the index.

I have a business background, so I should be able to read and understand financial statements. I should also be able to advise for a business direction, as part of the work I do professionally. I currently do not have the skills to take these financial statements, look at global developments, and determine if a price asked for a stock is a good valuation of the underlying company - these I would have to develop if I have any hope of beating the index through choosing a different portfolio of companies than the index provides.

The index has as a goal to best measure US stock market performance, and decides to pick 500 (arbitrary?) largest capitalization companies on the US stock market, and weights them using market capitalization/float. Induction and removal from the index passes a committee, is what I quickly read up on wikipedia.

1) Time for some theoreticic blabla
Basically, let's say the following. A stock in the index has an certain expected and unknown return Ri and volatility Vi. Stocks outside of the index have a certain expected and unknown return Ro and volatility Vo.

Ri=Ro
If it would be impossible to beat the index in terms of return, then Ri = Ro and it wouldn't matter if I picked stocks inside or outside the index in terms of return on investment. That would leave a difference in the amount of volatility experienced and risk ran.

If Vi = Vo as well, then picking more stocks rather than less would be the better choice. The amount of volatility experienced from the sum of stocks with the same underlying volatility is reduced with each addition of an extra stock. Basically the reason why one would not pick one stock, and picks 500 based on S&P 500 at the moment.

If Vi > Vo, then obviously adding lower volatile stocks would be better.

If Vi < Vo, then addition might still reduce overall risk, but may also increase it. This would basically mean we get higher volatility as companies have a lower capitalisation. [This is an effect we actually see in the market, small cap is more volatile/risky than large and megacap, so this is the more interesting hypothesis]. This would mean there is a negative correlation between capitalisation and volatility. The larger they are, the less volatile they would tend to be. If this is the case, then that correlation would have to be 0 for all the stocks inside the index (all 500 equally volatile), and then suddenly lower than 0 for stocks outside the index for it to be true that one cannot beat the index on either return or risk.

Ri < Ro
Simple to beat the index in this case, pick stocks outside of the index in order to have a higher expected return.

Ri > Ro
In this case, it is comparable to the Vi < Vo when Ri=Ro above. There is apparently a relationship between size of capitalisation and the expected return of the stock. This correlation would have to be 0 for all 500 inside the index, and negative outside for it to be true that one cannot beat the index on return.

Note that if Ri and Vi are also equal between the companies inside the index, then the weighting doesn't matter at all. If it is not the same, then you could start a same type of argument for the weighting method.

2) Stocks in the S&P 500 are in higher demand
As shown by all the index funds and mutual funds trying to mimic the S&P500 and other indexes and the people here on the forum. As soon as a stock hits the S&P500 index, then demand for those stocks spikes. The following paper talks a bit about this effect: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1152224 - a stock will increase in price between 2.7% and 5.4% after announcement to the index. This effect doesn't work the other way, leaving the index doesn't seem to have a permanent price impact (if the companies exist longer time after the deletion). These effects point to Ro > Ri. Only if the returns of the other companies that stay outside of the S&P500 are much below Ri then it could compensate back to Ri >= Ro.

3) Valuations don't matter / reversion to the mean
This falls under the market timing category. If valuations and other fundamental values do not matter as per most of the index proponents here, then any form of market timing is impossible. If the stock market rises 10% tomorrow, then we expect still the same result per dollar invested, compared to if the stock market drops 10% tomorrow. The phrase here is "the stock market might crash tomorrow, but you don't know when it will crash and you will lose out on too much in terms of return by sitting at the sideline". Yet the same people will be the ones screaming "stock market is on sale" when prices do drop. By the same reasoning, it can never be on sale, as you expect the same return per dollar invested (and by the same reasoning, you just lost a crapload of time to FIRE)? Those two contradict each other and not many who scream both seem to understand that.

First conclusion
Based on all of the above, I cannot believe the statement "One cannot beat the index on return and volatility" to be true theoretically. Whether practically that one can beat it, is another statement itself, and one that I am not yet thoroughly convinced of, and that doubt is mostly caused by potential transaction costs. However, I do think it is possible to do what Scandium stated as a fallacy: "This is the same fallacy we see in every discussion about stock, that somehow a person reading enough financial statements will somehow predict the (uncertain) future better than someone else reading the exact same financial statements!". This is mostly true for companies that have a massive amount of speculative value, such as amazon, facebook etc and I would agree with that statement for those. For companies that are mostly 'done' such as for example Coca Cola, it becomes about evaluating the financial statements to other companies in a similar situation, and deciding where you get the best value for money. You also do this when buying something, and you compare quality and value of the item you are going to purchase.

Now to read the 16 other replies ;)

Joshua Kennon is in my list of blogs to follow/read, along with jhcollinsnh and MMM - lot's of wisdom there and coming from a similar angle.

TL;DR:
I think it may be possible to defeat the index, but don't know if I have the skill and/or information. The same is true for any average investor and is best served with index funds.
« Last Edit: December 29, 2014, 02:00:47 PM by ScroogeMcDutch »

index

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This is from 1975 to 2002. The SAME managers successfully did this for 27 years. This is not fund hopping. This is if you picked a random active mutual fund in 1975 and kept it for 27 years, you had a 76.6% chance of matching the market after fees and expenses, a 2.1% chance of significantly beating it, and a 21.3% chance of under-performing.

I'm fairly certain that the study you refer to doesn't factor out survivor bias. What if a fund closes in the 27 year period?

The data was for funds with at least 5 years of available data. So perhaps there is some survivor bias for younger funds. The study used 1569 funds. The study recorded each fund's alpha vs the S&P for each year net of fees and expenses. Then any under/out performance that was statistically luck was eliminated. 

trailrated

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Can we please start a new thread as a "competition" where people invest an imaginary 100k, we build a spreadsheet to track the fake data and see how many people who think they can beat an index because it is so easy actually do. I think Bogleheads does something similar.

Although it would not prove over the long haul of 10-20 years it would be interesting to see just over 1 year.

pbkmaine

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Okay. As I always do when I'm confused, I went back to the original article that cites this 76.6% statistic:

http://www-stat.wharton.upenn.edu/~steele/Courses/956/Resource/MultipleComparision/FDRMutualFundAlphas.pdf

Abstract: "Using a large cross-section of U.S. domestic-equity funds, we find that 76.6% of them have zero alphas. 21.3% yield negative performance and are dispersed in the left tail of the alpha distribution. The remaining 2.1% with positive alphas are located at the extreme right tail."

Why would I buy an actively managed fund? If I had some reason to believe that the manager was able to generate alpha. This study shows that only 2.1% of managers are able to do so. This article is the strongest proof I could possibly want of the value of index funds. In fact, I am wondering if the "90%+ of managers can't beat the market" actually comes from here, since 76.6% plus 21.3% equals 97.9%.

Scandium

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TL;DR:
I think it may be possible to defeat the index, but don't know if I have the skill and/or information. The same is true for any average investor and is best served with index funds.


I'd agree with this. Only problem is that 99% of stock-picking enthusiast think they are above average:) "Well, 100 years of historical data says it won't work, but I think I can do it!"

I need to check my copy of "common sense on mutual funds" to find the study on fund over/under-performance. The number I remember was 80-90% underperformed.

Dr. A

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Why would I buy an actively managed fund? If I had some reason to believe that the manager was able to generate alpha. This study shows that only 2.1% of managers are able to do so. This article is the strongest proof I could possibly want of the value of index funds. In fact, I am wondering if the "90%+ of managers can't beat the market" actually comes from here, since 76.6% plus 21.3% equals 97.9%.

So, without weighing in on the merits of the arguments, there seems to be some confusion on the point of debate.

I don't see anyone in this thread arguing that actively managed funds are a good idea. The argument is that someone with the skill set of an active fund manager can out-perform an index fund if they are managing their own money and directly investing in stocks. Supporters of this argument are claiming that this is because their returns will no longer have a drag from (among other things) management fees, restrictions on which stocks to buy, purchases that move the market, client redemption, dumping stocks to make the quarterly report look good, etc.

One piece of evidence being used to support this claim is that 75% of funds in the Wharton study matched the market despite a 2.5% drag on returns due to fees, suggesting that those same fund managers would have beat the market by 2+% if they were directly investing their own money the same way they were investing other people's money.

index

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I'm not sure I follow. For every buy/sell there is another person on the other side of the trade. Say you buy in the morning at $10 it goes to $11 at noon and you sell to person B. By the close the stock is back to $10. You made $1, person B lost $1 and the day is recorded as flat. The thing to remember about the market is there is someone on the other side of every trade.

If I buy 200 shares with a basis of $100 and sell them to 2 different people at $101, I'd be up $1/share. If the stock closes at $100 (flat), the 2 buyers would be losers for the day. 1 outperformed, 2 underperformed.

It seems more accurate to claim that the money in any trade is an equal sum game rather than the number of participants. I'm not even sure that's technically true given that there are options and futures leverage and market makers and margin (= additional money added to the market).

This is absolutely true. The number of participants does not matter only the number of shares. That's why I gave the second example of buying 100 shares from 10 individuals with only 10 shares a piece!


index

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Why would I buy an actively managed fund? If I had some reason to believe that the manager was able to generate alpha. This study shows that only 2.1% of managers are able to do so. This article is the strongest proof I could possibly want of the value of index funds. In fact, I am wondering if the "90%+ of managers can't beat the market" actually comes from here, since 76.6% plus 21.3% equals 97.9%.

So, without weighing in on the merits of the arguments, there seems to be some confusion on the point of debate.

I don't see anyone in this thread arguing that actively managed funds are a good idea. The argument is that someone with the skill set of an active fund manager can out-perform an index fund if they are managing their own money and directly investing in stocks. Supporters of this argument are claiming that this is because their returns will no longer have a drag from (among other things) management fees, restrictions on which stocks to buy, purchases that move the market, client redemption, dumping stocks to make the quarterly report look good, etc.

One piece of evidence being used to support this claim is that 75% of funds in the Wharton study matched the market despite a 2.5% drag on returns due to fees, suggesting that those same fund managers would have beat the market by 2+% if they were directly investing their own money the same way they were investing other people's money.

Exactly.

This is not a recommendation for actively managed funds. Only an argument that the common stat that 98% of mutual fund managers do not beat the market is flawed. The paper says ~79% of mutual fund managers do beat the market by 2.5%+.   

Scandium

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Why would I buy an actively managed fund? If I had some reason to believe that the manager was able to generate alpha. This study shows that only 2.1% of managers are able to do so. This article is the strongest proof I could possibly want of the value of index funds. In fact, I am wondering if the "90%+ of managers can't beat the market" actually comes from here, since 76.6% plus 21.3% equals 97.9%.

So, without weighing in on the merits of the arguments, there seems to be some confusion on the point of debate.

I don't see anyone in this thread arguing that actively managed funds are a good idea. The argument is that someone with the skill set of an active fund manager can out-perform an index fund if they are managing their own money and directly investing in stocks. Supporters of this argument are claiming that this is because their returns will no longer have a drag from (among other things) management fees, restrictions on which stocks to buy, purchases that move the market, client redemption, dumping stocks to make the quarterly report look good, etc.

One piece of evidence being used to support this claim is that 75% of funds in the Wharton study matched the market despite a 2.5% drag on returns due to fees, suggesting that those same fund managers would have beat the market by 2+% if they were directly investing their own money the same way they were investing other people's money.

That is correct. I'd argue that individual stock-pickers do no better, and likely worse. But I'd love to see some data for or against this! Most studies are just concerned with fund managers.

Another datapoint is hedge funds, which are closed (thus smaller and not faced with many limitations of mutual funds) and can do whatever the heck they want. They have not outperformed the market either, even before their outrageous fees.

Dr. A

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That is correct. I'd argue that individual stock-pickers do no better, and likely worse. But I'd love to see some data for or against this! Most studies are just concerned with fund managers.

One problem, I think, is that even if it is true that a skilled investor can beat the market, the people who might have the knowledge, experience and temperament to do it can make a shit-ton more money buy sticking their own stash in a couple mutual funds and drawing a big salary from an investment house.

Another datapoint is hedge funds, which are closed (thus smaller and not faced with many limitations of mutual funds) and can do whatever the heck they want. They have not outperformed the market either, even before their outrageous fees.

Data?

I have no doubt hedge funds lose big-time after fees, that seems like a no-brainer. But I'm skeptical about the claim before-fees without something to back it up.

Scandium

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That is correct. I'd argue that individual stock-pickers do no better, and likely worse. But I'd love to see some data for or against this! Most studies are just concerned with fund managers.

One problem, I think, is that even if it is true that a skilled investor can beat the market, the people who might have the knowledge, experience and temperament to do it can make a shit-ton more money buy sticking their own stash in a couple mutual funds and drawing a big salary from an investment house.

Another datapoint is hedge funds, which are closed (thus smaller and not faced with many limitations of mutual funds) and can do whatever the heck they want. They have not outperformed the market either, even before their outrageous fees.

Data?

I have no doubt hedge funds lose big-time after fees, that seems like a no-brainer. But I'm skeptical about the claim before-fees without something to back it up.
http://www.washingtonpost.com/business/a-hedge-fund-for-you-and-me-the-best-move-is-to-take-a-pass/2013/05/23/17e4689c-c1b3-11e2-ab60-67bba7be7813_story.html

Quote
The latest performance data (via the HFRX Global Hedge Fund Index) reveal that hedge funds havenít fared well at all: They returned a mere 3.5 percent in 2012, while the S&P 500-stock index gained 16 percent. Over the past five years, and the hedge fund index lost 13.6 percent, while the indices added 8.6 percent. Thatís as of the end of 2012; it has only gotten worse in 2013. Most hedge funds have fallen even further behind their benchmarks this year, gaining 5.4 percent vs. the marketís rally of 15.4 percent. As a source of comparison, the average mutual fund is up 14.8 percent.

Christof

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Believing indices beat the majority of people shows a fundamental misunderstanding of how the stock market works. The price of the S&P is the sum of what investors are willing to pay for each of 500 companies added together according to market cap. By virtue of this "voting" with money, there is a buyer and seller on every trade. One person wins and one loses.

The price of a share is the amount that the last buyer was willing to pay for a usually ridiculous tiny amount of shares in a company for which he or she found a seller. The price of the S&P is the what 500 individual buyers paid for their shares.

Buying a company (which buying shares is) is fundamentally no different from buying eggs at the grocery store. Care to explain why someone is loosing and someone is winning when buying eggs?

Dodge

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This is from 1975 to 2002. The SAME managers successfully did this for 27 years. This is not fund hopping. This is if you picked a random active mutual fund in 1975 and kept it for 27 years, you had a 76.6% chance of matching the market after fees and expenses, a 2.1% chance of significantly beating it, and a 21.3% chance of under-performing.

I'm fairly certain that the study you refer to doesn't factor out survivor bias. What if a fund closes in the 27 year period?

The data was for funds with at least 5 years of available data. So perhaps there is some survivor bias for younger funds. The study used 1569 funds. The study recorded each fund's alpha vs the S&P for each year net of fees and expenses. Then any under/out performance that was statistically luck was eliminated.

If you only count the funds from 1975 which are still around, those numbers make sense.  This is because the poor performing funds are killed off.  The only funds which stick around for that long, are the funds which performed well.  If you choose a random fund from 1975, chances are your fund wouldn't be around today.  Survivorship Bias is definitely a factor here.

"Of the 355 equity funds in 1970, fully 233 of those funds have gone out of business. Only 24 oupaced the market by more than 1% a year. These are terrible odds." Jack Bogle (2007)

Christof

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This study shows that only 2.1% of managers are able to do so. This article is the strongest proof I could possibly want of the value of index funds. In fact, I am wondering if the "90%+ of managers can't beat the market" actually comes from here, since 76.6% plus 21.3% equals 97.9%.

No, the study shows that in 76.6% it doesn't matter whether you buy an index fund or an actively managed fund, because the active fund generates the same result after fees as the index fund. For the remaining part, though, you are 900% more likely to loose money than to earn money.

And even that isn't correct, because the percentage is the number of funds rather the total money invested...

Dodge

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Believing indices beat the majority of people shows a fundamental misunderstanding of how the stock market works. The price of the S&P is the sum of what investors are willing to pay for each of 500 companies added together according to market cap. By virtue of this "voting" with money, there is a buyer and seller on every trade. One person wins and one loses. At the end of the day there is approximately a normal distribution of winners and losers. Half of the investors beat the market, half lose to it.

Incorrect.  "Dollars" does not equal "Investors".  It is certainly possible for the majority of "Investors" to underperform the average, but it is not possible for the majority of all "Dollars" to underperform the average.  Over the long term, the index does beat the majority of people.  The longer the time period, the larger the gap.  This isn't opinion, it is an observable fact.  Indexing (taking the average) guarantees you will beat or match at least half of the dollars invested in the market each year, every single year, for as long as your investing horizon happens to be.  When the gains are compounded, it's incredibly difficult to beat this.

pbkmaine

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The term I used was "generate alpha". I stand by what I said.

Eric

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Win/Lose
Tight/Loose

That is all.

Christof

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The term I used was "generate alpha". I stand by what I said.

alpha is after expenses. Market average to me is before expenses. The alpha is zero, because they make more than the market average, but collect this in fees and transaction expenses.

Win/Lose
Tight/Loose

Thanks. It's one of those words that is difficult to spell as someone who is speaking English as a second language...much like latter and ladder.

pbkmaine

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If you only knew the number of native English speakers who don't know the difference between loose and lose!

Eric

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If you only knew the number of native English speakers who don't know the difference between loose and lose!

See previous posts in this thread.  ;)

money_bunny

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I've always wondered if a lot of the edge that fund managers and brokers had back in the day was access to insider information via the social clubs, information given out over golf clubs, and other "Old Boy" networks?
Today they don't have that with SOX and other laws.

surfhb

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Another silly article which fails to mentions the fact that the laws of math and statistics says I will beat a vast majority of active investors over my lifetime......from Buffet on down.   

All this while doing nothing:)    I have better things to do with my life than try to squeeze out a couple extra points after 40-50 years of investing.
« Last Edit: December 29, 2014, 05:52:35 PM by surfhb »

Dr. A

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Another datapoint is hedge funds, which are closed (thus smaller and not faced with many limitations of mutual funds) and can do whatever the heck they want. They have not outperformed the market either, even before their outrageous fees.

Data?

I have no doubt hedge funds lose big-time after fees, that seems like a no-brainer. But I'm skeptical about the claim before-fees without something to back it up.
http://www.washingtonpost.com/business/a-hedge-fund-for-you-and-me-the-best-move-is-to-take-a-pass/2013/05/23/17e4689c-c1b3-11e2-ab60-67bba7be7813_story.html

Quote
The latest performance data (via the HFRX Global Hedge Fund Index) reveal that hedge funds havenít fared well at all: They returned a mere 3.5 percent in 2012, while the S&P 500-stock index gained 16 percent. Over the past five years, and the hedge fund index lost 13.6 percent, while the indices added 8.6 percent. Thatís as of the end of 2012; it has only gotten worse in 2013. Most hedge funds have fallen even further behind their benchmarks this year, gaining 5.4 percent vs. the marketís rally of 15.4 percent. As a source of comparison, the average mutual fund is up 14.8 percent.

Christ on a cracker. Well, there you go.

innerscorecard

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I see that many of those responding here sadly haven't actually read the article, and are responding to a straw man, not the actual arguments in the article.

surfhb

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I love the underlying theme of the article:   Those of you more sophisticated investors who wish to beat the indexes shouldn't be investing in the indexes entirely.   

Um yeah....no shit Sherlock!   :)

dungoofed

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Parts of the original article sound like an argument in favour of RAFI Fundamental Indexing Methodology. Anyone here have experience with these products? I find that the fees are still a bit high but they definitely hold potential.


josstache

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I was looking on his site to see if there was a log of his historical returns.  I couldn't find that (though the reply after this one posted a link to it), but I did find this:

Quote
#2 What Are Your Ultimate Plans?
Within 5 years, I hope to consolidate everything I own into a single hedge fund or holding company and issue equity to outside investors.  Iím also considering launching a value based mutual fund for regular investors who want to buy shares of global stocks and bonds using the same method I use to choose investments for my firm.

#4 What Stock Should I Buy?
Donít ask me this because Iím not going to tell you what Iím buying, selling, or trading.  I will, however, tell you how I find companies, what I look for, and the philosophy I used to achieve what I did because men before me were generous and shared their knowledge with me.  At some point, when I launch a mutual fund, hedge fund, or take the holding company public, if you want to own what I own, you can just buy shares of whatever vehicle I choose to utilize.

Not to say that the guy hasn't written quality articles with valid points, but it helps to understand where someone is coming from.
« Last Edit: December 29, 2014, 08:17:37 PM by josstache »

index

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Another silly article which fails to mentions the fact that the laws of math and statistics says I will beat a vast majority of active investors over my lifetime......from Buffet on down.   

All this while doing nothing:)    I have better things to do with my life than try to squeeze out a couple extra points after 40-50 years of investing.

I think you are missing the point of the article and the arguments in this thread. The common parroting around here is the index is impossible to beat, yet the same paper used incorrectly to cite this actually started 78% of mangers beat the index before fees and expenses.

The article linked in this thread simply explains why those with the aptitude choose to invest their own money. Over the long term, it's likely that someone with the aptitude of a fund manager will slightly beat the market by 1-2%.

For those with the temperament, earning an extra couple of % is the difference between retiring well and rich.