" What we can learn from Paul the octopus? "

Dan Gardner is a prolific writer with profound insights! 

His latest book is Why Expert Predictions Fail-and Why We Believe Them Anyway.

Some words from the author’s website,

In 2008, as the price of oil surged above $140 a barrel, experts said it would soon hit $200; a few months later it plunged to $30. In 1967, they said the USSR would have one of the fastest-growing economies in the year 2000; in 2000, the USSR did not exist. In 1911, it was pronounced that there would be no more wars in Europe; we all know how that turned out. Face it; experts are about as accurate as dart-throwing monkeys.

Predictions & forecasts form a sizeable component of active investing i.e. relative to passive investing. Enclosed is link to a wonderful article titled What we can learn from Paul the octopus written by Dan Gardner.

The article points out that a few right calls or predictions or winning streak-whether it is a fund manager or an economist or Paul the octopus...doesn’t make any of them an oracle, an expert or a guru. One should consider the hand of luck and randomness!

The author points out to our unfortunate habit of paying attention to hits while ignoring misses.

I am reproducing these words from the article,

Consider Nouriel Roubini, the economist who shot to global gurudom after he correctly predicted the meltdown of 2008. Every time he is interviewed, every time he is introduced to an audience, Roubini's famous call is mentioned. What is never mentioned is that Roubini also called for a recession in the United States in 2004, 2005, 2006, and 2007. Or that after the crash of 2008 he said oil would stay below $40 a barrel throughout 2009 (it doubled in price). Or that he said stocks were going nowhere but down (they soared).

I'm not saying Roubini simply got lucky in 2008. He's a smart guy with lots of genuine insight. But he's no oracle.

Link to the article, the author gives some examples: successful fund managers, economists and of course Paul...no one is an oracle!

http://www.dangardner.ca/index.php/articles/item/32-what-we-can-learn-from-paul-the-octopus

" Active or Passive? "....an objective analysis by Vanguard.

Enclosed is a link to an objective analysis of ‘Active or Passive?’ done by John Ameriks on Vanguard Blog in September 2009!

Vanguard’s founder and former CEO John C. Bogle launched the first index mutual fund in 1976-which now happens to be one of the largest equity funds in the world.

According to me, the basic arguments posted on the blog are akin to the laws of gravity and hold good for all geographies and free financial markets.

Consider the following words; I have underlined the important sentences,

Zero-sum: You don’t need to believe in efficient markets, rational behaviour, economics, or the tooth fairy to establish that a portfolio that holds all the securities in a capitalization-weighted market index (i.e., an index weighted like the S&P 500 and other common indexes, but containing all the securities in the market) will, after costs, outperform the average dollar invested in the market if active management costs more than cap-weighted indexing, which it generally does.

You do have to believe in basic arithmetic. (And the index must be cap-weighted, as this wouldn’t necessarily be true for other indexing methods.) But the result is purely mathematical from there, and is based only on the definition of the word “average”—not on fancy/complicated theories that require any additional assumptions.

Importantly, this basic math applies regardless of the market, or the so-called efficiency of the market.

Further....

...that in inefficient markets (think small-cap stocks or emerging markets), you tend to get much wider dispersion in manager results. There are lots of home runs, and lots of strikeouts (or worse).

But it’s still the case that, regardless of which investors beat the average and which fall below, the performance of the average dollar in an inefficient market is equal to the performance of a cap-weighted index of that inefficient market...

Some more wisdom....

...given the amount of noise in the data, we very often just can’t say whether any outperformance or underperformance is due to luck or skill.

Sure, there are some managers/investors who will frequently end up on the upside of wild swings, but there are also those who frequently end up on the downside. In such an environment, it’s generally harder to distinguish who is really adding value or subtracting it, given the additional background noise.

My Observations:

Considering the fact that modern Indian financial markets are highly competitive due to the presence of a large number of professional active investors (who are paid to generate alpha-a short list would include numerous MF managers, Insurance managers, PMS managers, FII and hedge fund managers, treasury managers, pension managers, family offices, analysts, stock-pickers, advisors, and many more)-the zero-sum equation mentioned above kicks in leading to randomness of outcomes.

On account of intense competition, out and under performers are a result of randomness and unpredictability. Out performances are usually transient and known in hindsight.

By default if some active investors / managers beat the market by a wide margin-their equally brilliant, motivated and competitive counterparts will be hit badly!  To quote the blog, you tend to get much wider dispersion in manager results.

Therefore the realistic return from any market or asset class is the ‘market average’ return as measured by broad market cap-weighted indices that map a sizeable component of market capitalization! To my mind, buying the market portfolio (cap-weighted index) is a more logical method of investing in a country's enterprise / businesses-which is what equities as an asset class are all about.

http://www.vanguardblog.com/2009.09.25/active-or-passive.html#more-245

A famous fund manager and stock picker turns to indexing !

Jeffery Vinik, a famous fund manager and stock picker, turns to indexing after stock picking gains....read on...

http://www.bloomberg.com/news/2010-12-17/jeff-vinik-s-hedge-fund-turns-to-index-funds-after-stock-picking-gains.html

" Index Funds are Fabulous "-Meir Statman

Meir Statman of Santa Clara University is a professor of behavioural finance. Behavioural studies in finance have become a rage over the past few years-behavioural finance, in brief, tells us that market participants are not always rational!

Professor Statman says that ‘index funds are fabulous’ in a recent interview with Morningstar, titled, Knowing Others’ Mistakes Won’t Make You Rich.

In the interview, he also gives a few examples of cognitive errors that people tend to make, some excerpts,

“...there is a range of cognitive errors that people commit, and it's important for people to know that. For example, mutual fund companies tend to advertise their most successful funds, the ones that have five stars from Morningstar.

Well, investors are left thinking that it's very easy to get a very successful fund. They never advertise their one star funds, and so you have to be aware that because mutual fund companies do that it tilts your view as to the likelihood of success. And so you should tilt it back, and say wait a minute, this cannot happen.

 Hindsight is another one that is very important to guard the gains. It is very easy for all of us to say that in 2007 we knew for sure that the market is going to be terrible in 2008.

If you actually had people write down in pen what they thought in 2007 at the time you would find that they said maybe it will go down, but then maybe it will not go down until 2009 and so on.

But now when we get to be in 2010 they remember only that they knew that the market is going to go down, and that really is hindsight that is speaking. So these are two of more cognitive errors that get in the way.”

Link to the interview,

http://www.morningstar.co.uk/uk/news/article.aspx?lang=en-GB&articleid=93968&categoryid=13

I believe, Indian markets are getting increasingly competitive with an ever increasing number of professional participants-a short list-would include active investors such as: MF managers, PMS managers, Insurance scheme managers, FII and hedge fund managers, treasury managers, other institutional investors, analysts, stock-pickers and so on and so forth.

With the presence of numerous brilliant, competitive and highly motivated participants-it is not easy, for individual professionals to find and exploit mistakes / pricing anomalies-i.e. consistently.

Asset allocation to passive indexes (ETFs / funds) is important as markets become more competitive & efficient thus resulting in a reduction of pricing mistakes and anomalies!

" A Dying Banker's Last Instructions "

Enclosed is a NY Times article dated 26^th November 2010, titled, A Dying Banker’s Last Instructions.

The article is about Gordon Murray-a former salesman at Goldman-who rose to become Managing Director at Lehman and CSFB. As he was diagnosed with brain cancer-he decided to pen a small book The Investment Answer.

The article mentions that Gordon Murray later in his career learnt about the failings of active portfolio management, which had taught him to erroneously believe It’s American to think that if you’re smart or work hard, then you can beat the markets.

Gordon Murray, later on in his career, is influenced by Dimensional-a passive mutual fund company, which teaches him, No one can predict the future with any regularity, so why would you think that active managers can beat their respective indexes over time?

http://www.nytimes.com/2010/11/27/your-money/27money.html

' The market ...it's crazy...but the fact it's crazy doesn't make you a psychiatrist '

Meir Statman of Santa Clara University is a Professor of Finance whose research focuses on behavioural studies.

Despite being a proponent of behavioural finance he believes that ordinary investors cannot get a better risk-adjusted return than they can in low-cost index funds!

Being a behavioural finance proponent he does not believe that markets are efficient-but that does not mean people should not Index, his brief explanation is as under,

Q: You pound the drum for index funds. Is that because you think the markets are efficient and therefore unbeatable over the long-term?

A: The market is not efficient. It's crazy, but the fact that it's crazy doesn't make you a psychiatrist. It's crazy like a wild animal. You wouldn't want to go against a wild lion because it's crazy. It's crazy in ways you cannot understand and cannot forecast.

People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it.

Practically speaking, individual investors should treat the market as unbeatable and realize that when they try to beat it because it is inefficient, they are likely to injure themselves, rather than gain at the expense of another.

Can professionals beat the market? His answer,

Q: Do you think pros can beat the market?

A: Yes, they can. But it's still a zero-sum game. If some people win, it means that some people lose relative to what they can get by being in an index fund.

My interpretation of the above for Indian investors / advisors,

·        Indian markets are competitive because they comprise of a large number of professional investors who are all attempting to generate alpha, a brief list includes: MF, PMS, insurance, treasury, FII and hedge fund managers, stock pickers, analysts both fundamental and technical and so on and so forth.

·        The constant analysis and activity of the above ensures that Mr Market knows more than individuals and hence it is difficult for individuals to beat it (outguess the market) consistently.

·        Therefore, ‘beating the market’ is a) more of a random outcome b) it is known in hindsight and c) past data is of little predictive value going forward.

·        I am tempted to repeat Meir Statman’s sage advice for Indian investors: People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it. Practically speaking, individual investors should treat the market as unbeatable...!

Link to the article,

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2010/11/16/BU991GCEF9.DTL&type=printable

' Buy and Hold is still a winner '....Burton Malkiel

Dr Burton Malkiel is the economics professor at Princeton and author of a best-seller A Random Walk Down Wall Street. If my memory serves me right it has run into nine editions till date and remains an all time investment classic.

In a recent WSJ article, titled ‘Buy and Hold is still a winner-’ Professor Malkiel reinforces the timeless wisdom of a buy and hold investment strategy using passive indexing i.e. even during the turbulent first decade of the 21^st century.

The lessons from his analysis, in principle, are applicable to Indian investors also: it is rather difficult to outguess and beat the markets consistently!

Some outstanding words (in italics) from the article,

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.

I am reproducing a sample of ‘market timing’ from the article.

Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades.

The logic of passive indexing, in brief,

Low-cost passive (index-fund) investing remains an excellent strategy for at least the core of every portfolio. All the stocks in the market must be held by someone. Therefore, if one active portfolio manager is holding the better-performing stocks, then some other active manager must be holding those with below-average returns.

http://online.wsj.com/article/SB10001424052748703848204575608623469465624.html

Pearls of investment wisdom from 'The Little Book of Commonsense Investing'

John C Bogle’s The Little Book of Commonsense Investing is one of my favourites. John C Bogle as we know launched the first index mutual fund in 1976 and it went on to become one of the largest equity funds in the world.

Mr Bogle remains a dyed-in-the-wool indexer and has been a strong advocate of cap-weighted indexing, ever since his senior thesis as a student at Princeton University more than 60 years ago.

Some wisdom from the book-these are quotes from ‘investment giants’ other than Mr Bogle-who also support passive indexing.

I believe that in principle the following words (from the book) have a universal application and hence should be understood by investors and investment advisors everywhere!

‘For the markets in total, the amount of value added, or alpha, must sum to zero. One person’s positive alpha is someone else’s negative alpha. Collectively, for the institutional, mutual fund, and private banking assets, the aggregate alpha return will be zero or negative after transaction costs.’ --Gary P. Brinson, CFA, former president of UBS Investment Management in ‘The Future of Investment Management’, Financial Analyst’s Journal, July / August 2005, Vol.61 No.4

‘A low cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth. In this book, Jack Bogle tells you why’. -- Warren Buffet.

‘By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb…’--Warren Buffett

‘Market cap based indexing will never be driven from its deserved perch as core and deserved king of the investment world. It is what we should all own in theory and it has delivered low-cost equity returns to a great mass of investors…the now and forever king-of-the-hill’. --Clifford A. Asness-hedge fund manager, of AQR Capital Management in an unpublished paper called, ‘Capitalization vs. Fundamentally Weighted Indices’.

‘Toss a coin, heads and the manager will make $10,000 over a year, tails and he will lose $10,000. We run (the contest) for the first year (for 10,000 managers). At the end of the year, we expect 5000 managers to be up $10,000 each and 5000 to be down $10,000. Now we run the game a second year. Again, we can expect 2500 managers to be up two years in a row; another year 1250; a fourth one, 625; a fifth, 313 managers who made money for five years in a row. (And in 10 years, just 10 out of the original 10,000 managers). Out of pure luck…. A population entirely composed of bad managers will produce a small amount of great track records…. The number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits’. --Nassim Nicholas Taleb, Fooled By Randomness, (NY, Texere, 2001)

‘Buying funds based purely on their past performance is one of the stupidest things an investor can do.’ --Jason Zweig, columnist Money magazine.

‘As a dyed in the wool indexer, of course, I believe the classic index fund must be at the core of that winning strategy. But even I would never have the temerity to say what Dr. Paul Samuelson of MIT said in a speech to the Boston Society of Security Analysts in the autumn of 2005: ‘The creation of the first index fund by John Bogle was the equivalent of the invention of the wheel and the alphabet’. Those two essentials of our existence that we take for granted every day have stood the test of time. So will the classic index fund.’ --John C Bogle

‘Well, Jack, we are wrong. You win. Settling for average is good enough, at least for a substantial portion of most investors’ stock and bond portfolios. In fact, more often than not, aiming for benchmark-matching returns through index funds assures unit holders of a better-than-average chance of outperforming the typical managed stock or bond portfolio. It’s the paradox of fund investing today: Gunning for average is your best shot at finishing above average. We’ve come around to agreeing with the sometimes prickly, always provocative, fund executive known to admirers and detractors alike as Saint Jack (Bogle): Indexing should form the core of most investors’ fund portfolios. So here’s to you, Jack. You have a right to call it, as you recently did in a booklet you wrote, The Triumph of Indexing.’ Tyler Mathisen ‘In Your Interest’ Money magazine August 1995.

" Investment Club " is an oxymoron !

Another terrific write-up by Dan Solin, titled “Investment Club” is an Oxymoron...his analysis conceptually, is also applicable to Indian investors because the fundamental logic of passive investing is valid for all geographies!

The success of active management is typically known in hindsight, is not predictable from past performance and is associated with randomness-as a result of market efficiency.

Dan Solin writes,

I was recently invited to debate active vs. passive management at an investment club. The club members, a group of wealthy retired men, refer to themselves as investment "gurus." They are absolutely convinced of the merits of active management (defined as the ability to pick stocks or mutual funds that will beat designated benchmarks).

Read the entire article, the link is as under,

http://www.huffingtonpost.com/dan-solin/investment-club-is-an-oxy_b_779933.html

Dan Solin has written a wonderful book The Smartest Investment Book You’ll Ever Read and is a financial columnist with The Huffington Post

" Why I Index?"-Commonsense observations !

Something that I had read on passive indexing a couple of years back...these happen to be " Why I Index? " kind of general observations from a fee-only financial advisor based in America.

According to me the following " Why I Index? " are typical issues that are applicable in principle to all geographies. They should be kept in mind by investors / advisors while deciding their strategic asset allocation.

I index because I grew tired of being disappointed by active funds that delivered wonderful returns right up until the day I invested.

I index because for years I only discovered funds that I should have owned, not that I should own.

I index because I enjoy my free time and have not seen any overall gain from the hours spent analyzing active funds.

I index because it occurred to me that those who argue the strongest for active funds tend to be the same people who benefit the most if I buy active funds.

I index because I trust indexes more than active managers. Indexes do not get bored, get overconfident, quit, die, or defect to other firms.

I index because indexes are transparent. I know what my money is invested in and why.

I index to eliminate risk without sacrificing return. The high probability that an active fund will not keep up with its benchmark adds uncompensated risk.

I index because as my assets grow I prefer simplicity to complexity.

I index because as I get older cost matters more to me.

I index because I now realize that all I need is the return of index funds to achieve my financial objectives. And that is what really matters.

Fund Manager turnover...wise advice from John Bogle !

John C Bogle is the founder and former CEO of Vanguard-he launched the first index mutual fund way back in 1976.  Till this day he remains one of the most vocal proponents of passive indexing.

I am reproducing an interesting extract from his interview that appeared in ‘Investment Advisor’ issue of May 2010.

This is what he said...although it is in the American context; a quintessential Indian investor who is investing in equities in order to benefit from the long-term India growth story should take note of Mr Bogle advice,

“...the index fund simply gives you the returns earned by American business and those returns are very similar to the growth of earnings in corporate America and are very similar, and this shouldn't surprise anybody, to the growth of our GDP, the growth of the American economy.

So in fact you're getting a share in American business or a share in America when you buy an index fund. You can hold it forever. You don't have to worry about the portfolio manager changing. This is a world where the portfolio manager changes every five years for mutual funds.

So if you're investing for a lifetime, and it's very important to get this idea out there, and you have four mutual funds, that means you have four managers in five years, eight managers in 10 years, 16 managers in 20 years and 32 managers in 40 years.

Anybody seriously put forth the proposition that you can beat the market when you have 40 managers in 50 years.”

Link to the entire interview,

http://www.advisorone.com/article/30-30-interviews-john-bogle

Time for a Reality Check !

Dan Solin is a graduate of John Hopkins University and the University of Pennsylvania Law School.

He has written a wonderful book The Smartest Investment Book You’ll Ever Read and is a financial columnist with The Huffington Post

Enclosed is a link to his write-up titled Time for a Reality Check dated 26^th October 2010. 

The important lesson is that ‘predictions and forecasts’ in financial markets are very difficult-even for professionals.  Active investing involves all kinds of future predictions and forecasts-great stocks, managers, time to be in and out of the market and so on.

Dan Solin is a strong advocate of passive indexing!

The futility about some of these forecasts reminds me of terrific stuff that I had read in the book Black Swan

“What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.”

And

“Thomas Watson, the founder of IBM, once predicted that there would be no need for more than just a handful of computers.”

http://www.huffingtonpost.com/dan-solin/time-for-a-reality-check_b_772954.html

The investor's 'dream team'

Charles Ellis is among the greatest investors of the 20^th century and author of the perennial investment classic Winning the Loser’s Game.

He was associated with the giant Yale Endowment Fund and his firm Greenwich Associates is an advisor to giant institutional investors.

In Winning the Loser’s Game he poses a question...what would an investor’s dream team comprise of?

In other words if a typical investor was given a choice of choosing his ‘dream team’ to manage money-who would he select? Which individuals would he choose to manage his money?

Ellis goes on to answer the question...the team would clearly comprise of Warren Buffett-his partner Charlie Munger, Peter Lynch and George Soros...these guys are obvious choices! It’s a no-brainier.

Further says Ellis-the investor’s dream team would also comprise of all the hedge fund managers-since they too have expertise, insights, knowledge and information...Ellis doesn’t stop...he says why not even have all the best analysts from the best Wall Street banks, from all those brokerages and all those research outfits...!

In short...a typical dream team would certainly comprise of all the finest professionals in the business-if we as investors had a choice wouldn’t we want such a ‘star-studded’ team manage our money? And what if we could hire all of them at a low cost?

Let me reproduce the sage advice of Charles Ellis-how each and every investor can permanently have a dream team comprising of the best professionals work for him !

In fact, you can have all the best professionals working for you all the time. All you have to do us agree to accept all their best thinking without asking questions. (Most of us do the same sort of thing every time we fly: We know that our pilots are trained for and committed to safety. Boring as it may seem, we relax in our seats and leave the flying to the experts.)

To get the combined expertise of all these top professionals, all you do is index-because an index fund replicates the market, and today’s professional-dominated stock market reflects all the accumulated expertise of all those diligent experts making their best current judgments all the time.

And as they learn more, they will quickly update their judgment, which means that you will always have the most up-to-date consensus when you index.

...the ‘market portfolio’ or index fund is actually the result of all the hard work being done every day by the investor’s dream team.

Passive or index investing is seldom given anything like the respect it deserves. But it will, over time, achieve better results than most mutual funds-and far better results than most individual investors achieve.

Conceptually, the timeless and seminal advice of Charles Ellis is also applicable to Indian investors...it always was, it is right now and will be applicable till eternity!

Indian investors can buy cap-weighted broad market index funds / ETFs-including (cap-weighted) Total Market Index fund-they are akin to buying the market or the combined expertise of all professional active managers who participate in Indian markets.

A short list would include all MF managers, insurance managers, all PMS Managers, treasuries managers-corporate & bank, all analysts, all institutional investors, broker-advisors, family offices and so on and so forth.

The combined expertise / thinking of all professionals, at any given point in time, is reflected in the market prices-and therefore in the market capitalization of individual companies...therefore when an investor buys broad market cap-weighted index funds / ETFs he is in effect hiring the combined expertise of all professionals (at a very low cost)-the proverbial ‘dream team.’

How Power Blinds Us to Our Flaws...!

Enclosed is link to another superb article dated 16^th October 2010 by Jason Zweig,

“What Conflict of Interest? How Power Blinds Us to Our Flaws”

It is about how dozens of powerful people on Capitol Hill actively traded during the financial crisis.

According to me, power enforces the illusion that one is larger and more brilliant than the market.

The author quotes Meir Statman, of the Santa Clara University,

 If you passed a law saying that [members of Congress and their staffs] can only invest in index funds, on the whole you would do them a great favor, for two reasons," says Meir Statman, a finance professor at Santa Clara University. "First, they won't be reading news coverage about themselves that they and their constituents don't like. And two, they're more likely to make more money on index funds than by trying to outsmart the market."

http://online.wsj.com/article/SB10001424052748704049904575554224110186824.html

I don't know and I don't care...!

Jason Zweig is an eminent personal finance columnist in the US and has written famous books such as “Your Money & Your Brain.” He edited the revised edition of Ben Graham’s perennial classic “The Intelligent Investor.”

I am posting a link to an excellent article titled I don’t know and I don’t care written for the media in 2001.

He narrates his experiences about ‘picking’ hot funds and ‘star’ managers...finally he realizes that it would be more logical to invest in broad market index funds.

Indexing give you the freedom to say I don’t know and I don’t care...because you do away with the need to forecast and identify the next hot stock or manager. 

Individual stocks and managers represent additional risks (over and above the market risk) and these often remain uncompensated!

Indian investors & investment advisors should also try and understand the logic of indexing as explained by Jason Zweig.

http://money.cnn.com/2001/08/29/investing/Zweig/

Two great investment strategies !

Enclosed link to a great media write-up titled Two Great Investment Strategies which was done a couple of years back by Dr Ajay Shah.

He gives a superb explanation of survivorship bias in fund evaluation.

Except for the CRISIL SPIVA Scorecard, I don’t recollect seeing any comparisons of active and passive in India which make adjustments for this important factor.

As a result outperforming active funds (from a given sample) appear much better than they actually are!

In principle, correction for survivorship bias is valid for all managed portfolios present in the market.

http://www.mayin.org/ajayshah/MEDIA/1998/two-strategies.html

Common misconceptions and misplaced beliefs about indexing...some answers

In the following blog I have attempted to answer and address some common misconceptions as well as misplaced beliefs about indexing...some of these may be of more relevance to Indian investors.

Myth-1: The index is typically comprised of a smaller number of stocks whereas the fund manager or stock picker can pick and choose from the entire market.

Reality-1:  The number of stocks, in an index is not relevant, what is important is how much or what percentage of market capitalization the index captures or maps.

Therefore indexes when used as (cash market) investment vehicles in index funds or ETFs try to capture the various sources of risk so that investors can hope to earn the resultant expected returns.

Hence, for example, a total market index is designed to mimic the behaviour of the market as a whole and thereby capture its characteristics and peculiarities i.e. equities as an asset class.

Similarly other indices such as large-cap or mid-cap indices or narrower sector indices-help capture the behaviour and peculiarities of the respective sub-segments of the market or sub-asset categories.

An individual stock (or even a handful) cannot hope to capture a market’s behaviour nor the characteristics of any of its sub-segments-and this also true for portfolios managed by individual managers / advisors.

In other words individual stocks (and managed portfolios) will have a wide range of outcomes or returns (at random)-relative to the market.

Myth-2:  A cap-weighted index generally tends to ‘overweight’ large and growth companies and ‘underweight’ smaller and / or ‘value’ ones.

Reality-2:  Nothing really is known about ‘fair value’ of a security and therefore any stock (regardless of its capitalization) is just as likely to be ‘over or undervalued.’

In other words the presumption that large-caps are overvalued is rather ‘subjective’ and a result of individual opinion...therefore it can never be the ‘absolute’ opinion.

Further, due to the beauty of the cap-weighted ranking method-if the price of a big company falls for some reason-its aggregate market cap will also fall-and as a result the security will reduce in weight and ‘rebalance’ automatically / instantly in the portfolio.

E.g. some big banks in US indices fell in ranking in the broad market indices (due to fall in price) as the sub-prime problem broke out-and they automatically moved (rebalanced) to a lower slot as (simultaneously) other companies from different sectors moved up in weighting.

In the cap-weighted index-all these adjustments happen instantly and automatically as events unfold.

On the other hand-in actively managed portfolios the investor or portfolio manager has to take a view i.e. remove some of those companies or instead buy more? In an actively managed portfolio one has to decide whether to increase the weight or reduce the weight of individual components-as events unfold rapidly.

Myth-3:  Fund management experts are better placed (relative to the market) in arriving at ‘correct valuations’ or right price of a security-and therefore indexing is on a weaker ground because there is no expert taking calls on valuations.

Reality-3:   What is the definition of right price? It is the ‘price’ at which a ‘buyer and seller’ enter into a voluntary exchange of goods and services! This happens all the time in a free market.

This makes the ‘market price’ as closest to the fair value of a security because numerous buyers & sellers are entering into voluntary exchanges-based on their choices and perceptions.

The market price of a security is the best estimate of what numerous market participants (all those buyers and sellers including numerous professional managers / analysts) are thinking at any given point in time.

Some individuals (typically active investors) can keep arguing about the definition of ‘right price’ because each of them has a subjective valuation process-to use an analogy e.g. different buyers of an apartment will (each) have different criteria for arriving at the right price or valuation of the same apartment. 

Some will dispute with the price or ‘value’ of the apartment (for a number of reasons) saying it is ‘overpriced’ while several others will define the ‘price’ as ‘right’ because of proximity to school, or railway station or overlooking a garden and so on.

The right price is therefore the agreed price between the apartment buyer and seller. When both enter voluntarily into a transaction-it becomes the market price or fair price.

An analyst can spend days and days (working on a spreadsheet) making arguments why the ‘agreed price’ of the apartment was incorrect...but value finally lies on the eye of the beholder and no amount of expert analysis (done independent of the market process) can change this reality.

‘Market Price’ of a security aggregates dispersed knowledge of numerous market participants.

Hence when an individual active investor is attempting to ‘beat’ or ‘outguess’ that price (through commonly known tools / methods of analysis in active investing) it is the equivalent of playing ‘chess’ against thousands of invisible opponents.

Myth-4:   Companies or stocks (usually) get into an index after the run up happens hence those stocks are already overpriced-by the time find a berth into an index.

Reality-4:     The presumption over here is that there exists some authority (an individual expert) who knew the right valuation (of the stock) in the first place.

But for a moment let us assume that some active investors did manage to spot some great companies in their infancy i.e. before they got into the index and hence managed to capture a good deal of returns in infancy. However, those smart active investors also ended with some lousy stock picks-this happens all the time!

Let us assume that the lousy picks (the negative outcomes) were a case of ‘bad luck’...it would then imply that the great picks (done in infancy before those stocks got into the index) were ‘good luck.’ Some financial economists would call stock picking outcomes as the equivalent of throwing darts-mostly luck!

In a highly competitive and efficient market it implies that the ‘absolute skills’ of individual portfolio managers is intact...but their skills relative to the market are on the decline.

The market is nothing but an entity comprised of numerous equally brilliant active managers / stock pickers-all trying to outperform each other and by that definition- the market.

Myth-5:   Index components are decided (periodically) by the index committee-hence there is a stock selection process involved-similar to active management.

Reality-5:    There is a major difference: the index committee is not paid to beat the market. In direct contrast the objective of an active manager is to outperform the relevant market (index) and the manager is paid to do so. 

Therefore the criteria of an index committee are to formulate a portfolio that is at best a representative sample of the characteristics and behaviour of a market and by definition this should map the market (or its sub-segments) in terms of value or capitalization.

Moreover, once security ABC or XYZ gets into an index-its subsequent change in fortunes (i.e.  Its weight in the index) are left to the market forces. The index committee goes out of the picture.

On the other hand the same security in an actively managed portfolio will be regularly monitored by the portfolio manager who will take (active) decisions based on various criteria-such as profits, brand, competitiveness, ROCE, new projects, change in management, FII positions and so on and so forth, fund inflows and outflows into his scheme, trading calls, his own insights, gut, market information and so on.

Myth-6:   Outperformance in the ‘efficient’ US market maybe difficult-agreed! However, in emerging markets (like India) experts can (as yet) locate mispricing with relative ease and hence consistently beat the market (index)

Reality-6:   First of all let us understand-the composition of the modern Indian stock market- we have numerous MF managers, FII managers, hedge fund managers, PMS managers, insurance companies, treasury managers-bank and corporate, pension managers, analysts, family offices, broker-advisors and many other professional active managers-all of whom are attempting to beat the market and are paid to do so. Financial media adds to the information flow in the market.

Therefore publicly available information in a competitive market like India-is essentially ‘broadband’ or a commodity.

This competition results in efficiency.

In other words-alphas is a reality in any efficient market-but they are random, transient and known in hindsight. Therefore there are no ‘free-lunches’ or proverbial diamonds (mispricing) lying scattered on a heavily populated road just waiting for the fortunate few to pick them up! Even if ‘mispricing’ anomalies exist-they are kind of randomly scattered and it is rather tedious to capitalize on them consistently.

One can outperform only by exploiting the mistakes of others-but in a market that is increasingly dominated by professionals-it is difficult (for individual managers) to locate victims i.e. consistently.

Even if the market is presumed to be ‘informationally’ inefficient-for every alpha in the zero-sum game (of outperformance) there will be an ‘anti-alpha’ or underperformance. Hence for every out performing manager or active investor there will be an underperforming counterpart somewhere in the system.

Points to Remember: 

A cap-weighted index portfolio is a representation of the entire market (or its segments) and therefore at any given point in time the index is a reflection of the way the world (investors in the aggregate) values its assets.

Any active deviation from market weights-is an individual judgement and no subjective valuation (done independent of the market process) can ever be sacrosanct. 

Therefore any active deviation from market weights can lead to out and under performances-which will be random, transient and known in hindsight.

Some thoughts on the inherent limitations in trying to outguess or beat the market

Active investing has a lot to do with all types of ‘predictions & forecasts’-especially when the objective is to beat the market (index).

For example stock pickers have to ‘predict’ and therefore identify a couple of stocks with higher future rates of return...this has to be done from among the large number of companies typically listed on a stock exchange...and do this in competition with numerous contemporaries attempting a similar exercise.

Similarly manager pickers have to predict (from a large pool) the few managers who they believe will pick stocks with a higher rate of return-and in the process beat the market and other managers (also) attempting a similar exercise.

Predictions can extend to attempting market timing i.e. a great time to enter the market and then exit it.

Forecasts in active investing normally also extend to macro-economic domain such as predicting interest rates, government action affecting an economy, oil prices, and global cues and so on and so forth.

This narrows down the debate to understanding the difference between ‘physical / natural’ sciences and ‘social’ sciences.

Natural sciences such as physics, astronomy, medicine, engineering, chemistry etc deal with the natural phenomena found in our universe. On the other hand social sciences are the study of human interaction as individuals and as groups-for example their choices, preferences and so on.

‘Prediction’ is easier in natural sciences, e.g. an engineer can use a mathematical model to predict the stresses in a concrete structure such as a dam or a bridge or a skyscraper...similarly an aeronautical engineer can predict the impact of natural forces on an aircraft in flight via simulations in a wind tunnel or on a computer.

Likewise, medical sciences such as cardiology are moving towards ‘predicting’ heart attacks before they can occur in (otherwise) perfectly healthy people. For example, huge advances in cardiac imaging technology can pick up heart blockages in infancy and with a high level of accuracy-thereby the risk of a future stroke can be ‘actively predicted’ beforehand and necessary lifestyle changes be suggested to a possible future victim i.e. ‘in advance.’

Prediction is therefore easier with physical phenomena because they work according to a predictable past pattern and in accordance with natural laws.

Such ‘prediction’ luxuries may not be available to social sciences e.g. economics and investments.

This is because it involves human interaction, emotions, choices, perception & behaviour-which are relatively difficult to ‘forecast and predict’ (in advance) by using mathematical models or commonly tools such as charts (using past price patterns) or discounted cash flow models and so on! In other words past data can be of little predictive value going forward.

For example, in the stock markets it is rather difficult to arrive at the fair price of a security by making use of the usual tools of active management. Price at any given point in time is a reflection of what thousands and thousands of market participants are ‘thinking’-it is an estimate of what people collectively believe & perceive!

Likewise it is extremely difficult to figure out short-term market movements by using past patterns. Mr Market is almost like a human being whose thoughts change very often and hence making predictions & forecasts is tedious.

Price movements are impacted by ‘news’ or arrival of ‘fresh’ information and how numerous market participants respond / react to it (almost instantly)...I cannot think of any tool available that can accurately ‘predict’ this phenomena in advance. Fresh information could be anything-right from company specific to something like economic crises in Greece.

Arrival of fresh information / news is ‘random’ causing a random walk in prices.

Even if we assume the market is making mistakes-those errors, if any, will be accurately ‘predicted’ in hindsight.

Let me reproduce, as an example, two predictions that went horribly wrong and were highlighted in the book Black Swan, the words from the book are,

Thomas Watson, the founder of IBM, once predicted that there would be no need for more than a just handful of computers.

...Likewise, we are not spending long weekends in space stations as was universally predicted three decades ago. In an example of corporate arrogance, after the first moon landing the now defunct Pan Am took advance bookings for round-trips between earth & the moon.

Nice prediction, except the company failed to foresee that it would be out of business not long after.

The above examples represent human choices & behaviour-not easy to predict or foresee-unlike engineering problems that are easier to ‘predict’ and solve by using mathematical equations.  

Investors, often confuse between ‘natural & social’ sciences-what works for the former may not work in the latter.

We (often) erroneously believe there are ready made tools, also available in ‘social sciences’-which when used by experts can help us (easily) in beating the market-by predicting (in advance) mispricing that maybe caused due to human behaviour, choices and interaction!

Hence, the market price is closest to what we call as ‘fair estimate’ of a security’s value. Passive indexing makes no attempt to outguess market prices.

It is important to understand the inherent limitations in attempting to outguess the market (consistently)-let me end with some words from the book Black Swan,

What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.