" The Arithmetic of the Financial System "

John Bogle is the founder and former CEO of Vanguard...he is perhaps the strongest proponent of indexing & he launched the first index mutual fund way back in 1976. His creation Vanguard is currently the world’s largest mutual fund company.

John Bogle’s book Enough begins with a wonderful epigram-a short witty poem depicting the reality of the modern financial system. It goes on to read something like this,

Some men wrest a living from nature and with their hands; this is called work.

Some men wrest a living from those who wrest a living from nature and with their hands; this is called trade.

Some men wrest a living from those who wrest a living from those who wrest a living from nature and with their hands; this is called finance.

The epigram is used by the author to describe the correlation between financial system and the economy of a country!

He then goes on to describe the ironclad equation under which the system works, what he terms as The Relentless Rules of Humble Arithmetic.

They are and I am quoting them from his book,

The gross return generated in the financial markets, minus the costs of the financial system, equals the net return actually delivered to investors.

Thus, as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted (i.e., forever), the ability of our citizens to accumulate savings for retirement will continue to be seriously undermined by the enormous costs of the system itself.

The more the financial system takes, the less the investor makes.

The investor feeds at the bottom of what is today the tremendously costly food chain of investing.

John Bogle sums up the above reality in these words, On balance, the financial system subtracts value from our society.

The author laments that we live in a world where we are merely trading pieces of paper, swapping stocks and bonds back and forth with one another...!

The author correctly asserts that all such activities obviously increase the costs and has led to the creation of complex financial derivatives which add to the mayhem due to immeasurable risks.

If I were an investor (or an investment advisor) the following is what I would interpret from the wisdom contained in Enough,

·        The financial system is an additional layer to the real economy that produces goods and services which all of us consume. When I say this, I would exclude plain vanilla commercial banking which facilitates economic activities.

·        As investors, we primarily plough our savings into companies that comprise the real economy...i.e. either as stakeholders in ownership (equities) or as lenders of capital (debt)....and we do this in order to meet our financial goals and objectives. Period!

·        It implies, therefore, as an investor I should try and be closest to the returns generated by the system itself i.e. the market rate of return delivered to investors in the aggregate or as a group. The portfolio that mimics the market average return is obviously a broad market cap-weighted index (fund / ETF)

·        As elsewhere (and also in India) the ‘market rate of return’ includes the performance of various professionals such as MF managers, PMS Managers, Insurance managers, stock pickers, FIIs, hedge funds and so on and so forth.

·        To expand upon the ‘relentless rules of humble arithmetic’...some of these active investors (at random) will outperform the market average in some time periods-such that their (equally brilliant and motivated) counterparts will underperform (at random) by an equivalent amount. Both i.e. the alpha and anti-alpha are usually known in hindsight. The market is not a fairy tale mythical land where everyone can extract excess returns 'above the average' at the expense of other active investors (also trying to outperform.)

·        To conclude: As investors it makes logical sense to reap the benefits of capitalism and enterprise by buying ‘capitalism in the aggregate’ via the market (broad index) portfolio...rather than indulge in (active) guesswork about individual pieces (stocks, companies, sectors and managers)....the individual pieces will exhibit random outcomes-both desirable and undesirable! The individual pieces will have additional (concentrated) risks over and above the market risk.

" Rich and Poor Serve Their Wall Street Masters"

Enclosed is link to an excellent article by Dan Solin, an actual example of portfolio churn which destroyed value for an investor. The author does comparison with passive index portfolios that would have created much more wealth for the investor.

http://www.huffingtonpost.com/dan-solin/rich-and-poor-serve-their_b_812718.html

Criticism of 'Market Efficiency'...but does it allow you to make money hand over fist?

Art Carden is a professor of economics at Rhodes College and the following paragraph is from his write-up, Why Economics is Crucial for Ethics.

“If you are making money hand over fist exploiting inefficiencies in the market, then I will believe you and listen to your criticisms of efficient markets.  Until then, I've seen nothing to suggest that markets are systematically inefficient in a knowable, predictable way.”

Active investors generally believe that ‘pricing inefficiencies or anomalies’ can be predictably & consistently exploited in stock markets....especially in the so-called more ‘inefficient’ emerging markets (such as India).

I believe, that no market can be perfectly efficient i.e.at all times and for all people...this implies that even if inefficiencies exist in the market, they are randomly scattered such that no individual can ‘outperform’ the market averages (by profiting from those anomalies) except for random chance!

To my mind, the practical implication of Art Carden’s observation is:

In a market (e.g. Indian stock market) that has the presence of thousands and thousands of professional active investors (MFs, FIIs, PMS Managers, analysts, stock pickers, treasuries, insurance companies, advisors, family offices, and institutional investors etc)-it is rather difficult for me to believe that individual professionals can keep outperforming by consistently exploiting the mistakes of their equally brilliant and motivated counterparts.

In other words, for an individual (s) to consistently exploit inefficiencies, profit from them and thus beat the market...their counterparts (also highly motivated investors trying to generate alpha) have to consistently turn CHARITABLE and allow others to ‘consciously’ win.

However, even if we believe markets are not efficient, then, in Jack Bogle’s words, (from his interview dated 4^th January 2011, Money Magazine...Investor’s Guide-2011)

You don't need the efficient-market theory to justify indexing. Indexing wins whether markets are efficient or inefficient. In an inefficient market, a good manager may be able to win by five percentage points a year over a decade.

But by definition, a bad manager must lose by the same amount. It all has to average out. So even if the market is very inefficient, the index will still capture your share of the market return.

Link to the interview,

http://money.cnn.com/2010/12/31/pf/investing/jack_bogle.moneymag/index.htm

" Telling someone you can't beat the market, is like telling a 6-year old, Santa Claus doesn't exist."

Professor Burton Malkiel of Princeton University is the author of a very famous investment book, A Random Walk Down Wall Street. The first edition appeared in the early 1970s and it has been so popular that it is now into its 10^th edition.

Burton Malkiel is a strong proponent of low-cost indexing and in the enclosed article and interview on Yahoo Finance-he says that investments via passive indexing (including ETFs) are becoming very popular!

Markets may not be 100% efficient-but it doesn’t mean that one can (consistently) beat them or be above average.

Stock prices (into the future) move at random-because news / fresh information (which causes prices to move) hits the market at random. It essentially implies that there are no ‘past patterns’ that can predict the future.

What is not news is already discounted into the prices by the market. This happens because the market is comprised of thousands of competitive, motivated and profit seeking people who do analysis 24*7*365. In other words prices (in the market) already reflect what can be known!

Hence, all that investors need to do is invest into low cost index funds / ETFs for their long-term financial goals and objectives.

And yet active management is hugely popular, people keep trying to beat the market and pay others to do the same ...why? In the words of Burton Malkiel,

“Telling someone that you can’t beat the market, is like telling a six-year old that Santa Claus doesn’t exist,” according to Malkiel. Basically, people deny the facts that show most investors don't make huge profits. 

He explains that we all keep trying for two fundamental reasons: investing is fun and some people DO make money.

In the market peoples' beliefs are similar to the fable of Lake Woebegon-the fictional land-where all children are ‘above average!’ Unfortunately, in their attempt to chase the rainbow of 'beating the market' many fail to capture the market average return, which over the long term is decent enough to meet many of our financial goals.

According to me, the sage advice of Dr Burton Malkiel is applicable to investors everywhere!

Link to the Yahoo Finance article and interview,

http://finance.yahoo.com/tech-ticker/burton-malkiel-markets-aren’t-100-efficient-but-you-still-can’t-beat-‘em-yftt_535789.html

Dan Solin's "Best & Worst Investing Awards for 2010"...a good guide for Indian investors too!

Enclosed is a link to Dan Solin’s write-up titled Best and Worst Investing Awards for 2010...they are the writer’s hand out on best and worst awards for “best and worst predictions, investment advice, financial products..." and so on and so forth.

According to me the article is a useful guide for investors everywhere, some kind of a general check list about what one should do and the things to be avoided.

What caught my attention was Dan Solin’s hand out for The Best and Worst Financial Product...this is what he has written, at points 9 & 10 of his article,

9. Best Financial Product: Exchange Traded Funds which, when used correctly, can permit investors to invest intelligently, at low cost. Unfortunately, they are more often misused to pick sectors and trade frequently, which reduces returns.

10. Worst Financial Product: Another tough one. Hedge funds, variable annuities, equity-index annuities and private equity funds all qualify. However, the award goes to Principal Protected Notes. Their name got them the nod. The principal is not protected against issuer default. They have excessive fees and the upside is grossly overstated. Their complexity makes it very difficult for investors to understand how they are being ripped off and why much simpler alternatives would be superior investments. This combination of qualities typifies the conduct of many brokers and other "investment professionals", and earned this product the award, but it was very close.

Daniel 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

Link to the write-up,

http://www.huffingtonpost.com/dan-solin/the-first-annual-solin-aw_b_801249.html

" 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