Thoughts for the individual investor
A hard look around the table
There’s a wonderful quote from Warren Buffett that most of you have probably read before from his 1987 Letter to Shareholders” in the Berkshire Hathaway Annual Report: “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’”
It’s a fact that, like in poker, a lot of investors overrate their skill, totally misunderstand the role of luck and lose their shirts. Sadly, a lot of Robinhood investors were the patsies over the last year or two.
In this post I want to explore the idea that thoughtful individual investors who manage their own portfolios (DIY investors) are not the patsies. First, a thought about active vs passive investing.
Active vs passive
We all know the statistic that most actively managed ETFs and mutual funds underperform their benchmarks. The last data I looked at shows that only one in ten funds outperformed their benchmarks over a ten year period. That sounds bad.
But, there’s another way of looking at it. It stems from what William Sharpe calls “the arithmetic of active management”. In 1991 this finance professor and Nobel Laureate explained in a paper that the average actively managed fund actually beat the market before fees. By fees I mean the management expense ratio, MER.
You can think of it this way: together active (ignoring MER) and passive perform the same as the market, because they are the market. Since passive also perform the same as the market, active (ignoring MER) performs the same as the market.
So, the average active fund manager beats the market if you ignore the MER. The problem active fund managers have is that the MER acts as a huge anchor. My point is that the market may be hard to beat but it’s not that hard, the evidence being that the average fund manager can do it if you ignore MER.
But, readers will immediately think: ‘we can’t ignore the MER’. Actually, we can if we are DIY investors. My MER is essentially zero
The other players at the investing (poker) table
The vast majority of stocks in the U.S. are held by pension funds, hedge funds, insurance companies, family offices, and retail investors – some 72%. The balance is split roughly equally by actively managed mutual funds and ETFs on the one hand and passive mutual funds and ETFs on the other – each with about 14%. So, 72% plus 14% plus 14% equals 100%. As can be seen from the follow chart published by the CFA Institute, the passive fund share has gradually increased at the expense of the active fund share.
For CFA Institute report see here.
Movement at the poker table
An argument has been made that the decline of active fund share from 19% in 2010 to 14% in 2020 (as shown on above chart) means that a lot of weaker players have left the poker table.
Michael Mauboussin puts it this way in a January 4, 2017 report titled “Looking for Easy Games – How Passive Investing Shapes Active Management published by Credit Suisse:
“It is likely that the investors moving from active to passive are less informed than those who remain. This is equivalent to the weak players leaving the poker table. Since the winners need losers, this makes the market even more efficient, and hence less attractive, for those who remain. If you can’t identify the patsy, or weak player, it’s probably you.” I only have a pdf of this report.
The idea is that the average skill of the players who remain is higher; tougher to compete against. But if you add the 14% active fund share to the 72% direct holding share, that still leaves the vast majority of stock holdings under active management. Effectively only 5% of active investors have left the table.
Passive share are still at the table and are patsies
The 14% share of indexing equity mutual funds and ETFs are still buying stocks. It’s just that when the funds buy shares they are ‘price acceptors’, i.e. they could care less about whether they are getting value for the dollars they are paying out. To some degree, with the rise of passive price accepting investing, the number of patsies at the table is growing.
Mauboussin also writes in the same report that: “passive management introduces the possibility of market distortions…” He points out that: “…crowding, [is] a condition where investors do the same thing at the same time without full consideration of the implications for future asset returns. We can separate the concerns about crowding into asset mispricing and a reduction in liquidity. There is growing evidence that passive investing may lead to less efficient prices and an increase in market fragility associated with lower liquidity.” (Emphasis added)
His conclusion: “More passive and noise investors create more inefficiency and hence opportunity for active managers.” Price acceptors are patsies.
Sector and themed ETFs are patsies at the table
I remember the late 1990s just before the Dot Com bubble burst. Investors had piled into tech themed mutual funds. The rationale was that it was hard to identify the ultimate tech winners and putting your money in a tech themed mutual fund allowed you to diversify amongst a basket of tech stocks. That sounds pretty logical. The fund managers had a problem. As the money poured in there were no sensible tech company stocks to invest in. Many companies were no more than a tech concept and a business plan. Having no product, let alone sales, was not a drawback. The tech fund managers could only hold their noses and invest the money in whatever stock was available that fitted the description ‘tech stock’.
To some degree this is true today with sector and themed ETFs. In the next real bubble it will true in spades.
Today there are some 8,000 ETFs with close to $10 trillion in global assets. Only a tiny fraction of these are passive investment vehicles. The vast majority are sector and themed ETFs. The various managers of these sector and themed funds are obliged to place the money in the described sector or theme regardless of the investment merits. They are price acceptors. These funds are an invitation to speculate and trade.
It is to be noted that investors, or speculators, trade ETFs actively. The Mauboussin report refers to comments by Jack Bogle, founder and former chief executive officer of the Vanguard Group, who “notes that the shares of the 100 largest ETFs have an annualized turnover rate of 880 percent while the annualized turnover rate for the 100 largest stocks is about 120 percent. The SPDR S&P 500 ETF Trust alone has averaged about 9 percent of the volume on the New York Stock Exchange over the past five years, and its average daily trading volume is more than four times that of Apple, Inc. the company with the largest market capitalization in the U.S.”
“Institutions that use ETFs to speculate, hedge, and arbitrage are the most active traders of ETFs. Individuals who trade frequently are the next largest segment.” Sector and themed ETF traders are patsies.
Noise traders are patsies at the table
Mauboussin also references the role of “noise traders”, a term coined by Fischer Black, a renowned economist. Mauboussin quotes Black: “People who trade on noise are willing to trade even though from an objective point of view they would be better off not trading. Perhaps they think the noise they are trading on is information. Or perhaps they just like to trade.” Noise traders create profit opportunities for more skillful investors and supply markets with liquidity. But they can also slow the rate of price discovery and cause pricing distortions.” In other words, “noise traders” are one cause of market inefficiency. Noise traders are patsies.
Levelling the playing field at the table
Today’s investors, both individual and professional, have greater access to information, can rely on better theory, and have more computing power than their predecessors. As Michael Mauboussin suggests, “If an investor with today’s capabilities were to travel back to the 1960s, he or she could run circles around the competition.”
I have access to the full investment research of Canada’s largest bank. I also have access through my discount broker to reports from the world’s largest independent stock analysis company.
Professional investors learn their trade in school. Individual investors have access to the writings of Warren Buffett and a number of other investing legends. In the end, skill comes from practice, from making mistakes and learning from them. Wall Street professionals are often not patsies. Individual investors are on a level playing field with the Wall Street pros.
Paradox of skill
I’ve noted in the last couple of paragraphs that investing skill has probably increased over the years. It’s interesting to compare this skills increase with other fields. Sports is instructive. Athletes in Olympic competitions are better than they were ten years ago. This is because of training, sports psychology and so on. Stephen Jay Gould, a biologist at Harvard University made an interesting point looking at baseball batting averages. Batters, pitchers and fielders had all upped their games over the years. But what he found was that batting averages have remained relatively stable over the years. Is that a contradiction?
The explanation is that the spread in batting averages between the very best and the very worst batters had narrowed. The last player to achieve a batting average over .400 for a full season did so in 1941. The paradox is that while players’ skills had improved, none was able to bat over .400 for a full season. In statistical terms what had happened was that the standard deviation of batting averages shrank.
Let’s apply this thought to investing. If the skill level of the average investor is higher than 30 years ago, we would expect to see highly skilled investors continue to achieve superior results. We would just not expect to see as many Warren Buffetts with extreme outlier investment returns.
Let me close with words of encouragement for individual investors.
Lowenstein tells us: “Most of what Buffett did, such as reading reports and trade journals, the small investor could also do. He felt very deeply that the common wisdom was dead wrong, the little guy could invest in the market, so long as he stuck to his Graham-and-Dodd knitting. But people, he found, either took to this approach immediately or they never did. Many had a “perverse” need to make it complicated.” (Lowenstein, Buffett, The Making of an American Capitalist, 1995,2008) p.331’(Emphasis added)
With a sound investment process and excellent access to information, individual investors are at no disadvantage to the Wall Street pros. They should not be the patsies at the table.
I believe today the ‘Graham and Dodd knitting’ really refers to Warren Buffett’s own investment philosophy and process that I have described in earlier posts.
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