Posts Tagged ‘investments’

Sebastian Mallaby’s book, More Money Than God: Hedge Funds and the Making of the New Elite, looks at the birth and rise of the hedge funds. Perhaps more interestingly, it seeks to answer the question of how those funds made money if you subscribe to efficient market theory (which you should).

A. W. Jones, the original hedge fund (or “hedged” as he called it) could explain it’s profits by an inefficient market. Before Jones, the concept of a hedge fund did not exist and he and his team began doing things that nobody else was doing. They were simply more efficient.

In the late 1960s and 1970s, Steinhardt, Fine, Berkowitz & Co. were the biggest players. This could be explained by two factors. First, they could have simply been lucky. By the time they came along there were 200 hedge funds, so the chance of one of them consistently beating the market was fairly high. Secondly, there was what you could argue was insider trading. Perhaps not to an illegal level, and it is unfair to level this claim just at hedge funds, however, it was clearly going on.

Over the next few decades, hedge funds continued to generate money. Can this be reconciled with efficient market theory? Yes and no. A lot of the profits came from exploiting loopholes and finding inefficiencies in the market. The fact that this was possible shows that markets are not always efficient.

However, if you take Malkiel’s argument that this might be there, but is just not useful, that view holds. Firstly, you have to keep exploiting new ideas because pretty soon everyone else copies you. Secondly, for an investor, there is no way to know in advance who will find the inefficiencies. It is easy to work out which hedge funds found them after the fact, but picking them in advance could well be impossible.

Also, while some funds do have amazing performance, most are not. In a 2006 paper, “The A,B,Cs of Hedge Funds: Alphas, Betas, and Costs” Roger Ibbotson and Peng Chen calculated that after adjusting for biases, the average return was 9%.

The book’s conclusion is generally agreeable. Index funds represent the best way forward for consumers, but hedge funds maybe represent good value for institutional investors.

Two of the books I have read recently, Everything Is Obvious and The Signal and the Noise, made references to Burton Malkiel’s book “A Random Walk Down Wall Street”. They pointed out that the stock market is entirely unpredictable and therefore investment bankers are just guessing. I was curious to read more, so I picked up the book itself.

An index tracks stock market movements. For example the FTSE 100 tracks 100 companies on the London Stock Exchange, while the Standard & Poors (S&P) 500 or Russell 3000 track a far more broad range of stock prices. These therefore provide a good indication of whether the stock market moves up or down.

Now take a mutual fund – these are professionally managed funds that the general public put their money in for someone to manage on their behalf. The benchmark here is not whether they can grow their investment, but whether they can grow their investment at a better rate than the index (because the stock market generally moves up anyway). If they were just guessing, you would expect 50% of mutual funds to beat the index, and the other 50% to fail, in both cases just due to chance.

However, the research, as discussed at length in A Random Walk Down Wall Street, shows that only 40% of mutual funds can beat the index! This is not just guessing – this is worse than guessing. Professional investment managers not only do not add any value to the funds they are managing, they actually subtract value.

You could make the case that there are just a lot of bad fund managers. However, the research refutes this too. As Malkiel describes, if you take the top performing funds over a five year period they almost invariably fail to beat the index over the next five year period.

This should not actually be that surprising. The Wall Street Journal has long shown that throwing darts at the stock listings produces a better return than the experts; a noticeably better return once you adjust for risk. To see it in practice (I include this as an anecdote to make the facts more believable) just watch the BBC documentary Million Dollar Traders in which eight complete notices only lose 2.5% in a period where their multi-millionaire master-of-trading coach loses 5%.

Of course it is hard to believe. Why are all these people employed if they add no value? That is a fact I find hard to reconcile. Surely if we are talking about efficient markets, at least one bank would have realised they could fire all these traders and replace them with monkeys? Counter arguments to this suggest that the average trader actually earns a pittance, and that because it is in the interest of traders (justifying their own job) and brokers (getting rich of the transaction fees from all this needless trainers) to maintain the illusion that they actually do something, the industry keeps selling these products to the general public who simply don’t realise.

The evidence, at least if Malkiel is to be believed, is clear. You should invest all your money in an index tracker with the lowest fee you can find. That produces the most consistent returns compared with a mutual fund that charges you higher fees to produce a lower return. Nate Silver says the same thing.

In the final part of the book, Malkiel goes on offer some investment advice for those who do not want to use an index fund. He also hints that he picks individual stocks too. This is odd as it goes against a lot of what the evidence he has presented says, but is consistent with what the psychology says – that we have a really hard time accepting what the scientific evidence says when it contradicts our own pet theories, achievements and so called “common sense”.