30 ms·
A Professor Who Was Right About Index Funds All Along
- shubhamjain 10y agoBeing lucky doesn't explain the existence of Renaissance Technologies[1], one of the very first quant fund companies, which has averaged a 71.8% annual return from 1994 through mid-2014. In fact, "the fund’s worst year was a 21 percent gain, after subtracting fees". Of course, it's very much of an outlier — just like Facebook / Google / Uber, if we retrospectively see startup funding and hedge fund investing. [1]: https://en.wikipedia.org/wiki/Renaissance_Technologies https://en.wikipedia.org/wiki/Renaissance_Technologies
- jdmoreira 10y agoLuck can be the actual explanation. By the law of the large numbers, some funds will be a success for quite some time. Just as some people do win the lottery. I don't think it's surprising that a couple of funds have a great track history even if the game is just pure luck.
- kiba 10y agoHow do you distinguish between pure luck and actual skills?
- michaelcampbell 10y agoI believe his point is that you can't, because "actual skills" need not exist. It might ALL be luck, and outliers will exist. And, their existence doesn't prove anything about luck or the lack of it.
- Godel_unicode 10y agoConversely, if the difference between luck and skill is unknowable, everyone who wins might be skillful. As you said, the existence of winners is not revelatory about the existence of skill. Related: one can be highly skilled and still lose to someone who is highly lucky.
- icebraining 10y agoThat's the argument from A Random Walk for index funds: even if such skills exist, they're indistinguishable from luck, therefore one can't make an informed choice of active fund.
- IshKebab 10y agoIt's impossible to perfectly distinguish them. Anyone that seemed to be skillful could just be incredibly lucky. But you can get determine a likelihood that they are lucky by monitoring their performance over a long time / lot of games. It's just that if you are evaluating a whole lot of people looking for a rare skillful person, you need a whole lot more time/games to be sure they aren't lucky than if you just had one person to evaluate.
- pixl97 10y agoYou cut that sentence short... "How do you distinguish between pure luck, actual skills, and illegal manipulation?"
- lordnacho 10y agoYou should see that your candidates will falter as time passes. Suppose there are 10 funds with the track record of RenTech. In 10 years, you wouldn't expect them all to be as stellar.
- user5994461 10y agoYou do more MATHS :D There are models to model the risks and the potential outcomes.
- nabla9 10y agoThey may also play version of martingale strategy where they pay for higher returns now with increased losses if some rare event in the future happens. This is how very successful hedge funds can beat the market for decades. There is hidden risk somewhere and you better jump off before it is realized.
- nemo44x 10y agoBelieve me, Jim Simons didn't rely on luck. He's a mathematics genius and rather creative. You could say he was lucky in that he sort of pioneered the entire algorithmic trading thing and was well ahead of the curve because of that. It was simply low hanging fruit for a long time before others began to catch on.
- des429 10y agoI had a conversation with a co worker about this. Its basic probability. Lets assume they make at least 1 trade a day and they have been doing this for the past 25 years. Its a simple binomial probability problem. For them to be correct on that many trades and it to be 'luck' would be a probability in the ~0.00001% range.
- Godel_unicode 10y agoYou're assuming all trades are the same size and have the same upside (and downside) risk.
- darawk 10y agoNo, luck cannot be the explanation for what these quant funds do. These funds are run by mathematicians. People with PhD's in probability and physics. They are not being fooled by randomness. They are right, and they are right consistently. However, they are also at least generally, not making traditional 'investing' decisions. They are making statistical arbitrage bets - they are looking for instances where mispricing exists in the market, and they can make a guaranteed (statistically) profit by buying and selling statistically equivalent securities at different prices. The classical simple example is pairs trading: you notice that coke is always worth 10% more than pepsi, so when you see coke trading at 15% more than pepsi, you short coke and buy pepsi, betting that the gap will close to its traditional norm. Now, what they are doing is obviously substantially more complex and rigorous than that, but that is its flavor.
- dasil003 10y agoWow, this is the height of hubris. Of course luck can play a factor. There's no law of the universe that a correlation you observe over the past century of human activity is going to hold indefinitely. Obviously some quant funds have better models than others and it's not wrong to attribute that to intelligence and skill, but they absolutely can have the rug pulled out from under them by changing market conditions make no mistake.
- lordnacho 10y agoThey trade very, very often. You can be lucky if you buy a couple of stocks and wait around a few years. Someone I know had parents who bought Nokia in the 1980s and sat on it until the mid 200s. That's luck. You can guess a coin flip 5 times in a row. A few people out of a hundred will do so. But you cannot get significantly over 50% correct on millions of coin flips. That's not luck.
- dasil003 10y agoFirst of all, I explicitly said that it's not wrong to attribute winners to skill, but you still feel the need to put my argument in a binary box, very well. Your mistake is treating each trade as an independent event. But in reality all those trades may share a single methodology which can be invalidated by a single unprecedented market change. Yeah, a fund is a perennial winner until it's not. You can call it being unlucky or you can say they went from being smart to stupid. It doesn't really matter what you call it, the point is past performance is no guarantee of future returns.
- frandroid 10y agoThe point is not that all human-picked funds/portfolios perform worst than index funds, but that most of them do.
- hash-set 10y agoGo over to Bogleheads and say that. They'll set you straight pretty fast. The point is that over a long enough period of time, there is no advantage to managed funds vs. index funds and the managed funds usually underperform. Some firms have played tricks with their funds to make them appear to beat the market, but it's never sustained.
- deleted 10y ago[deleted]
- deleted 10y ago[deleted]
- dajohnson89 10y agoBut in the event of an extreme rally, your picked stocks can make you a huge return. Fast. Then you cash out and play it safe. Risky, but this is why people try to beat the market. This is the allure of gambling.
- pedrocr 10y agoThe point of index funds isn't that at any moment in time no one can have a market beating strategy. The point of index funds is that by definition the bulk of the market can't have above average returns. So as a retail investor your best bet is to just find a cheap way to ride the average of the market.
- ikeboy 10y agoThat's a valid point, but plenty of people do claim that "no one can have a market beating strategy". Strong EMH.
- hilop 10y agoAnd yet one of the assumptions of the EMH is that there are people who beat the market (using pre-public information), which is why you can't. The EMH is just saying that 31/32 teams will not win the Super Bowl. Unless there's a version of the EMH that doesn't believe in the speed of light.
- darawk 10y agoThose people are demonstrably wrong. See: all successful quant funds, HFT firms, etc..
- walshemj 10y agoTrue but some of my active funds correctly saw the problems with the UK banks and got out before the big losses an index fun would have had to buy those banks and taken the loss.
- deleted 10y ago[deleted]
- ourmandave 10y agoRenaissance Tech is an interesting read. Here's a couple of stand out items I cherry picked for no particular reason what-so-ever... According to the Center for Responsive Politics, Renaissance is the top financial firm contributing to federal campaigns in the 2016 election cycle, donating $33,108,000 by July.[33] By comparison, over that same period sixth ranked Soros Fund Management has contributed $13,238,551.[33] On 25 September 2008, Renaissance wrote a comment letter to the Securities and Exchange Commission, discouraging them from implementing a rule change that would have permitted the public to access information regarding institutional investors' short positions, as they can currently do with long positions. The company cited a number of reasons for this, including the fact that "institutional investors may alter their trading activity to avoid public disclosure".[32]
- n72 10y agoPoint is, could you have identified Renaissance Technologies in 1994 as one of the few companies to beat the market? If not, then your odds are better going with an index fund. At this point, because of Renaissance Technologies' success, their fees will likely offset the gains they'll net you.
- ves 10y agoThey still make you tons of money net of fees. However, because of their success, they very quickly attracted all the money they thought they could handle and closed the fund to new investors. I think recently their performance slipped a bit and they started taking money again, but the above point was true for a long time.
- auntienomen 10y agoThere's a subtlety here: Renaissance is a company which manages hedge funds. They're famous because their main fund, Medallion, has done exceptionally well. The only investors in Medallion are Renaissance employees; it's capacity is limited, so that even employees can't generally invest as much as they'd like. Renaissance also manages several other hedge funds, which have much higher capacity, and have both employee and outside investors.
- hash-set 10y agoIt could be another Madoff scheme.
- deleted 10y ago[deleted]
- turar 10y agoAgreed, it doesn't explain many other outliers too. A classic exploration of this, and a direct refutation of Malkiel is Buffett's own: https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors https://www8.gsb.columbia.edu/articles/columbia-business/sup...
- paulpauper 10y agothis company is like citadel, which is that their main business is market making and non-directional trades. They dont pick directional investments, as most investors do. rather they are in the middle picking up pennies, except many billions of them. But these returns may be exaggerated or there is information missing...20% a year far exceeds the rate capital is being created by the global economy. At that rate, it would eventually own the world and all markets. I think their actual returns, assuming the fund still trades (its operations are very opaque) are much less...maybe 5-6% year. The bigger a fund gets, the more impact its trades have on markets, which limits its size
- vostok 10y agoThis is not an accurate description of that hedge fund.
- rasz_pl 10y agoTime travel. You land in 1990, you can either try to replicate netscape/broadcast.com/yahoo/google/myspace/etc coding your heart out, or you start an investment fund and let money snowball by picking obvious winners from memory.
- Teodolfo 10y agoAmusing trivia: Peter Brown, co-CEO of Renaissance Technologies, got his PhD under the supervision of Geoffrey Hinton.
- forinti 10y agoBrazilian banks have been offering these for decades. It's astonishing that this could be a novelty in the US.
- the_duke 10y agoIf you read the article, you would have seen that those have existed in the US for 40 years.
- maxerickson 10y agoThe article mentions the Vanguard 500 Index fund and states that it launched 3 years after 1973. So it's hard to understand what you mean when you call it a novelty in the US. (without being deeply familiar with the history, I think the Vanguard 500 fund must have been one of the earliest index funds anywhere, if not the very first)
- bpicolo 10y agoIt was the first index fund, yep
- grondilu 10y agoMe, I don't even believe in funds. If managers are not better than blindfolded monkeys, why should we even pay them? Just buy diversified stocks, and never sell unless you need cash. https://en.wikipedia.org/wiki/Buy_and_hold https://en.wikipedia.org/wiki/Buy_and_hold
- G2kyd7 10y agoI think it's much cheaper to buy ETFs compared to buying single stocks. Also easier to rebalance in a diversified portfolio. The key is to pay as little in fees as possible.
- grondilu 10y ago> I think it's much cheaper to buy ETFs compared to buying single stocks. You will pay a lot more but it'll be a one time cost. Whereas ETF fees are a yearly one. > Also easier to rebalance in a diversified portfolio. The strategy I was talking about means you should never have to do that.
- ikeboy 10y agoSo your strategy isn't, "buy the whole market", it's "buy the market as it existed in $current-year", which misses all the new stocks that come out. (Also it assumes you have a fixed amount to invest and never want to invest more)
- grondilu 10y agoI don't get what you mean. You can buy and hold, and keep buying.
- ikeboy 10y agoBut then it's not a one time-fee. More generally, your strategy only works if you're investing a large amount every time, it doesn't scale down. You can't put 10k into 5000 stocks, and even 500 stocks would be difficult.
- petra 10y agoOne you decide to invest in an index fund, what "advice" needs to be automated ?
- n72 10y agoRebalancing, tax loss harvesting, and asset allocation as you grow older (i.e. more weight in fixed income as you approach or are in retirement.)
- nabla9 10y agoRisk management and asset allocation that matches changes in your personal life and your risk profile. For example: If you know you need to use $200,000 within next two years, you might want to start moving part of that sum slowly from stock index fund into other less volatile assets (like bonds etc). You can do that for yourself approximately without knowing about theory, but if there is cheap automated system that can provide personal solution based on portfolio management theory with few bucks, it's can be worth of the small sum they ask.
- G2kyd7 10y agoThe most important advice is to stay the course and leave your investment alone. I read somewhere that the biggest gainers at Fidelity (?) were those who forgot they had an account at all.
- n72 10y agoI recommend Weathfront and Betterment to all my less mathematically inclined friends. However, if you spend only a few hours getting acquainted with asset allocation and rebalancing principles, you can do pretty everything that these services do without their fees.
- mrwinalot 10y agoAnd what do you recommend for your mathematically inclined friends? Any books you recommend for asset allocation and rebalancing principles?
- n72 10y agoYup, I've written a brief primer to accompany my will: https://github.com/nickgieschen/investingguidelines https://github.com/nickgieschen/investingguidelines
- toephu2 10y agoNone, just put your money in an S&P 500 fund. I doubt you will be able to beat that in the long run anywhere else (Even though there are flaws w/ how the S&P 500 is run now [1]). [1] http://www.joshuakennon.com/sp-500s-dirty-little-secret/ http://www.joshuakennon.com/sp-500s-dirty-little-secret/
- n72 10y agoYou can do better by diversifying more. By picking asset classes with a low correlation, you can reduce risk while increasing return. Hence, you can eek our more from a simple mix of say: 60% US 30% Int'l 6% REITs 4% Gold All of this can be bought with low cost mutual funds. http://thismatter.com/money/investments/portfolios.htm http://thismatter.com/money/investments/portfolios.htm
- nemo44x 10y agoWith enough money invested I find Betterments fees very reasonable. Especially when you consider features such as tax loss harvesting. Is that something that requires little to no time if you actively manage your index funds? Maybe there are tools which aid you with that?
- jbuzbee 10y agoI'm a big believer in index funds and have been putting my money into them for a long time. But... you have to wonder where this is all ending up as more and more people move to passive index funds. The power of the market is based on millions of individual opinions on the price of a company's stock. On average, over time, these collective opinions will be correct. But say in the extreme case, it got to the point where all funds were invested passively, we'd lose this pricing mechanism. Individual stock prices would not reflect the true value of a company. Instead, the price of each company's stock, healthy and sick alike, would just rise and fall in synch with the market as a whole. But then perhaps this would be self-correcting as sophisticated investors would notice the pricing errors, create managed funds and the cycle would start anew...
- aantix 10y agoI think you're correct on your last statement; anytime there's predictability introduced into a system, there's going to be a counter-action you can perform to exploit those tendencies.
- n72 10y agoThere are companies which will fairly obviously perform well in the future. However, because of active investing, this projected performance gets priced in, so they aren't a bargain. If the whole world except one active investor invested in indexes, then the active investor would have a very easy time, since that projected performance wouldn't be priced in and the stock would be a bargain.
- OscarCunningham 10y agoWho would that investor trade with?
- icebraining 10y agoI'm not an expert, but index funds still purchase the stocks, so when the active investor bought a stock at an increased price, it would increase the market cap and so the index fund would buy some more of it from them.
- kelukelugames 10y agoCan you put in the title what they were right about? Otherwise it's a clickbait title.
- paulpauper 10y agoThis is good advice. Despite the financial crisis of 2008, the S&P 500 is still up 80% since 2005 after dividends
- mark-r 10y agoThere's an aspect of self-fulfilling prophecy to this. Higher demand leads to higher prices, and as more money flows into indexes the stocks in those indexes are going to rise relative to the rest of the market. Thus their earnings become harder to beat.
- ap22213 10y agoWouldn't that knowledge be accounted for in the individual stock prices?
- smileysteve 10y agoOnly if people (and funds) continue to not invest solely in index funds, to which there would be economic incentive, because in the short term, those might perform better.
- ucaetano 10y agoNot exactly, as money flows to those stocks, they become overpriced, and will under-deliver returns in the future. On the other hand, other stocks will be undervalued, giving better returns in the future. So it is a self-correcting system, not a self-fulfilling prophecy.
- tedmiston 10y agoDisclaimer (since it's buried in the middle): Burton Malkiel is CIO at Wealthfront, one of the most popular robo-advisors.
- dpweb 10y agoReturns are used to quantify results, but you can't compare returns between a hedge fund or trading or market making operation - and a retail customer putting away their retirement money. Two entirely different operations at work that result in an overall annual return for each. In buying a stock, you're buying exposure to a number of factors that affect the stock price: the company, the money flows into/out of that company's industry, and the flows in/out for stock market as a whole. In buying an index you get a more pure exposure to the stock market as a whole. When indexes do well, its only because money is flowing into it from other asset classes (or "money printing" by central banks). Whether we should accept Efficient market hyposisis as explanation of Indexes beating pros, is a little more complicated. Yes, its true everyone has access to the same information. In fact, it's illegal to trade on insider information. However, when Indexes beat pros, people are quick to say, 'yep.. Efficient market..', but Indexes have support that the individual stocks or baskets don't have. A pledged support by the Fed to print money to prop it up. Take Wells Fargo. Maligned in the news, down stock price, but still a powerful bank. Buying the stock - not a irrational decision. But, will the Federal Govt let them go down? They didn't AIG, but who knows. Now imagine the Index crashes, the Fed steps in. Indexes have the advantage here.
- mikeg1991 10y agoWhy do you say that we can't compare the results of each? Aren't individual stock and index's competing within the same environment (same systemic and unsystemic risk factors)? Difference being that the unsystemic risk is non-existent.
- nodesocket 10y agoHere is a graph of my personal account which I manage myself vs the S&P 500 index. I am currently beating it with gains on the year of 7.3%, but only thanks to the last couple of strong months. I was deep in the red early on. http://imgur.com/a/XHNTZ http://imgur.com/a/XHNTZ
- BeetleB 10y agoIt's not even a year old. I'm not sure I get your point. Many active funds beat the S&P 500 over 5 or even 10 years.
- hammock 10y agoWhat software are you using there?
- toephu2 10y agoSo? You must haven't been investing for very long. Try keeping that up for 10 years straight then come report to us.
- n72 10y agoYou don't understand the concept of sample size.
- kolbe 10y agoI'm going to use this as an opportunity to yet again rail against the idea of indexing. It's a good thing in theory, but like most things, when it's taken to extremes, it's horrible. Passive investments wherein the investor takes zero interest in these investments are and have always been a terrible idea, and nothing in modern history has facilitated this more than index funds. When you give a friend of a friend $10,000 to start a company, do you just hand it over no questions asked and with no follow-up? Or do you try to get engaged with your investment? Make sure the CEO isn't sitting on his ass collecting a paycheck? Scrutinize it for potential frauds? Well, that's what you do in an index fund. Except it's not even a friend of a friend that you're trusting. It's some group of people who likely live thousands of miles away who may or may not have an opiate or alcohol addiction or are complete sociopaths or are just regular humans who know how to legally take advantage of you when you aren't paying attention. You want to know why CEO pay is so high? It's because CEOs have no accountability for raising their pay when investors aren't paying attention to what they're doing. You want to know why CEOs are taking short-term action to boost stock prices at the expense of long-term viability? It's because they care about the short, you care about the long, and you have no voice when you're in an index fund. You want to know why CEOs are issuing debt to do stock buybacks? To empire build by paying too much for their competitors? To play accounting games to boost short-term earnings? Index funds are the tail that's wagging the dog, and they are going to be a disaster. And unlike derivatives, which can mess with stock prices but largely leave the fundamental structure of the company untouched, the dog that's being wagged here is the viability of globally important corporations that we depend on. They were fine when 5% of the market just piggy backed onto the other passive (though attentive) investors. But now passive and inattentive investors are a massive proportion of the market.
- edanm 10y agoI disagree. For one thing, there are still plenty of active investors around. The fact that the less active investors around, the easier it is for them to make returns, will help the market stable and full of "enough" investors. It is absurd to worry right now about not having enough finance professionals, considering just how many people are in the market. In terms of what's best for a single person deciding where to invest money right now, indexing seems to provide the best opportunity. It's clear that most investors will not spend the requisite time tracking companies, nor should they considering the benefit of specialization.
- hiou 10y agoIndex fund tracking has become successful because one of the goals of US Government policy is to maintain that things like the S&P 500 continue to go up over time. If they go down people get voted out of office. So the index funds have the full force of the US Government watching over them. This is why economics is not just some math puzzle but often more about politics and sociology.
- bjterry 10y agoThe goals of the Federal Reserve are "maximum employment, stable prices, and moderate long-term interest rates." The real goal, though, is economic growth, and we just happen to believe that those intermediate goals are good at serving long-term economic growth. The prices of stocks are one of the most forward-looking macroeconomic measures that we have available to us. The better we get at improving long-term economic growth, the higher stock prices will go, other things being equal. So basically, if you have good policy, stock prices should always go up (in real terms). If the Federal Reserve were perfect at preventing recessions and everyone knew it, stock prices would be higher. While you would probably not want to make stock index growth the target of monetary policy because of Goodhart's Law, it is very reasonable to take it into account as a part of a forecast of how well your policy is working.
- Animats 10y agoIt would be interesting to have a fund which was mostly an index fund, but avoided "losers" based on simple criteria. Picking overpriced losers is easier than picking winners. (I did that for the first dot-com boom, at "downside.com".) That's a concept worth testing against historical data.
- lordnacho 10y agoThat's what smart beta does. You take an index and rejig it slightly to eke out a somewhat better return.
- countingteeth 10y agoIt doesn't work though.
- alecco 10y agoYeah, that is all fine a few decades back. But today we are experiencing huge bubbles caused by central banks. Stocks are hyper-inflated by QE and near-zero rates. When all that stops it will pop violently. And sooner or later, they will have to stop. This affects bonds even more, of course.
- deleted 10y ago[deleted]
- lordnacho 10y agoAs someone who's been at hedge funds for over a decade, I often wonder what I'd do if I just had ordinary access to the markets. First of all, I have to ask why the equity market should be your benchmark. And if it's because you think the market generally goes up (not obvious) why don't you just get leverage on your ETF, so that you basically always beat the market? There's another way to beat the market. Smart beta products do variations of it, but here's a concrete one. Basically my brother had some class about markets and needed something fast, so I just told him to take the S&P 500, lop off the top 25% of stocks measured by beta, and scale up the rest. Ta-da. You'll probably find costs are high, and there's a bunch of admin, but I suspect there's now a bunch of smart beta ETFs that do the same thing. As for the EMH, I doubt that it's true. The problem for ordinary people is you won't be allowed to invest in strategies that are very good. It makes sense for people on the inside: suppose I have a strategy, with a Sharpe > 5, that uses very little capital. What am I going to do with that? Get investors? No, I'll borrow money and take the profits myself. What does that leave? A bunch of strategies with much less attractive risk profiles. If I have a Sharpe of around 1, I'm expecting long flat periods. I'll have to get investors for that. But investors are fickle. One bad year and they flee, even though you should have one every few years. You could easily have a couple of losing years with that kind of Sharpe. So what do we find with that type of shop? They're made of marketing. Box-checker salespeople who know what to say to institutional investors. IIs who buy IBM. Or are quick to jump the gun. /rant
- carlosgg 10y agoWhat surprised me the most about the article was that Mr. Malkiel could still hold an executive position in such a competitive industry (sixth paragraph). I hope at least some of us here are chief-of-something at the age of 84. :)
- graycat 10y ago> “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns.” Ah, instead he believes he can talk "the vast majority of investors" into believing that they can significantly beat "average returns"? Hmm. Maybe in Lake Wobegon. IIRC the index fund idea, W. Sharpe's work, etc. DOES need stock pickers also doing their best. Or, for anything with any promise in public a stock market, there has to be some smarts in there someplace. The reason throwing darts works so well is because of the stock pickers with the smarts working hard to buy the winners and sell the losers.
- zachruss92 10y agoI love articles like this. I get so frustrated when I see colleagues hire a financial advisor that sells them a "managed portfolio" that is on-par with it's market comparable index and/or sell them on products like annuities that make no financial sense whatsoever. And they charge 1%-1.5% of assets under management which can be 10x what something like Vanguard would charge you. Personally, I use Betterment (a competitor to WealthFront) simply becasue I can set a target asset allocation, and they will balance my portfolio accordingly. The tax loss harvesting capabilities that both companies offer are really interesting, theoretically, but there is no empirical evidence either way as to whether it actually will save you money in the long-run. Before betterment, I invested in mid-large cap index funds from Vanguard.
- esqrama 10y agoA discussion between the father of modern finance, Nobel prize winner Gene Fama, known for the Efficient Markets Hypthesis and his colleague and father of behavioral economics, Richard Thaler, of Chicago Booth, dissecting this question. http://review.chicagobooth.edu/economics/2016/video/are-markets-efficient http://review.chicagobooth.edu/economics/2016/video/are-mark...
- redsparrow 10y agoFor Canadians interested in learning about index-based investing I recommend the Canadian Couch Potato site[0]. If you don't want to put a lot of thought into it he has some sample portfolios, but also has a lot of resources for learning more. He's also very good about answering questions in the comments on his posts. [0] http://canadiancouchpotato.com/ http://canadiancouchpotato.com/