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Say more. Why do I believe in the Capital Asset Pricing Model and Efficient Markets (both proven wrong) if I invest in Vanguard's cheap S&P 500 ETF? I invest i

by malchow 10y ago

Say more. Why do I believe in the Capital Asset Pricing Model and Efficient Markets (both proven wrong) if I invest in Vanguard's cheap S&P 500 ETF? I invest in their S&P 500 ETF because it's the cheapest way to get diversified exposure to the 500 largest American companies, and I believe that the 500 largest American companies will be more valuable in the future as a combination of valuation, scale, and cash flows to owners, than they are right now.

AnimalMuppet 10y ago
The S&P 500 is a reasonable, good investment. I think Efficient Markets is saying "you can't do better". That claim may be false. And yet, it may be close enough to true, especially for a small investor, that Vanguard's ETF is good enough (that is, it's not worth the time and effort to try to find something better).
jackcosgrove 10y ago
While you may not believe in CAPM and EMH and still invest in Vanguard funds, many do both. I used to participate in the Bogleheads forum and encountered many doctrinaire EMH proponents there. It's not an unreasonable inference to connect the two.
ctkrohn 10y ago
If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks within the S&P 500 and thereby outperform the index. A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees. I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. So even if the EMH is false in some broad sense, individual investors should act as if it were true and simply invest in low-cost diversified funds.
- hsitz 10y ago
  You say "A disbeliever in EMH should look to identify these managers and pay them some fee". In the next breath you say that even if the EMH is false "individuals investors should act as if it were true". This makes your post somewhat ambiguous; not so clear about which position you're advocating. How "plausible" is it that these managers are "impossible to identify ex ante."? Why is it plausible? "Impossible" seems like a pretty strict standard (akin to strong EMH), why not just say instead that identifying such managers before they outperform is "practically impossible" or just "really, really, damn hard and something that you're deluding yourself about if you think you can do it." Also (assuming it is your position), it's important to clarify that you don't disagree with the assertion that many people do identify market-beating managers before they outperform. Probably millions of people have done it; it happens every day. What they don't do (in my opinion) is use skill or knowledge to identify the outperforming managers. If they do identify an outperforming manager (of which there are always many) it happens because of chance or luck. (Just as, IMO, the outperformance itself of almost all outperforming managers is due to luck or chance, not skill.)
  - ctkrohn 10y ago
    Here's perhaps a better way to say what I'm getting at: identifying and investing with a manager that predictably outperforms a benchmark is just as difficult an intellectual challenge as constructing a portfolio that outperforms that same benchmark. Both of these tasks are so difficult as to be essentially impossible for an unsophisticated retail investor.
    - VLM 10y ago
      I'll throw you a better analogy, identifying and hiring an outperforming programmer should be much simpler than identifying and hiring outperforming investment managers because there is relatively little effect of chance on programming output and measurement of success is mostly objective. Yet we know that hiring for programmers is utterly hopelessly broken beyond all belief, industry wide. Therefore its very unlikely that people of a similar cognitive and training level that utterly failed at hiring programmers could possibly select outperforming investment managers given that being an even more difficult job. No one in HR or management is going to be selecting outperforming investment managers. Its possible that someone outside HR and management is better at selecting the best programmers. Certainly plenty of advice from outsiders is given to hire more of coincidentally highly politically correct demographic group A or group B. Or perhaps ivy college admissions officers magically know how to pick future great programmers (LOL). Professors and college advisors might put forth a weak argument in their own favor. Still, money seems to talk and greed means management and HR, however awful they are at selecting programmers, none the less are the best skilled at it, regardless how low that skill level is.
- nradov 10y ago
  Logically even if the EMH is false that doesn't necessarily imply the existence of investment managers who can reliably identify mispriced securities. It's entirely possible that the EMH is false and yet no one is able to take advantage of that. But your recommendation makes sense either way.
  - ctkrohn 10y ago
    Right, those anomalies could simply exist unexploited until the market is better understood. For example, you used to be able to earn money buy buying the 501st largest company in the US: if it happened to become the 500th largest, all the S&P 500 index funds would be forced to buy its stock, and it would outperform the other stocks that had already been in the index. Similarly, the 500th largest stock would be a good sale candidate: if it becomes the 501st largest company, the index funds will become forced sellers. Now this effect is very well known, and there's no more money to be made by exploiting it.
- ethbro 10y ago
  > I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. I think this is the kernel of what Bogle was saying and Vanguard is now reaping the benefits of. Old system: active traders beat the market, therefore they charge fees slightly less than the alpha they're supposed to generate New system: customers are more aware that their active trader(s) may not be the winners, so the acceptable fee to pay the traders decreases to the product of the alpha AND the risk of not picking the right traders https://www.zacks.com/stock/news/250937/warren-buffett-on-active-vs-passive-investing-outlines-the-bet-in-berkshire-shareholder-letter https://www.zacks.com/stock/news/250937/warren-buffett-on-ac...
- random_comment 10y ago
  > If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks This isn't how causation works. > A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees. It is as much work to identify good fund managers as it is to identify good company managers. You might as well save some money if you go this route and invest in a portfolio of companies directly. > Furthermore, a smart manager will charge fees that are equal to the alpha they generate. Warren Buffett seems quite smart, I mean he made it to rank #1 on the world's rich list and I think he's one of the few on the top #100 that did it by investing in other companies rather than just building his own. Judging from his 40 year performance data he's generated rather more alpha than any other manager. He charges fees that are very close to 0.00001% for being a partner with him. That would seem to contradict your point.
- md_ 10y ago
  > I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. Why would they? Unless they're so rare that there are only a few of them, one would expect the market to encourage "fair" pricing of active management--yet a key dogma of passive investing is that the market is generally efficient, but the market for actively managed mutual funds isn't! It seems more plausible to me that (handwavy): 1. People can, in fact, beat the market, with lots of effort (e.g. very large college endowment funds, which outperform smaller ones, presumably by spending more on management and research) 2. The barriers to entry are typically high (because most investors won't trust their money with someone with an unproven track record) 3. Those high barriers to entry both allow the few established genuinely successful fund managers to charge higher fees than otherwise (to your point, eating up the alpha they generate) and ensure that "managing a fund" requires good sales skills and not just good management skills (see, lots of hedge funds) Or, in short, lots of markets are inefficient--both the stock market and the market for managed funds. But because the stock market is much bigger than the fund market, it's probably _less_ efficient. Or so we hope.
lr4444lr 10y ago
I think the other commenters hit on the important points and anticipated my distinctions. Note that I said "on a significant level". That did not imply blind or absolute faith. There are other investment options to match your bullish outlook if you think CAPM and EMH are wrong to the approximation that suits your involvement, knowledge, and risk profile, but you chose an index ETF. Why?
- kd0amg 10y ago
  Perhaps GP believes he does not have the skills to identify market inefficiencies, or believes he does not have the skills to identify fund managers who have the skills to identify market inefficiencies. Those would seem to rule out picking securities himself or choosing an actively-managed fund. Or maybe he just believes the market might stay irrational longer than he can stay solvent.

by malchow 10y ago

AnimalMuppet 10y ago

The S&P 500 is a reasonable, good investment. I think Efficient Markets is saying "you can't do better". That claim may be false. And yet, it may be close enough to true, especially for a small investor, that Vanguard's ETF is good enough (that is, it's not worth the time and effort to try to find something better).

jackcosgrove 10y ago

While you may not believe in CAPM and EMH and still invest in Vanguard funds, many do both. I used to participate in the Bogleheads forum and encountered many doctrinaire EMH proponents there. It's not an unreasonable inference to connect the two.

ctkrohn 10y ago

If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks within the S&P 500 and thereby outperform the index. A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees. I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. So even if the EMH is false in some broad sense, individual investors should act as if it were true and simply invest in low-cost diversified funds.

hsitz 10y ago
You say "A disbeliever in EMH should look to identify these managers and pay them some fee". In the next breath you say that even if the EMH is false "individuals investors should act as if it were true". This makes your post somewhat ambiguous; not so clear about which position you're advocating. How "plausible" is it that these managers are "impossible to identify ex ante."? Why is it plausible? "Impossible" seems like a pretty strict standard (akin to strong EMH), why not just say instead that identifying such managers before they outperform is "practically impossible" or just "really, really, damn hard and something that you're deluding yourself about if you think you can do it." Also (assuming it is your position), it's important to clarify that you don't disagree with the assertion that many people do identify market-beating managers before they outperform. Probably millions of people have done it; it happens every day. What they don't do (in my opinion) is use skill or knowledge to identify the outperforming managers. If they do identify an outperforming manager (of which there are always many) it happens because of chance or luck. (Just as, IMO, the outperformance itself of almost all outperforming managers is due to luck or chance, not skill.)
- ctkrohn 10y ago
  Here's perhaps a better way to say what I'm getting at: identifying and investing with a manager that predictably outperforms a benchmark is just as difficult an intellectual challenge as constructing a portfolio that outperforms that same benchmark. Both of these tasks are so difficult as to be essentially impossible for an unsophisticated retail investor.
  - VLM 10y ago
    I'll throw you a better analogy, identifying and hiring an outperforming programmer should be much simpler than identifying and hiring outperforming investment managers because there is relatively little effect of chance on programming output and measurement of success is mostly objective. Yet we know that hiring for programmers is utterly hopelessly broken beyond all belief, industry wide. Therefore its very unlikely that people of a similar cognitive and training level that utterly failed at hiring programmers could possibly select outperforming investment managers given that being an even more difficult job. No one in HR or management is going to be selecting outperforming investment managers. Its possible that someone outside HR and management is better at selecting the best programmers. Certainly plenty of advice from outsiders is given to hire more of coincidentally highly politically correct demographic group A or group B. Or perhaps ivy college admissions officers magically know how to pick future great programmers (LOL). Professors and college advisors might put forth a weak argument in their own favor. Still, money seems to talk and greed means management and HR, however awful they are at selecting programmers, none the less are the best skilled at it, regardless how low that skill level is.
nradov 10y ago
Logically even if the EMH is false that doesn't necessarily imply the existence of investment managers who can reliably identify mispriced securities. It's entirely possible that the EMH is false and yet no one is able to take advantage of that. But your recommendation makes sense either way.
- ctkrohn 10y ago
  Right, those anomalies could simply exist unexploited until the market is better understood. For example, you used to be able to earn money buy buying the 501st largest company in the US: if it happened to become the 500th largest, all the S&P 500 index funds would be forced to buy its stock, and it would outperform the other stocks that had already been in the index. Similarly, the 500th largest stock would be a good sale candidate: if it becomes the 501st largest company, the index funds will become forced sellers. Now this effect is very well known, and there's no more money to be made by exploiting it.
ethbro 10y ago
> I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. I think this is the kernel of what Bogle was saying and Vanguard is now reaping the benefits of. Old system: active traders beat the market, therefore they charge fees slightly less than the alpha they're supposed to generate New system: customers are more aware that their active trader(s) may not be the winners, so the acceptable fee to pay the traders decreases to the product of the alpha AND the risk of not picking the right traders https://www.zacks.com/stock/news/250937/warren-buffett-on-active-vs-passive-investing-outlines-the-bet-in-berkshire-shareholder-letter https://www.zacks.com/stock/news/250937/warren-buffett-on-ac...
random_comment 10y ago
> If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks This isn't how causation works. > A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees. It is as much work to identify good fund managers as it is to identify good company managers. You might as well save some money if you go this route and invest in a portfolio of companies directly. > Furthermore, a smart manager will charge fees that are equal to the alpha they generate. Warren Buffett seems quite smart, I mean he made it to rank #1 on the world's rich list and I think he's one of the few on the top #100 that did it by investing in other companies rather than just building his own. Judging from his 40 year performance data he's generated rather more alpha than any other manager. He charges fees that are very close to 0.00001% for being a partner with him. That would seem to contradict your point.
md_ 10y ago
> I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. Why would they? Unless they're so rare that there are only a few of them, one would expect the market to encourage "fair" pricing of active management--yet a key dogma of passive investing is that the market is generally efficient, but the market for actively managed mutual funds isn't! It seems more plausible to me that (handwavy): 1. People can, in fact, beat the market, with lots of effort (e.g. very large college endowment funds, which outperform smaller ones, presumably by spending more on management and research) 2. The barriers to entry are typically high (because most investors won't trust their money with someone with an unproven track record) 3. Those high barriers to entry both allow the few established genuinely successful fund managers to charge higher fees than otherwise (to your point, eating up the alpha they generate) and ensure that "managing a fund" requires good sales skills and not just good management skills (see, lots of hedge funds) Or, in short, lots of markets are inefficient--both the stock market and the market for managed funds. But because the stock market is much bigger than the fund market, it's probably _less_ efficient. Or so we hope.

lr4444lr 10y ago

I think the other commenters hit on the important points and anticipated my distinctions. Note that I said "on a significant level". That did not imply blind or absolute faith. There are other investment options to match your bullish outlook if you think CAPM and EMH are wrong to the approximation that suits your involvement, knowledge, and risk profile, but you chose an index ETF. Why?

kd0amg 10y ago
Perhaps GP believes he does not have the skills to identify market inefficiencies, or believes he does not have the skills to identify fund managers who have the skills to identify market inefficiencies. Those would seem to rule out picking securities himself or choosing an actively-managed fund. Or maybe he just believes the market might stay irrational longer than he can stay solvent.