How to Win the Loser's Game, Part 8
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Transcript:
Before moving on, let’s briefly summarise.
Mathematically, after costs, the average returns of a passive investor have to exceed the average returns of an active investor.
The market cap-weighted index reflects the consensus view of the market and therefore is the ideal starting point for a passive investor.
But the cap-weighted index isn’t perfect and, depending on how much risk they’re prepared to take, investors may want to tilt their portfolios towards other types of risk, or beta, such as small company or value stocks.
Beta, as we’ve said, is a measure of overall market risk. But what about alpha? that’s the name given to any return provided by a fund or an individual security over and above the benchmark index.
First and foremost you should be indexing. Alternatively you could tilt your portfolio towards different types of risk.
But is there ever a case for chasing alpha - either by choosing stocks yourself or by employing an active fund manager?
Professor Ken French from Tuck School of Business says: “That’s a great question. Does it make sense for the average investor to invest in an active fund? What I know is that the active investor who does invest in an active fund has to expect to lose relative to a passive strategy.”
Professor John Cochrane from the University of Chicago says: “I take a dim view of active management. For any investor to invest, you have to understand why the person you’re giving your money to is in the half that’s going to make money, and not the half that’s going to lose money. What’s special about him? What’s special about you that you know how to evaluate him?”
So, let’s be clear about this. All the evidence is stacked against active fund management. But, say for example, in spite of everything our experts have said, you still want to take a gamble with part of your portfolio, how DO you choose an active fund from the thousands of funds available?
Daniel Godfrey from the Investment Management Association says: “Well certainly not just by looking at past performance. A consumer would need to do a number of things. Firstly they can just offset the decision-making altogether and go to an independent financial adviser, and many do. And they will select funds for them, and that may be a mix of active and passive funds, and that’s a perfectly sensible thing to do. But they may wish to make decisions for themselves."
Bill McNabb from Vanguard says: “If you get the right manager, with a long-term philosophy and a consistent philosophy, and you have a low-priced portfolio, your chances of actually performing as well or better than the index go up.”
An example of a fund management company that does take a long-term view, and which keeps costs down by trading less, is Edinburgh-based Saracen Fund Managers.
David Keir, Head of Research at Saracen, says: “I think in the old days, everyone tried to take a long-term approach. But it feels with the advent of hedge funds, quarterly numbers, that a lot of the financial industry has been getting caught up in the short-term noise and volatility.”
Statistically, small funds like those run by Saracen, tend to perform better than very large ones. And their managers are more likely to invest their own money in them, which is always a good sign.
Chief Executive Graham Campbell says: “One thing that Warren Buffett certainly has is a huge amount of his own personal savings involved with his fund, and investors should always consider, Is the fund manager aligned with them as much as they should be?”
Also, remember the benefit of having exposure to different factors of risk.
Value investing is particularly worth investigating - as are the writings of the man usually credited with founding it - the British-born American academic and professional investor Benjamin Graham.
For an insight into Graham’s investment philosophy, we visited the university where he studied and taught.
Professor Bruce Greenwald from Columbia Business School says: “You’re looking for cheap, ugly, disappointing, obscure and otherwise orphaned stocks. Portfolios formed on those bases significantly outperform portfolios of glamour stocks.”
Like Bachelier, Samuelson, Sharpe and Fama, Graham’s aim was to take the guesswork out of picking stocks. He famously inspired one of his pupils, Warren Buffett. And Buffett’s subsequent success is testimony to the validity of Graham’s approach.
Buffett has described Graham’s book The Intelligent Investor as by far the best book about investing ever written.
In it Graham wrote that investment is most intelligent when it is most businesslike,
In his preface to the fourth edition of the book, Buffett said:
The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.
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