A Long Bet

[Quant]

SKC, any idea what say the top 10, 20, 30, 40 or 50 stocks on the ASX have returned (without including cyclical's like miners) vs the all ords for instance? I had a quick look yesterday when doing my reply above and the 9 stocks I mentioned outperformed the all ords by 2% over the last 12 months and thats ignoring dividends.

given half are XFJ constituents I think the answer may lie in
a xfj/xjo spread or ratio chart . XFJ was way oversold 12 months ago . Cheapest it had been in around 3 years , was pretty well bound to outperform XJO on any market rally , not to mention the incredible run by XLF in US which would have likely helped banks here also . I pointed out in a blog here last june where NAB was trading $24 on a 10 x 2017 multiple and would have been close to a 10% gross yield , was a no brainer .



lower band orange represents 10 x 2017 multiple and the upper band is 15 x 2017 multiple in NAB , with Divs damn close to 50% return in a boring old top 20 bank in 12 months . when opportunity knocks you got to answer the door

ANZ was even better trading well under 10 x 2017 mult and had a gross return with divs well north of 50%

 

[craft]

Yes I agree. And the fact that this hasn't been observed in the ASX means the active/passive probably hasn't quite hit the tipping point yet. However I think it's definitely happening in the Gold space where GDX/GDXJ are causing havoc and throwing relative valuations out of whack.



Yes this would be one way to take advantage... literally to go with the flow. However, if the passive dominance becomes a problem and whatever prevailed has to unwind... you would obviously act in the exact opposite manner.

Here's another great article on this issue.
http://www.barrons.com/articles/man-vs-machine-how-has-indexing-changed-the-market-1499491233

If passive dominance becomes a problem – what unwinds it and when?

What unwinds it and when is always the question for an active market participant whenever he sees an opportunity to be on the other side of prevailing wisdom.

The point with passive investing should be to take both stock selection and timing out of the equation so that all that matter is expenses.

You take stock selection out by buying the broadest ETF to match you long term expense exposures.

You take timing out by dollar cost averaging over a full cycle of sentiment swinging from passive being in fashion to out of fashion.

If the criticism of passive investing is timing or breadth related – the bigger point is probably being missed.


I would certainly tell anybody young who asks me:

Unless you are passionate about investing yourself.

From your very first pay check, have your super paid (and resulting investment cash flow re-invested) into the lowest cost broadest ETF you can and never change or even think about it again. This will undoubtedly produce a higher confidence level of retiring well than paying for active managers.

Hopefully most industry superanuuation funds now have broad based low cost ETF options.

 

[craft]

I bet if they made another 10 year bet immediately after this bet ends Buffett would most likely win again.

Maybe not.

He’s saying he’s too old to collect on another bet but Berkshire is perpetual, so take that with a grain of salt.

Buffett is an active investor, an extremely good one.

However he wanted to show a certain demographic the power of passive investing and the difficulties of picking consistent active managers.

That demographic wouldn’t be aware of the difficulties of ensuring the passive outcome when you have a single lump sum a single start and single finish date to deal with. He couldn’t really afford to lose because had he got the timing wrong he would mis the opportunity to influence the debate.

Buffett had to outsmart other active investors – so his start point and valuation was critical because he didn’t have control over the endpoint. That he doesn’t jump into renewing the bet now should tell you something about current valuation and the point SKC advances at least in USA.


No way he would have taken the passive bet without some active valuation perspective to back the timing up.

Buffet wanted to show the attributes of passive to the market he is aiming the message at, but he didn't have the time to put all the attributes into place to make it a certainty. It takes a unique active manager to make a muppet of the other active managers whilst promoting passive investing.

 

[Ves]

If passive dominance becomes a problem – what unwinds it and when?

Haven't thought about this in much detail and haven't researched it at all, but I'm a bit cynical of this debate and the voices in the media/industry who benefit from pushing it.

It's not like passive investment is going to completely cure 'human emotions' or de-couple the relationship between cashflow & long-term return. There's going to be booms and busts, and times where active will be more popular again and vice versa.

Probably a bit of hindsight bias in a lot of the 'expert arguments' because that always makes it easier to fit an agenda.

 

[Value Collector]

Haven't thought about this in much detail and haven't researched it at all, but I'm a bit cynical of this debate and the voices in the media/industry who benefit from pushing it.

It's not like passive investment is going to completely cure 'human emotions' or de-couple the relationship between cashflow & long-term return. There's going to be booms and busts, and times where active will be more popular again and vice versa.

Probably a bit of hindsight bias in a lot of the 'expert arguments' because that always makes it easier to fit an agenda.

Buffett knows (probably more than anyone), the study and effort it takes to be an active investor and beat the market over time, and he knows the "average person" isn't going to do that (hence why they want to pay hedge funds to do it for them).

So he recommends that the person not willing to put in the time and effort simply go the inactive route, because he believes the active route on average won't beat the market once the fees are taken out.

His recommendations are

1, Be active and put in the time and effort yourself

2, be passive and accept the market rate of return

he doesn't recommend 3

3, Be passive, but pay a high fee to some to be active on your behalf.


He explains it pretty well here, it goes back to Ben Graham,

 

[craft]

Buffett knows (probably more than anyone), the study and effort it takes to be an active investor and beat the market over time, and he knows the "average person" isn't going to do that (hence why they want to pay hedge funds to do it for them).

So he recommends that the person not willing to put in the time and effort simply go the inactive route, because he believes the active route on average won't beat the market once the fees are taken out.

His recommendations are

1, Be active and put in the time and effort yourself

2, be passive and accept the market rate of return

he doesn't recommend 3

3, Be passive, but pay a high fee to some to be active on your behalf.


He explains it pretty well here, it goes back to Ben Graham,

To achieve 2) he specifies
A (broad, low cost) index fund bought consistently over a long period of time.
All three elements are important.

 

[willy1111]

If passive dominance becomes a problem – what unwinds it and when?

What unwinds it and when is always the question for an active market participant whenever he sees an opportunity to be on the other side of prevailing wisdom.

Maybe yield?

Continous funds going into passive pushes up the stock price but it doesn't increase earnings of the share or ability to pay out more dividend/yield.

If dividend yield goes significantly below yield on fixed interest, there may be a change in flow from stocks to fixed interest.

Probably more likely in Aus as we derive great yield, which can replace personal exertion income. US seems to have more of a reputation for paying out lower dividend yield, retaining earnings to grow the business, so maybe yield may not be a catalyst for the unwinding in US market?

 

[Value Collector]

To achieve 2) he specifies
A (broad, low cost) index fund bought consistently over a long period of time.
All three elements are important.

Absolutely, because if you don't do all three and you begin to try and "time the market", you are not taking a passive position.

 

[Value Hunter]

Maybe not.

He’s saying he’s too old to collect on another bet but Berkshire is perpetual, so take that with a grain of salt.

That he doesn’t jump into renewing the bet now should tell you something about current valuation and the point SKC advances at least in USA.

Buffet wanted to show the attributes of passive to the market he is aiming the message at, but he didn't have the time to put all the attributes into place to make it a certainty. It takes a unique active manager to make a muppet of the other active managers whilst promoting passive investing.

Craft, if after the conclusion of the bet another identical ten year bet started and you were forced to pick one side to bet on (lets say you placed a $10,000 bet) would you back Buffett or his opponent?


In regards to Buffett not jumping into renewing the bet, the current bet is not yet even officially over, lol. Besides he has already proved his point why would he need to prove it again? Also would his opponents take the same bet if it was offered again? I am going to say no.

In terms of hedged funds having the potential to outperform during a really weak market, the argument is nice in theory but in a typical ten year cycle you will usually have weak and strong periods. Yes if in the ten years immediately after the current bet ends we have one of these relatively uncommon ten year periods where returns are really low say 1 or 2% per annum compound, its possible.

That is the important point that Buffett would not necessarily win the bet in every single ten year period but in the vast majority he would.

Also I am not convinced that hedge funds always outperform during bear markets. If you look at what typical hedge funds might do aside from bottom up long stock picking, things like shorting, currency trading, derivatives, macro investing, etc lets address them all one by one.

Shorting will likely do well during a bear market but most long-short funds have much smaller short portfolios than long portfolios. For example they might be 75% long, 15% short and the rest in cash. However, given that most fund managers suck at stock picking the long portfolio might under-perform by so much that it overwhelms the profits from their short portfolio.

Currency trading is notoriously difficult and very few people can do well out of it in the long-term. Too many unknowns and variables involved.

Derivatives, apart from the people using derivatives for hedging, for the other participants its probably 90% + losing money and 10% of them making big profits. As for macro-investing I would say the odds of making a good return long-term are about the same as currency trading. Its very tough due to the complexity and number of unknowns and variables involved. That is why there are very few George Soroses (plus his politcal influence certainly can affect outcomes in some cases).

Yes during the start of the bet Buffett was losing to the hedge funds but one brief bear market period is not enough evidence to suggest that hedge funds reliably outperform in bear markets. We need to see a lot more evidence of this.

Also on the final paragraph Craft, you yourself are an accomplished active investor and you also promote passive investing for the majority of people, just as Buffett does. So how are you different from Buffett other than that you did not go out of your way to publicly humiliate the active funds management crowd?

 

[Value Hunter]

craft said: ↑
To achieve 2) he specifies
A (broad, low cost) index fund bought consistently over a long period of time.
All three elements are important.

Craft would the same concept of buying consistently over a long period of time not apply to active managed funds for a passive/"defensive" investor? Every fund active or passive will go through bad periods, so if we are talking about "the average person" I do not see how that changes. I remember reading somewhere that Magellan (in the U.S.) later did a study of investors who invested into the Magellan Fund when Peter Lynch was the fund manager. Over that roughly 13 year period where his funds produced something like 29% annualized returns, apparently the majority of his investors lost money investing in Magellan funds. Most likely because they had a short term time horizon and picked the wrong times to enter and exit the fund.

 

[kid hustlr]

I find this passive / active investment discussion strange. Even the articles I'm reading don't actually outline the discussion.

Are people suggesting passive investment is bad because:
1. It's leading to higher valuations as retail investors pile in unaware of risks? or
2. It leads to some type of systematic risk within the system and ultimately financial meltdown as financial products behave outside of a way they were designed/expected to.

If the answer is 1 - I don't see a problem with this. Bull markets and bear markets happen and if retail investors are being drawn in at the wrong time this is completely standard behavior. If risk appetite was growing for active managers it would lead to increased P/E's anyway so for me this point is irrelevant.

If the discussion is point 2 then this is slightly more complex. Are people implying that ETF's make up such a large portion of the market that active / aggressive selling will lead to ETF selling and a self fulfilling prophecy? This just created volatility but the passive ETF is doing it's job. Perhaps slippage during hugely volatile times as they try to re balance could lead to under performance?

I think during hugely volatile times ETF's which aren't passive (aka derivative based or managed in such a way to provide exposure without holding the underlying) may be at risk but I'm not sure why passive ETF's which hold the underlying would be influenced (except simply being more volatile).

I think Buffet's bet was great, put simply, giving someone your money and asking them to manage it, along with a couple of other billion, whilst letting them take 1-2% a year fee, it's hugely unlikely they will beat the market.

To achieve 2) he specifies
A (broad, low cost) index fund bought consistently over a long period of time.
All three elements are important.

This is great and what people need to realise. Constant re-investment, stick to a plan, don't panic.

"If you want to be hear for the good days, you've got be here for all the days"
"Everyone has a plan until they get punched in the face"

 

[Value Collector]

Even though Buffett is an "Active" investor, he is still pretty passive in a lot of ways.

I mean compared to Buffett, you would have to describe the hedge funds and most traders as "Hyper Active"

Buffett claims that his Berkshire subsidiaries will never be sold, if he buys 100% of a business, it will spend the rest of its economic life in his portfolio, Even some of his Share holdings are looked at the same way, and for the stocks he does finally sell, turnover is slow.

 

[craft]

I find this passive / active investment discussion strange. Even the articles I'm reading don't actually outline the discussion.

Are people suggesting passive investment is bad because:
1. It's leading to higher valuations as retail investors pile in unaware of risks? or
2. It leads to some type of systematic risk within the system and ultimately financial meltdown as financial products behave outside of a way they were designed/expected to.

If the answer is 1 - I don't see a problem with this. Bull markets and bear markets happen and if retail investors are being drawn in at the wrong time this is completely standard behavior. If risk appetite was growing for active managers it would lead to increased P/E's anyway so for me this point is irrelevant.

If the discussion is point 2 then this is slightly more complex. Are people implying that ETF's make up such a large portion of the market that active / aggressive selling will lead to ETF selling and a self fulfilling prophecy? This just created volatility but the passive ETF is doing it's job. Perhaps slippage during hugely volatile times as they try to re balance could lead to under performance?

I think during hugely volatile times ETF's which aren't passive (aka derivative based or managed in such a way to provide exposure without holding the underlying) may be at risk but I'm not sure why passive ETF's which hold the underlying would be influenced (except simply being more volatile).

I think Buffet's bet was great, put simply, giving someone your money and asking them to manage it, along with a couple of other billion, whilst letting them take 1-2% a year fee, it's hugely unlikely they will beat the market.



This is great and what people need to realise. Constant re-investment, stick to a plan, don't panic.

"If you want to be hear for the good days, you've got be here for all the days"
"Everyone has a plan until they get punched in the face"

Good thoughts KH.

If passive is done by the math, ie. Broadly and consistenetly over the long term then it must beat the average of active participants by the amount of expenses incurred by active participants.

Active should be able to acknowledge the above. Its the bench mark above which you have to measure yourself to see if you are winning at the less than zero-sum active game.

Active is aslo probabily right in thinking consistently over the long term is going to prove toublesem to some who are jumping on the band wagon now (jumping on the band wagon is contridiction of cosistency required of passive in the first place) but will eventually fail to stay the course of passive investing - setting up varying fund flows which can be actively exploited. That is not a failing of passive investing theory, as you alluded its a failing of implementation.

 

[craft]

craft said: ↑
To achieve 2) he specifies
A (broad, low cost) index fund bought consistently over a long period of time.
All three elements are important.

Craft would the same concept of buying consistently over a long period of time not apply to active managed funds for a passive/"defensive" investor? Every fund active or passive will go through bad periods, so if we are talking about "the average person" I do not see how that changes. I remember reading somewhere that Magellan (in the U.S.) later did a study of investors who invested into the Magellan Fund when Peter Lynch was the fund manager. Over that roughly 13 year period where his funds produced something like 29% annualized returns, apparently the majority of his investors lost money investing in Magellan funds. Most likely because they had a short term time horizon and picked the wrong times to enter and exit the fund.

There are only two components to altering your return from the market. Selection and timing. Selection is made passive by goint broad and cheap. Timing is made passive by consistency over a long period.

So yes if you want a active manager making the selections for you and think they will justify their costs, you probably should still dollar cost average your entry and exit to make your timing as passive as possible unless you have some timing skills. With out a framework emotions make most people bad timers.

 

[craft]

Craft, if after the conclusion of the bet another identical ten year bet started and you were forced to pick one side to bet on (lets say you placed a $10,000 bet) would you back Buffett or his opponent?


In regards to Buffett not jumping into renewing the bet, the current bet is not yet even officially over, lol. Besides he has already proved his point why would he need to prove it again? Also would his opponents take the same bet if it was offered again? I am going to say no.

In terms of hedged funds having the potential to outperform during a really weak market, the argument is nice in theory but in a typical ten year cycle you will usually have weak and strong periods. Yes if in the ten years immediately after the current bet ends we have one of these relatively uncommon ten year periods where returns are really low say 1 or 2% per annum compound, its possible.

That is the important point that Buffett would not necessarily win the bet in every single ten year period but in the vast majority he would.

Also I am not convinced that hedge funds always outperform during bear markets. If you look at what typical hedge funds might do aside from bottom up long stock picking, things like shorting, currency trading, derivatives, macro investing, etc lets address them all one by one.

Shorting will likely do well during a bear market but most long-short funds have much smaller short portfolios than long portfolios. For example they might be 75% long, 15% short and the rest in cash. However, given that most fund managers suck at stock picking the long portfolio might under-perform by so much that it overwhelms the profits from their short portfolio.

Currency trading is notoriously difficult and very few people can do well out of it in the long-term. Too many unknowns and variables involved.

Derivatives, apart from the people using derivatives for hedging, for the other participants its probably 90% + losing money and 10% of them making big profits. As for macro-investing I would say the odds of making a good return long-term are about the same as currency trading. Its very tough due to the complexity and number of unknowns and variables involved. That is why there are very few George Soroses (plus his politcal influence certainly can affect outcomes in some cases).

Yes during the start of the bet Buffett was losing to the hedge funds but one brief bear market period is not enough evidence to suggest that hedge funds reliably outperform in bear markets. We need to see a lot more evidence of this.

Also on the final paragraph Craft, you yourself are an accomplished active investor and you also promote passive investing for the majority of people, just as Buffett does. So how are you different from Buffett other than that you did not go out of your way to publicly humiliate the active funds management crowd?

VH seems a bit of a ramble here, some points seem to contradict each other, but to answer your specific questions to me.

Would I back Buffett if he entered another bet? I would have to have a look at the details to make up my mind. We are at a different point of the resource vs value add technology cycle and demand vs consumption cycle then when the original bet was made.

I don't expect another bet to be made although if he could find a counterparty who promoted another layer of costs so as to trade in and out of the fund of fund managers based on a technical overlay, to improve the outcome - you never know.

There was clearly an active component to the bet because of the single entry and exit point. I think he's wedded enough to showing the benefits of passive investing to not make a lower probabilty active call and undermine his point - especially now that the original worked out well.

I don't necessarily promote passive - I just think everybody should be able to acknowledge the reality of the math so they can make an informed decision on what best suits their passions and skills.

[perhaps the real reason I talk about passive investing is that I have made a lot of money beyond what passive would have delivered. I prefer that money comes from arrogant knobs that knowingly enter the battlefeild rather than nice people that naively and unpreparedly enter the lions ring].

 

[Value Collector]

I was reading buffets 1979 annual letter this morning, and the top paragraph of this page shows how his style of "active management" is still quite "inactive" the hedge funds would be rushing to sell or hedge or some other hyper active behavior, they couldn't stand the thought of having a slow year. Buffett meanwhile just took it with a grain of salt and stuck to his plan.

 

[kermit345]

I'd back Buffet (passive) again and again if the bet was done in the same manner. My understanding is that the bet was Passive (low cost index ETF) vs fund of funds. As I stated in an earlier post over a 10 year period approximately 21% of active funds outperformed the index in the US and whilst you can say its only relative to that start and end point - from my readings this % stays relatively consistent across rolling 10 year periods. This is based on singular funds outperforming the index, so as soon as you take a fund of funds approach you're almost certainly going to underperform the index over 10 year periods.

Lets say each 'fund of funds' contains 5 active managers, there's a good chance that 4 or even all 5 of these will underperform the index whilst its highly unlikely that 2 or more will outperform. The higher the number of funds within the fund - the more chance it underperforms as it will become less and less likely that the fund concentrates on the active funds that outperform.

I don't think Buffet got lucky or was smart with the timing at all and its highly likely he would've won the bet no matter when it was taken. Without knowing what funds were used within the fund of funds its impossible to test alternative start dates but you can even look at the results at the moment and only one of the 'fund of funds' are even within cooee of the passive investment.

I assume we all somewhat agree that passive over the long-term will outperform active managers and in particular a group of active managers (ignoring picking stocks yourself). Therefore the questions I ponder like SKC posed are:

1) How do we take further advantage of this assumption? - i.e. like I suggested do the biggest stocks simply get bigger at an accelerated rate to the broader market as they are typically constituents of the most passive funds AND have the largest market caps which therefore increases their weighting within the passive funds.

2) How will it potentially come undone and what would be the consequences (a lot of guess work involved here)

Personally I think they are the two important questions.

 

[Faramir]

http://www.thebull.com.au/premium/a/70113-the-case-for-active-asset-management.html

Playing devil's advocate here. I do not believe in this article. So I am looking for counter arguments to put my mind at ease.

The case for active asset management
Something that got my eye:

We also find that some of the benefits of active management have been overlooked. Active managers:
• Hold companies to account

• Help to direct capital into faster-growing industries

• Work to improve standards of governance and make businesses more sustainable.

The last paragraph:

However, investors need to recognise that active performance is cyclical: selling out of a strategy with a strong philosophy and process after a short period of underperformance risks locking in that underperformance. But the potential value added from active management remains a critical tool in maximising return from a broad portfolio, and we believe that active management will in time start to regain share from passive.

I actually do not have any EFTs and I have 9 stocks. If I knew what EFT to buy, I will probably buy it and save myself much angst. Also I have been stung by a manage fund before and I feel very resentful or should I say regretful in making a decision to put money into a MLC product. So I believe in passive over active.

So please provide some counter arguments in the above article link. When I read it last night, I thought this can't be 100% true. OR someone can tell me this article is very valid and I choose active over passive. (Actually I won't, I prefer to choose my own stocks). At least please tell me what is good about this article or what has been overlooked.

Thank you.

 

[kermit345]

I'll dot point my reasons for preferring passive over active these days with a side note, there are some good factor investing funds out there now which seems to be the new flavor that tries to take the best from both worlds and with good reason. Note i'm not going to refer to any articles or back up my statements with direct facts, its just based on what i've read and learnt along the way, but if you search around enough you should be able to find articles or data that support my notes in some way.

- Only around 20-30% of active funds outperform passive funds in the equities space when talking 5 or 10 year return periods. It's also been shown that of these 20-30% only about 30% continue to outperform, so picking the best active manager right now essentially only gives you a 30% chance he will continue to be for the next 5 years.

- Active funds cost more, typically passive funds will cost you around 0.20% whilst active funds are typically anywhere in the 0.80% to 1.50% range (particularly higher for international managers). That's a lot extra to pay in fees for a fund that only has a 30% chance of outperformance.

- Active funds can often vary the level of their investment considerably, for example you may want 50% of your portfolio in aussie equities but your active manager may think there aren't enough opportunities around in the moment and holds 20% in cash, thus only 40% of your funds are ACTUALLY in aussie equities, thus you might not even be taking the level of risk you actually wish to - never an issue with passive.

- One area active managers can provide better returns is small companies due to the ability to sort out majority of the unprofitable junk that an index doesn't do, however once an active manager in this space has any form of success their FUM grows and they typically have an inability to move in and out of the small companies anymore. Hence either capping off to new investors or becoming large cap centric just like all the other managers that underperform.

- The above has focused on equities but essentially many of the same stats and views apply to property and fixed interest / bonds.

My view - Use passive or factor investing for your fixed interest, property and large cap equity positions within your portfolio and either invest yourself or find a quality manager in the small cap space. The passive part of the portfolio is incredibly easy to do with the range of vanguard or other ETF's available.

Anyhow thats all just my view, people will differ in opinion and thats fine but after the research and data i've seen i can't see my view being swayed anytime soon. The only way I can see active potentially becoming appropriate again is when the passive investment has got to the point that it makes up a huge chunk of the market which provides some opportunity via active maneuvering. That's yet to happen in my view but it could in the future as passive continues to be where the majority of funds flow.