Tuesday, March 11, 2008

The best laid schemes o' Mice an' Men

I am in Chicago, a little late reading the Sunday Times, but this article on beating the market caught my attention:

Investors collectively spend around $100 billion a year trying to beat the stock market. That’s the finding of a rigorous effort to measure the total costs of Americans’ efforts to surpass the returns they would have received by simply holding a stock index fund. The huge price tag helps explain why beating a buy-and-hold strategy is so difficult.

In his new study, Professor French tried to make his estimate of investment costs as comprehensive as possible. He took into account the fees and expenses of domestic equity mutual funds (both open- and closed-end, including exchange-traded funds), the investment management costs paid by institutions (both public and private), the fees paid to hedge funds, and the transactions costs paid by all traders (including commissions and bid-asked spreads). If a fund or institution was only partly allocated to the domestic equity market, he counted only that portion in computing its investment costs.

Professor French then deducted what domestic equity investors collectively would have paid if they instead had simply bought and held an index fund benchmarked to the overall stock market, like the Vanguard Total Stock Market Index fund, whose retail version currently has an annual expense ratio of 0.19 percent.

The difference between those amounts, Professor French says, is what investors as a group pay to try to beat the market.

The study's conclusion:

What are the investment implications of his findings? One is that a typical investor can increase his annual return by just shifting to an index fund and eliminating the expenses involved in trying to beat the market. Professor French emphasizes that this typical investor is an average of everyone aiming to outperform the market—including the supposedly best and brightest who run hedge funds.

The bottom line is this: The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.

I go further: The odds are, most definitively, against you. You might beat the market this year, but you won't the next. Repeat after me: You cannot beat the market. Put your money in an ETF—or a small basket of them—and leave it alone.

There are theories that decree this—equity prices reflect all known information and are an unbiased and collective valuation and thus you can only outperform the market through luck—but you do not have to subscribe to them, as mere arithmetic can make the case:

Active investing yields average returns. Proof. Let M be the entire market. By definition, M's return is the market's total return minus net costs. Let P be a subset of M such that x is in P if x is pursuing a passive strategy. That is, P is tracking the total market. Then P is also earning the market's total return, minus costs (which are very low). Now, let A be a subset of M such that x is in A if x is pursuing an active (that is, managed) strategy. Since M=P+A and both M and P are earning average returns, A is also earning average returns, minus costs (which are large). QED.

To be sure, you could now argue that A is composed of two subsets, those who consistently and substantially outperform the market and those who consistently and substantially underperform the market. I think its clear that, in a given period, some funds are in one subset and some are in the other—but, over the long-run, no one fund is consistently in either and you get reversion toward the mean.

As an aside, one reason M and thus P can earn the returns they do is because of A's active strategies that close arbitrage opportunities, set prices, close spreads, and otherwise make the market more efficient. Is that worth $100 billion? Definitely.