The Lives of Others

From the State Department's fact sheet for American athletes traveling to Beijing for the 2008 Olympics: Your hotel room is bugged.

All visitors should be aware that they have no reasonable expectation of privacy in public or private locations. All hotel rooms and offices are considered to be subject to on-site or remote technical monitoring at all times. Hotel rooms, residences and offices may be accessed at any time without the occupant’s consent or knowledge.

To test, when I visited last February, every night I ruminated aloud on how my coworker was a Taiwanese nationalist. And a proselytizing Christian. Fortunately she left unharmed.

On the Rationality of Active Investing

Learned hand Luis Villa links to my post on achieving alpha and asks,

The interesting question, in my mind, is why so many people are so irrational. This is a gold mine for the behavioral economists, and a nice counter-argument for when someone tells you that better information creates more efficient markets.

He concludes:

I long for a Love-ian explanation of why this happens in theoretically rational markets with nearly perfect price information.

Luis's is a good question. I think there are three unrelated but collaborative factors.

First, active investing is not irrational if most folks believe mutual funds are the superior investment vehicle—remember, rational isn't epistemic. ETFs are a relatively-recent invention—they have been available in Europe since only 1999—and have not yet reached ubiquity. Indeed, many folks do not even know what ETFs are, let alone the returns they offer or low costs they charge. Many 401(k) plans, moreover, continue to offer few if any passive funds. Mutual fund fees, such as front-end loads, create incentives for brokers to push expensive funds over cheaper index funds. Thus, given the relative dearth of information about and access to ETFs, the choice of active funds over passive funds is often rational.

Second, not all of the costs of active investing are "wasted" on unachieved excess returns. Some of the costs go toward tax minimization strategies, for example, that a passive fund does not provide. This portion of the cost should not be included in the calculation.

The best for last: I believe the most accurate explanation is that investors, individually and as a group, are generally making the right choices. Recall I closed my previous post with this nugget:

One reason the market and thus passive investors can earn the returns they do is because of active investor's strategies that close arbitrage opportunities, set prices, tighten spreads, and otherwise make the market more efficient.

This suggests that the overall outcome ($100 billion spent chasing excess returns) is net beneficial, but does not comment on why any individual investor rationally puts his or herself in the active camp.

To answer that, let's study investing at the margins. There is both a cost and a return to active investing. Active investors hope that the return is in excess of the market, net costs. This excess is called alpha. Assume there are no active investors, only passive. Then the market would be a cacophony of noise, and any active investing strategy would reap substantial reward. The cost would also be high, both because there would be few suppliers of such service and because the infrastructure for doing so (equity research, realtime operating systems, the city of Greenwich) would not exist, but the alpha would still be significant. Given these outsized returns, capital will flow out of passive and into active investing.

Now let's look at the other extreme and assume all market participants are engaged in active strategies. The outsized returns will be bid down, but the costs would also be much lower as the supply of funds and their managers meets demand and economies of scale kick in, lowering marginal cost. In this all-active world, the typical return would approximate the market's total return. Given the lack of alpha, capital will flow out of active strategies and into index funds.

In either market, put yourself at the margin. Everyone is passive? Achieving alpha is easy, as you just have to beat the noise. Everyone is active? Then just mimic their strategies by tracking the entire market and achieve similar returns without the cost. With each person switching from passive to active, or from active to passive, the marginal utility, along with the efficiency of the market, increases or decreases. Eventually, equities are efficiently priced as folks long the hot stocks and short the stinkers, spreads tighten, and arbitrage opportunities close. At this point, because the market is efficient, it no longer pays to expend excess cost on active investing. Thus the guy at the margin moves into an index fund, simply tracking the whole market and earning the market's return. If enough people choose passive over active strategies, perhaps the next guy will notice that spreads are too wide or some stock is underpriced. If so, he will choose an active strategy and achieve alpha.

And so it goes, until we reach the $100 billion equilibrium we are at today, where the marginal cost of active investing meets its marginal utility. The balance might be imperfect—too many folks free-riding with their passive investments or tilting at windmills in pursuit of alpha—but I bet its pretty damn close. Disagree? Then just move to the other side of the fence—you will gain excess net returns and make the market more efficient.

On an Employer who Loves Dogs

My coworker, napping:

A particularly beautiful breed.

Android at LugRadio

But we in it shall be remember'd: LugRadio Live USA 2008 is the 12 and 13th of April in hilly San Francisco.

I will be there, speaking on Android, our forthcoming complete, free, and open mobile platform. It will be a hit, a very palpable hit.

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.

Tonight is the Night

We released version m5-rc15 of the Android SDK. See also Apps for Android.

Per usual, I shall twitter the election results from tonight's four state battle royal.

And, finally, this presidential contest Google Maps mashup is cute and fun.