The history of science is not confined to revelatory insights about the world. It is also a history of bold and sometimes reckless experimentation. On the morning of Sunday February 4th 1912, for example, an Austrian tailor, Franz Reichelt, climbed to the first floor of the Eiffel Tower, 360 steps up. He climbed onto a table, checked the direction and speed of the wind, and then stepped out into the void.
Reichelt was wearing a prototype parachute, made from a combination of waterproof fabric and silk. Large silk sheets connected his arms to his ankles. A silk hood stood above his head.
He fell for four seconds, accelerating as he fell, until he hit the ground at sixty miles an hour. He was killed instantly. The impact left a dent in the frozen Parisian soil six inches deep.
They had tried to warn him. Gaston Hervieu, who had conducted a successful parachute trial with a 160-pound test dummy a year beforehand, warned that there were technical reasons why Reichelt’s parachute would not work. Modern parachutes use 700 square feet of material and should be deployed only above 250 feet. Reichelt’s parachute used less than 350 square feet of material, and he deployed at only 187 feet. He had neither sufficient surface area of fabric nor enough altitude to make a successful jump. Experts at the Aéro-Club de France had also warned him:
“The surface of your device is too small. You will break your neck.”
The laws of science are immutable. There are no shortcuts.
Unfortunately for most economists and many fund managers, economics and modern portfolio theory are not science, and they do not obey the laws of nature. ‘Finance world’, for want of a better phrase, is an entirely man-made construct. Its laws, such as the efficient market hypothesis, hold sway only in the minds of its believers.
The efficient market hypothesis, or EMH, is still taught at business schools.
EMH states that it is impossible to beat the market because the efficiency of the market causes all share prices, at all times, to incorporate and reflect all known market information.
The stock market may be roughly efficient, but it is not 100% efficient.
There is a great deal of difference between being roughly right and 100% right. Just as there is a great deal of difference between jumping off the Eiffel Tower with 700 square feet of parachute and jumping off with less than 350 square feet of parachute.
Between them, EMH and its intellectual cousin, the Capital Asset Pricing Model (CAPM), continue to account for squadrons of fund managers falling ingloriously out of the sky into an early grave.
CAPM describes the risk and expected return of an asset in a diversified portfolio. More details are unnecessary – largely because the theory is nonsense – but suffice to say that between them, EMH and CAPM require an awful lot of “assumptions” for these theories to “work”.
Among those assumptions:
1) All investors are seeking to maximize returns;
2) All investors are 100% rational and risk-averse;
3) All investors are 100% diversified across a broad range of investments;
4) All investors have an equal relationship with prices that they cannot influence;
5) All investors can lend and borrow without limit at the same interest rate;
6) There is no such thing as transactions costs or tax;
7) All assets are 100% liquid and perfectly divisible;
8) All investors have identical expectations;
9) All investors have access to infinite amounts of information simultaneously.
Probably the best refutation of EMH lies in Warren Buffett’s 1984 introduction to Ben Graham’s ‘The Intelligent Investor’ – a book Buffett himself describes as the best book on investment ever written. (We agree.)
Another solid refutation of EMH lies in the performance of Buffett’s investment holding company, Berkshire Hathaway, during his management.
Between 1965 and 2015, the company’s shares returned, on average, 20.8% per annum to shareholders. If you were fortunate enough to have bought Berkshire Hathaway stock back in 1965 and have held on to it since then, that equates to an overall return of over 1.5 million percent.
Such an astronomical return is not just a refute, it’s a rebuke, of EMH.
Buffett’s colleague Charlie Munger makes the following observation:
“Efficient market theory is a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact, one of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.”
“And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter]
“And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.”
(The Greek letter sigma is used as a measure of standard deviation – of how much some series of events vary around the average. For a certain type of statistical distribution, for example, one third of events will be more than one ‘sigma’ from the average, only 5 percent will be more than two ‘sigmas’ away and only 0.3% more than three ‘sigmas’ away. All you really need to know is that when economists start using Greek letters, they are resorting to pretentious theoretical nonsense.)
Warren Buffett knows that the market isn’t 100 percent efficient. He has publicly stated that if it were, he’d be a bum on the street corner with a tin cup.
If you’re playing a game against financial professionals, which is what investing ultimately amounts to, it’s a huge advantage for you to be able to play by different rules.
Here are some of the rules that bind institutional fund managers into highly restrictive investment constraints.
The more assets under management that a fund manager controls, the less likely he is to outperform versus his peers. Buffett, himself no slouch at deploying large amounts of capital, has publicly acknowledged this.
As he writes in his Superinvestors piece above (“Size is the anchor of performance”):
The fate of Fidelity’s Magellan Fund is a good example of how that anchor weighs managers down. When the highly successful Peter Lynch left Magellan in May 1990 after 13 years with the group, the fund had grown to $13 billion in assets. By the time Morris Smith had left in July 1992, the fund was up to $20 billion.
On Jeffrey Vinik’s departure in June 1996, assets were up to $50 billion. By the end of the century, Magellan assets had grown to over $100 billion (the fund was closed to new investors in September 1997 and peaked at almost $110 billion in August 2000), only to see them fall back to $52 billion on manager Robert Stansky’s departure in 2005, through a combination of investment losses and investor outflows.
That Warren Buffett chose to use the listed business Berkshire Hathaway as his primary investment vehicle is no accident.
Firstly, it meant he could deploy the cash pool or ‘float’ of his reinsurance business to make investments long before he would need to pay out on any insurance policies that the business underwrote. In other words, he had effectively free access to other people’s money and he could invest it unconstrainedly.
Secondly, since he wasn’t managing the capital of unit-holders in a mutual fund, he didn’t have to worry about investors redeeming their funds.
Berkshire Hathaway’s public listing means that he has what’s known as “permanent capital”. Shareholders are free to sell their shares, if they wish, but such share sales have no impact on Berkshire’s investment portfolio whatsoever.
Let’s explore the difference a bit more. Share sales have no impact on Berkshire’s investment portfolio. But it’s a different story for a mutual fund manager. The unit-holders of a publicly held mutual fund can seriously impact the fund manager’s performance if they choose to redeem their units when markets are falling.
Such redemptions force the fund manager to sell his investments when he least wants to. They also oblige him to make most of his portfolio “liquid” – i.e. it can be easily sold in order to pay out redeeming unit-holders.
Most institutional fund managers are obligated to match and ideally outperform some kind of investment benchmark.
If they’re managing a portfolio of US domestic blue chip stocks and large cap companies, then the benchmark will likely be an index like the Standard and Poor’s 500 stock index. Those 500 US businesses that are worth more than any other in the market.
If they’re managing a portfolio of global stocks, then their benchmark is likely to be something like the MSCI World Equity Index.
But the composition of the index matters a lot.
68% of the MSCI World Index is currently allocated to the US. This means that any global equity manager effectively has to have 68% of his or her portfolio dedicated to the US, irrespective of whether there is any inherent value in that market or not. This sort of indiscriminate madness is just one reason to be wary of passive exchange-traded funds and index-trackers.
As a private investor, you can buy what you want.
Even if you buy a concentrated position within your own portfolio — lots of one particular kind of stock, for example — you’re not going to move the market against you while you establish that position.
Fund managers have that problem day in, day out. But you don’t have to limit yourself to the largest stocks in your benchmark – because you don’t have a benchmark.
Nobody is trying to pick you off… or profit from your trading habits. You can operate under the radar, if you will.
Large cap domestic stocks, small cap foreign stocks, mid-cap emerging market stocks – you can buy literally anything you want. Institutional fund managers simply don’t have that flexibility. They have to buy from a comparatively small, fixed template of stocks, and they constantly have to worry about managing the liquidity profile of that portfolio.
Perhaps the single biggest opportunity set available to the private investor – one that is ‘out of bounds’ for most institutional managers — is the world of small cap companies.
Those are listed businesses with a market value of, say, between $300 million and $2 billion.
Small cap companies can make decisions more quickly than their larger competitors. Being nimble, they can take advantage of market opportunities more quickly than large conglomerates with top-heavy executive boards and bureaucratic management committees.
Being small, they can double in size more quickly than large companies.
If we could only use one phrase to sum up why fund managers so often fail to meet their investors’ expectations, it would be this one. A typical fund manager has little or no ‘skin in the game’ – it’s not like he’s managing his own money, so he’s more likely to want to hug that benchmark until it squeaks.
From 2003 to 2006, for example, the chief investment officer of T. Rowe Price (no relation) amassed ownership of equity in the management company worth over $75 million. His total personal investment in T. Rowe Price’s mutual funds amounted, apparently, to $1 million.
Whatever the quality of the cooking at this fund business, there was precious little eating going on, by this manager, at least.
And in the words of the British economist John Maynard Keynes, for professional fund managers, it’s essentially better to fail conventionally – clinging to that benchmark – than to succeed unconventionally – by actively choosing to steer away from that benchmark, potentially losing one’s job in the process.
Career risk accounts for why fund managers focus only on market relative performance, and almost never on the generation of absolute returns.
But you cannot take relative performance to the bank.
Many fund managers never even see the end investor. That role is intermediated by his own sales force, or by a third-party financial advisor. So it’s no surprise that an economic agent feels less compelled to deliver than a true principal.
As a private investor, the size of your portfolio is no constraint to performance whatsoever.
And because it’s your money, you’re more likely to want to manage it well. You can take the time to investigate opportunities that aren’t available to institutional fund managers. And you have the luxury of time to allow those investments to bear fruit.
These are ingredients for a win. Apple Inc used to run an ad campaign for one of their products that gets the point across nicely: think different.
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
The history of science is not confined to revelatory insights about the world. It is also a history of bold and sometimes reckless experimentation. On the morning of Sunday February 4th 1912, for example, an Austrian tailor, Franz Reichelt, climbed to the first floor of the Eiffel Tower, 360 steps up. He climbed onto a table, checked the direction and speed of the wind, and then stepped out into the void.
Reichelt was wearing a prototype parachute, made from a combination of waterproof fabric and silk. Large silk sheets connected his arms to his ankles. A silk hood stood above his head.
He fell for four seconds, accelerating as he fell, until he hit the ground at sixty miles an hour. He was killed instantly. The impact left a dent in the frozen Parisian soil six inches deep.
They had tried to warn him. Gaston Hervieu, who had conducted a successful parachute trial with a 160-pound test dummy a year beforehand, warned that there were technical reasons why Reichelt’s parachute would not work. Modern parachutes use 700 square feet of material and should be deployed only above 250 feet. Reichelt’s parachute used less than 350 square feet of material, and he deployed at only 187 feet. He had neither sufficient surface area of fabric nor enough altitude to make a successful jump. Experts at the Aéro-Club de France had also warned him:
“The surface of your device is too small. You will break your neck.”
The laws of science are immutable. There are no shortcuts.
Unfortunately for most economists and many fund managers, economics and modern portfolio theory are not science, and they do not obey the laws of nature. ‘Finance world’, for want of a better phrase, is an entirely man-made construct. Its laws, such as the efficient market hypothesis, hold sway only in the minds of its believers.
The efficient market hypothesis, or EMH, is still taught at business schools.
EMH states that it is impossible to beat the market because the efficiency of the market causes all share prices, at all times, to incorporate and reflect all known market information.
The stock market may be roughly efficient, but it is not 100% efficient.
There is a great deal of difference between being roughly right and 100% right. Just as there is a great deal of difference between jumping off the Eiffel Tower with 700 square feet of parachute and jumping off with less than 350 square feet of parachute.
Between them, EMH and its intellectual cousin, the Capital Asset Pricing Model (CAPM), continue to account for squadrons of fund managers falling ingloriously out of the sky into an early grave.
CAPM describes the risk and expected return of an asset in a diversified portfolio. More details are unnecessary – largely because the theory is nonsense – but suffice to say that between them, EMH and CAPM require an awful lot of “assumptions” for these theories to “work”.
Among those assumptions:
1) All investors are seeking to maximize returns;
2) All investors are 100% rational and risk-averse;
3) All investors are 100% diversified across a broad range of investments;
4) All investors have an equal relationship with prices that they cannot influence;
5) All investors can lend and borrow without limit at the same interest rate;
6) There is no such thing as transactions costs or tax;
7) All assets are 100% liquid and perfectly divisible;
8) All investors have identical expectations;
9) All investors have access to infinite amounts of information simultaneously.
Probably the best refutation of EMH lies in Warren Buffett’s 1984 introduction to Ben Graham’s ‘The Intelligent Investor’ – a book Buffett himself describes as the best book on investment ever written. (We agree.)
Another solid refutation of EMH lies in the performance of Buffett’s investment holding company, Berkshire Hathaway, during his management.
Between 1965 and 2015, the company’s shares returned, on average, 20.8% per annum to shareholders. If you were fortunate enough to have bought Berkshire Hathaway stock back in 1965 and have held on to it since then, that equates to an overall return of over 1.5 million percent.
Such an astronomical return is not just a refute, it’s a rebuke, of EMH.
Buffett’s colleague Charlie Munger makes the following observation:
“Efficient market theory is a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact, one of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.”
“And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter]
“And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.”
(The Greek letter sigma is used as a measure of standard deviation – of how much some series of events vary around the average. For a certain type of statistical distribution, for example, one third of events will be more than one ‘sigma’ from the average, only 5 percent will be more than two ‘sigmas’ away and only 0.3% more than three ‘sigmas’ away. All you really need to know is that when economists start using Greek letters, they are resorting to pretentious theoretical nonsense.)
Warren Buffett knows that the market isn’t 100 percent efficient. He has publicly stated that if it were, he’d be a bum on the street corner with a tin cup.
If you’re playing a game against financial professionals, which is what investing ultimately amounts to, it’s a huge advantage for you to be able to play by different rules.
Here are some of the rules that bind institutional fund managers into highly restrictive investment constraints.
The more assets under management that a fund manager controls, the less likely he is to outperform versus his peers. Buffett, himself no slouch at deploying large amounts of capital, has publicly acknowledged this.
As he writes in his Superinvestors piece above (“Size is the anchor of performance”):
The fate of Fidelity’s Magellan Fund is a good example of how that anchor weighs managers down. When the highly successful Peter Lynch left Magellan in May 1990 after 13 years with the group, the fund had grown to $13 billion in assets. By the time Morris Smith had left in July 1992, the fund was up to $20 billion.
On Jeffrey Vinik’s departure in June 1996, assets were up to $50 billion. By the end of the century, Magellan assets had grown to over $100 billion (the fund was closed to new investors in September 1997 and peaked at almost $110 billion in August 2000), only to see them fall back to $52 billion on manager Robert Stansky’s departure in 2005, through a combination of investment losses and investor outflows.
That Warren Buffett chose to use the listed business Berkshire Hathaway as his primary investment vehicle is no accident.
Firstly, it meant he could deploy the cash pool or ‘float’ of his reinsurance business to make investments long before he would need to pay out on any insurance policies that the business underwrote. In other words, he had effectively free access to other people’s money and he could invest it unconstrainedly.
Secondly, since he wasn’t managing the capital of unit-holders in a mutual fund, he didn’t have to worry about investors redeeming their funds.
Berkshire Hathaway’s public listing means that he has what’s known as “permanent capital”. Shareholders are free to sell their shares, if they wish, but such share sales have no impact on Berkshire’s investment portfolio whatsoever.
Let’s explore the difference a bit more. Share sales have no impact on Berkshire’s investment portfolio. But it’s a different story for a mutual fund manager. The unit-holders of a publicly held mutual fund can seriously impact the fund manager’s performance if they choose to redeem their units when markets are falling.
Such redemptions force the fund manager to sell his investments when he least wants to. They also oblige him to make most of his portfolio “liquid” – i.e. it can be easily sold in order to pay out redeeming unit-holders.
Most institutional fund managers are obligated to match and ideally outperform some kind of investment benchmark.
If they’re managing a portfolio of US domestic blue chip stocks and large cap companies, then the benchmark will likely be an index like the Standard and Poor’s 500 stock index. Those 500 US businesses that are worth more than any other in the market.
If they’re managing a portfolio of global stocks, then their benchmark is likely to be something like the MSCI World Equity Index.
But the composition of the index matters a lot.
68% of the MSCI World Index is currently allocated to the US. This means that any global equity manager effectively has to have 68% of his or her portfolio dedicated to the US, irrespective of whether there is any inherent value in that market or not. This sort of indiscriminate madness is just one reason to be wary of passive exchange-traded funds and index-trackers.
As a private investor, you can buy what you want.
Even if you buy a concentrated position within your own portfolio — lots of one particular kind of stock, for example — you’re not going to move the market against you while you establish that position.
Fund managers have that problem day in, day out. But you don’t have to limit yourself to the largest stocks in your benchmark – because you don’t have a benchmark.
Nobody is trying to pick you off… or profit from your trading habits. You can operate under the radar, if you will.
Large cap domestic stocks, small cap foreign stocks, mid-cap emerging market stocks – you can buy literally anything you want. Institutional fund managers simply don’t have that flexibility. They have to buy from a comparatively small, fixed template of stocks, and they constantly have to worry about managing the liquidity profile of that portfolio.
Perhaps the single biggest opportunity set available to the private investor – one that is ‘out of bounds’ for most institutional managers — is the world of small cap companies.
Those are listed businesses with a market value of, say, between $300 million and $2 billion.
Small cap companies can make decisions more quickly than their larger competitors. Being nimble, they can take advantage of market opportunities more quickly than large conglomerates with top-heavy executive boards and bureaucratic management committees.
Being small, they can double in size more quickly than large companies.
If we could only use one phrase to sum up why fund managers so often fail to meet their investors’ expectations, it would be this one. A typical fund manager has little or no ‘skin in the game’ – it’s not like he’s managing his own money, so he’s more likely to want to hug that benchmark until it squeaks.
From 2003 to 2006, for example, the chief investment officer of T. Rowe Price (no relation) amassed ownership of equity in the management company worth over $75 million. His total personal investment in T. Rowe Price’s mutual funds amounted, apparently, to $1 million.
Whatever the quality of the cooking at this fund business, there was precious little eating going on, by this manager, at least.
And in the words of the British economist John Maynard Keynes, for professional fund managers, it’s essentially better to fail conventionally – clinging to that benchmark – than to succeed unconventionally – by actively choosing to steer away from that benchmark, potentially losing one’s job in the process.
Career risk accounts for why fund managers focus only on market relative performance, and almost never on the generation of absolute returns.
But you cannot take relative performance to the bank.
Many fund managers never even see the end investor. That role is intermediated by his own sales force, or by a third-party financial advisor. So it’s no surprise that an economic agent feels less compelled to deliver than a true principal.
As a private investor, the size of your portfolio is no constraint to performance whatsoever.
And because it’s your money, you’re more likely to want to manage it well. You can take the time to investigate opportunities that aren’t available to institutional fund managers. And you have the luxury of time to allow those investments to bear fruit.
These are ingredients for a win. Apple Inc used to run an ad campaign for one of their products that gets the point across nicely: think different.
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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