Larry Swedroe – who’s writing I frequently enjoy – recently published a post on ETF.com entitled Scale’s Effect on Active Performance. The post is an excellent summary of the academic research into the relationship between fund size and performance which finds that active managers find it tougher to beat the market as they get bigger.
Towards the end of the article, Swedroe lists several possible explanations why this is the case, one of which caught my attention…
Third, the competition is much more highly skilled today. As Charles Ellis explained in a recent issue of Financial Analysts Journal, “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. … They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”
Ellis has been a proponent of this view for many years, most notably in his excellent book Winning the Loser’s Game, 5th Edition: Timeless Strategies for Successful Investing. Here are some quotes…
Unhappily, the basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management … 85 percent of investment managers have and will continue over the long term to underperform the overall market.
The problem is not that investment research is not done well. The problem is that research is done very well by many… As a result, no single group of investors is likely to gain and sustain a repetitive useful advantage over all other investors on stock selection. Because they are so large, so well-informed, and so active, institutional investors set the prices. That’s why the only way to beat the market is to beat the professionals who, as a group, are the market.
Just how good and tough to beat are the hundred largest institutions? Here are some realities: The very largest institutions each pay Wall Street $1 billion annually and pay their leading stockbrokers as much as $100 million apiece, and the stockbrokers earn it by making the best markets and providing the best research services they can deliver. The institutions have Bloomberg and all the other sophisticated information devices. Their professionals meet with corporate management frequently. They all have teams of in-house analysts and senior portfolio managers with an average of 20 years of investing experience – all working their contacts and networks to get the best information all the time. You get the picture: Compared to any individual investor, the institution has all of the advantages.
Sounds convincing, almost incontrovertible, doesn’t it? I must admit, that I have some sympathy for this line of reasoning. I recommend that every active investor read Ellis’ book while trying to keep an open mind. This may be hard to do, as many active investors believe in active management with an almost religious fervor.
If you do read it with an open mind, you’ll probably come to the same conclusion as I did: the majority of individual investors and institutions would be better off indexing. But don’t just take my word for it, check the research.
My opinion is based predominantly on the observation that most individuals and institutions can’t help but get themselves into trouble because they make errors in judgement and have difficulty controlling their emotions and their behavior. In other words, we’re human (myself included!) and we find it difficult to patiently stick with an active strategy, with the uncertainty and discomfort that may bring, long enough to reap the rewards (see my earlier post on how long it can take for active management to work).
This also results in active fund managers running”closet index” investment strategies – active enough to hopefully attract investors, while close enough to the benchmark to reduce the risk of getting sacked (you can read more about this in an earlier post: Beating the Market Part 3: Sheep Get Slaughtered). You could argue that this is, in some way, a rational response to the impatience of their clients.
That said, I’m not sure that it necessarily follows that its impossible to beat the market because the market is made up of too many smart people. In fact, the counter-argument could also be made: that too many smart people make the stock market even more inefficient.
For example, here’s a quote from Scott Fearon’s book: Dead Companies Walking, which I highly recommend. Fearon is a long-short equity manager with a long-term track record of out-performance. On page 206, he profiles the personality of the typical institutional investor under the sub-title: The Most Dangerous People in the World…
The financial world suffers from an inherent flaw: the people who work in it, by and large, are terrible investors.
Number one: They’ve spent their whole lives going along to get along. They’re climbers, strivers, joiners, cheerleaders. (That’s how they got those good degrees and those prestigious jobs in the first place!) This makes them naturally prone to groupthink and all to susceptible to manias and bubbles.
Number two: They are hypercompetitive, which keeps them from admitting failure and adjusting their strategies when things inevitably go wrong. This makes them all too susceptible to disastrous behaviors like averaging down and clinging to bad ideas.
Number three: They worship rich and powerful people, so they automatically defer to authority instead of questioning popular assumptions. Again, this makes them susceptible to manias and asset bubbles. It also creates an even more destructive mind-set –once they themselves rise to positions of power, they see themselves as infallible and worthy of worship.
Add it all up and there’s only one conclusion you can reach: these are the last people you want safeguarding your money.
Let’s suppose that Fearon’s profile of the typical institutional investor is accurate. In that case, isn’t it possible that filling the market with more materialistic, hyper-competitive people with a herd mentality is likely to make the market even more inefficient?
Of course you may be thinking that Fearon is overly harsh in his assessment of the average institutional investor. Fair enough. What then? Here’s a quote by the legendary hedge fund manager Seth Klarman in a paper entitled A Response to Lowenstein’s Searching for Rational Investors In a Perfect Storm…
Let me offer a simple thought experiment. Imagine that every adult in America became a securities analyst, full time for many, part-time for the rest. (With close to half the adults in this country already investing in stocks or mutual funds, this may not be. Every citizen would scour the news for fast-breaking corporate developments. The numerate ones would run spreadsheets and crunch numbers. The less numerate would analyze competitive factors for various businesses, assess managerial competence, and strive to identify the next new thing. Now, for sure, the financial markets would have become efficient. Right? Actually, no. To my way of thinking, the reason that capital markets are, have always been, and will always be inefficient is not because of a shortage of timely information, the lack of analytical tools, or inadequate capital. The Internet will not make the market efficient, even though it makes far more information available at everyone’s fingertips, faster than ever before. Markets are inefficient because of human nature—innate, deep-rooted, and permanent. People do not consciously choose to invest according to their emotions—they simply cannot help it (emphasis added).
As many smart people as there may be in a market they will still be people; influenced by the same emotions and subject to the same foibles as the rest of us.
One more viewpoint to consider. Institutional investors, whether smart or otherwise, are generally links in a long chain of principal and agent relationships, each with its own potential for conflicts of interest.
Believers in market efficiency (i.e. too many smart people in the market mean that the it’s impossible to beat) largely ignore effects of the principal and agent problem as Professor Paul Woolley from the London School of Economics explains in “Why are financial markets so inefficient and exploitative – and a suggested remedy”:
The crucial flaw has been to assume that prices are set by an army of private investors, or the “representative household” as the jargon has it. Households are assumed to invest directly in equities and bonds across the spectrum of the derivatives markets. Theory has ignored the real world complication that investors delegate virtually all their involvement in financial matters to professional intermediaries… who therefore dominate the pricing process.
Delegation creates an agency problem. Agents have access to more and better information than the investors who appoint them, and the interests and objectives of agents frequently differ from those of their principals. For their part, principals cannot be certain of the competence or diligence of the agents. Introducing agents brings greater realism to asset-pricing models and, more importantly, gives a far better understanding of how capital markets function.
Clearly most investors rely on agents to invest and most agents have conflicted interests. Do we have any reason to believe that having more smart people in the market reduces these conflicts? I’m not sure that it does.
Yes, the market is really tough to beat and most people are probably better off not trying to beat it. But I think it’s debatable that this is due to the problem of too many smart people operating in the market for 3 reasons:
- Markets may attract the wrong kind of people as investors (Fearon)
- Even smart people are still people (Klarman)
- Smart people may be looking out for their own interests (Woolley)