More on Beating the Market (constructive)

I know, I know. But, this article was too thought-provoking, and it explains the myth that the pros don’t beat the market:

A common reaction is that beating the market is too difficult and that it’s therefore a waste of time and money to try.But just the opposite is true. As I’ve previously noted, the problem is not that active managers fail to outperform the market; it’s that they keep that outperformance for themselves through high fees.

https://www.bloomberg.com/gadfly/articles/2017-03-30/even-be…

In the meantime, index providers have turned traditional styles of active management – such as value, quality and momentum – into shockingly simple indexes run by computers. Those indexes have beaten the market and are now widely available to investors as low-cost smart beta funds.

Smart beta has proved to be a popular alternative to traditional active management. According to Morningstar, investors pulled $313 billion out of actively managed mutual funds over the last five years through 2016. At the same time, they invested $314 billion in smart beta mutual funds.

The author then goes on to compare some really great funds from history (Magellan from 1977 to 1990, returning 29.1% annually!) to simple programmatic strategies that have the risk/reward profile.

We’ve all heard about super-advanced programs relying on micro-second trading advantages to bring in big profits for those companies able to hire top notch programmers, but this article is showing the equivalent to LTBH: simple calculations that could be employed using Excel macros and Yahoo stock price and data feeds. For instance, Dartmouth professor Ken French came up with a simple quantitative value strategy that selects the cheapest 30 percent of U.S. stocks by price-to-book ratio and equally weights among them. That strategy returned 23 percent annually over the same period as Lynch’s Magellan Fund, with a standard deviation of 17 percent. No Day Trading, no micro-second internet advantages needed.

But, there’s more.

I feel a second article is needed - What happens to “Technical Analysis in this world of programmatic mutual funds?” The art of TA has been built based on human reactions to price swings (eg, http://www.investopedia.com/articles/trading/04/011404.asp). If serious money is now controlled by computer programs instead of humans (whether those be retail investors like us or mutual fund managers), then someone who understands what the fund programming will do in certain situations might be able to position themselves to “play the player, instead of playing the cards.”

So, instead of “filling the gap” or “cup and handle” there might be predicting which stock will be cheapest in terms of price-to-book and invest in those, since that algorithm runs billions in funds (and historically that returned 23% annually from 1977 to 1990). Or it could look at the 30th least expensive price-to-book company and sell that since it’s at risk of falling below the computer program’s metric, and when that does happen that program will sell a ton of that company’s stock, so we bet against that stock just before that criteria is met. Or, big programs that trade a company or two specifically to affect it’s stock price and make it meet or fail certain other program’s criteria.

As for myself, I’ve got some money in index funds, but mostly I’m still a growth-seeking, story-loving, individual- stock picking dinosaur. But, I’m less than a decade from retirement. The young-ins among us may do well to consider these new “Smart beta” mutual funds for at least a portion of their portfolio.

10 Likes

Using the simplest measure of risk-adjusted return – annual return divided by standard deviation – both Lynch and the value strategy notched identical return-to-risk ratios of 1.4.

How to tell lies with statistics! By fiddling with “risk-adjusted return” they claim that Magellan’s 29.1% is no better than Ken French’s 23%. Let’s do the numbers:

Invest $1,000 in each fund. At the end of May 1990 Magellan’s account has $27,740.00 while Ken French’s account has only $14,770.00, a whooping $12,970.00 difference in favor of Magellan, 87.8% more than Ken French’s risk adjusted nonsense.

I can assure you that the corner grocer will take in payment the extra cash generated by Magellan but will laugh you out of the place if you try to pay with risk adjustment.

Two economists went deer hunting. They spotted one and fired. One missed by five feet to the right and the other by five feet to the left. In unison the shouted “BULLSEYE!”

Denny Schlesinger

11 Likes

Two economists went deer hunting.

I tell that joke all the time, too.

But, remember, we’re comparing to one of the greatest mutual funds of our (recent) times. That a simple program can achieve 23% per year over a 13 year period is pretty remarkable. The S&P with DRIP was under 15% for that same period. And as we know, most mutual funds don’t even make S&P level returns. It’d be interesting to pursue it and see how that simple program does over longer/shorter terms and different points in history.

And still, there is a need to factor in risk when making investments. I could probably investments that made more than Lynch, but at the time the perceived/calculated risk was significantly higher. So I do believe that factoring risk into an evaluation is appropriate.

In any case, the trend appears clear: $300Billion in funds moving from human manged funds to programmatic/index funds in the past 5 years is something to pay attention to.

4 Likes

What are some examples of these funds? I have some money in Vanguard’s small-cap and mid-cap Value Index Funds, but I don’t think that’s what you’re talking about, though there could be quite a bit of overlap on the stocks chosen.

1 Like

It’s best to Google Smart beta Funds or Smart Beta ETFs and read through the articles listed at Investopedia and work from there.

Perhaps someone else has a better reference guide. But this seems to cover it.

British Prime Minister Benjamin Disraeli: “There are three kinds of lies: lies, damned lies, and statistics.”

2 Likes