Chapter 11
On Investment Relativism
Happiness or Misery?
More than at any time in the history of the financial markets (or so it would seem), the quest for investment success has come to center on relative performance over the short term. We have entered what we might call “The Age of Investment Relativism.” All eyes seem focused on a comparison that has become as much a part of investors’ lives as the daily fluctuations in the stock market: “How did my equity portfolio perform relative to the Standard & Poor’s 500 Composite Stock Price Index?” Our happiness or misery seems to depend on how we answer that question.
Some 150 years ago, the impecunious and mercurial Mr. Micawber (in Charles Dickens’s David Copperfield) bestowed happiness or misery according to the following formula: “Annual income, twenty pounds, annual expenditures nineteen six, result happiness. Annual income, twenty pounds, annual expenditures twenty pounds six, result misery.”
Too many mutual fund portfolio managers and shareholders now seem to operate in a system representing a new form of Micawber’s formula: Market return, 17.8 percent, my return 18.3, result happiness. Market return, 17.8 percent, my return 13.2, result misery.
That last set of returns, in fact, describes the shortfall of the average domestic equity mutual fund compared to the stock market (as measured by the S&P 500 Index) over the past 15 years: 17.8 percent versus 13.2 percent. The 4.6 percentage point gap suggests why most equity fund managers are likely to be feeling considerable professional misery—albeit, perversely, along with stunning personal financial gain—as the 1990s end. While, given the great bull market, most fund investors have hardly felt much financial misery, it seems only a matter of time until they recognize not what was, but what might have been.
If the question were simply “Did the professional investment advisers outpace the market over the past 15 years?” the answer is clear. Most advisers did not. Indeed, as a matter of basic mathematics and elementary logic, most advisers cannot outpace the market over the long run. They ought to disclose, candidly and forthrightly (indeed passionately) to shareholders and prospective investors alike, not only the absolute rates of return they have achieved—in individual years and over the long term—but how those returns compared to the returns that would have been achieved by an appropriate benchmark standard accepted by manager and investor alike as a prime measure of success over the long pull. (While the Securities and Exchange Commission has required this type of comparative disclosure in fund investment reports since 1994, it is more often than not deeply buried in the text.)
TEN YEARS LATER
Happiness or Misery
A decade ago, I fear, I asked the wrong question: “Did the professional investment advisers outpace the market?” (Answer: “Most advisers did not.”) The right question: “Did the professional investment advisers make money for their clients?” Answer: “Far less than they claim to have made.” Yet it must be obvious that it is largely making money for investors that creates happiness, even as losing their money creates misery.
It turns out that there is a huge gap between the rates of return reported under current reporting standards by the funds themselves and the rates of return that fund shareholders themselves actually earn. The former we call time-weighted return, essentially the change in a fund’s net asset value during a given year. If, for example, a fund’s asset value during the year increased from $10 per share to $12 per share after the payment of $1.00 of income (or capital gains), the time-weighted return would be +30 percent.
The latter rates of return, what fund shareholders earn, we call dollar-weighted (or asset-weighted) return. To understand this concept, let’s assume hypothetically that the same fund’s assets were $1 million at the start of the year, growing to $1.3 million by year-end, reflecting the 30 percent return. Then, on the last day of the year, investors suddenly recognized that its 30 percent gain was pretty remarkable, so they immediately invested $10 million in the fund. In this obviously extreme case, the dollar-weighted return is just 4.9 percent—less than one-sixth of what the fund reported.
Of course this hyperbolic example overstates the typical difference. But it accurately exemplifies the major gap between the two sets of returns. For the 200 largest funds as of December 31, 1999, for example, the gap for the decade ended in 2003 averaged 3.3 percentage points. The average annual return reported by these funds was 9.8 percent, but the return actually earned by the investors in these funds averaged 6.5 percent. Sounds bad? It’s actually worse. Compounded over the decade, the cumulative returns reported by these funds averaged 152 percent, whereas the cumulative returns earned by their investors averaged just 88 percent, a stunning 64 percent loss of potential capital. Wise investors will demand that the mutual funds in which they are considering investing publish both figures, the better to measure the happiness—or misery—that fund managers have created.
A Powerful Bogey
But, while the change is almost never disclosed to investors, mutual fund managers seem to have decided to shift from a long-term to a short-term focus. Indeed, a powerful focus on
quarterly relative performance has developed, fostered by reporting in the media, by performance-sensitive institutional investors, and by individual investors seeking the latest leaders in short-term fund performance. Advisers have responded as you would expect. Performance is almost invariably based on a single standard—an omnipresent “bogey” (a Scottish word meaning “goblin,”
x and few advisers regard it in kinder terms): the redoubtable S&P 500 Composite Stock Price Index. Curiously, we often see weekly and even daily comparisons after a significant market
drop, but rarely after a sharp rally. The reason: Market indexes are, by definition, 100 percent invested at all times, and managers await (so far, to no avail) confirmation that their cash reserves will offer significant protection in declining markets. While the 30-stock Dow Jones Industrial Average remains our basic measure of
daily market swings, the market-value-weighted S&P 500 is used almost invariably in making relative return comparisons over longer periods.
Today, institutional pension officers scowl over their bifocals as they review the quarterly performance comparisons in regularly scheduled meetings with their investment advisers. Individual investors receive the data each quarter, either in real time on their computers, or later (shocking!) in the next morning’s newspaper. Such short-term focus can be only counterproductive.
These rat-a-tat volleys of comparative information are of relatively recent vintage. Indeed, mutual fund sponsors were prohibited by the Statement of Policy of the National Association of Securities Dealers (NASD) from publishing “total returns”—even without making comparisons—from 1950 through 1965. But, the total-returns teetotalers of the old days became the social drinkers of the early 1970s. It may not be stretching things to say that, by the early 1990s, they were on the verge of becoming alcoholics.
Does it really matter whether today’s omnipresent S&P comparisons have been fomented by the information overload in this miraculous age of communications technology? Or by the self-styled sophistication of institutional clients, who seem to have vested interests in frequently changing advisers? Or by the appetite of mutual fund investors for fund winners over the short term? Or by the overly aggressive marketing of funds? Whatever the reason, relative investment performance—investment relativism, if you will—is the order of the day.
Managers should still be held to a performance standard, but two problems must be recognized: Managers are too often held to a single standard, irrespective of investors’ objectives, and the measurements, far from being appropriately based on long-term investment returns, are overwhelmingly dominated by extremely short periods. We might well ask: To what avail?
Despite the overpowering performance success of the S&P 500 during the past five years—and therefore the improved returns achieved by many closet index funds—large-cap trees do not grow to the sky, and some retribution may lie ahead. (Investors who believe that large - cap stocks are somehow destined for permanent ascendancy, of course, would fare better in a low-cost true S&P 500 Index fund.) But in the long run, investors will not be well served when fund managers, caught up in the perception that beating the market each quarter is happiness and losing is misery, use the S&P 500 Index as the mandatory measuring stick for their own portfolios. All too often, the script reads: “S&P technology stocks, 14 percent of the value of the index, 21 percent of my portfolio; GE, 3 percent of the S&P, 1.2 percent of my portfolio,” and so on. The manager then attempts to rectify such mismatches. In this practice, clearly, the benchmark supplants judgment. Portfolio managers invest not on the basis of analysis and conviction, but in relation to a market standard, gingerly shading the weights of their portfolio holdings somewhat higher or lower than those of the benchmark. In the absence of genuine managerial judgment, the implicit questions quickly follow: “Is my ‘bet’ [as it is usually described] the right one? Or should I align my portfolio more closely to the Index?” A lot of casino capitalism, by managers and investors alike, is being labeled as investing, and betting—even betting not to lose—may be the best word to characterize a strategy of overreliance on the composition of an unmanaged and relatively unchanging market index.
The Rise of Closet Indexing
Taken to extremes, the process seems to work something like this: “I think Coca-Cola stock is grotesquely overvalued. But, in case it keeps going up, I’ m going to buy a 1.5 percent portfolio position for protection. Since that’s less than Coca-Cola’s 2.0 percent weight in the S&P 500 Index, I’ll have a good defensive position versus the Index when Coca-Cola takes the tumble it so richly deserves.”
Isn’t that philosophy the antithesis of professional investment management? Yet hasn’t it become the formula followed by nervous portfolio managers anxious to hold their jobs? Isn’t it the result of the marketing department’s holding sway over the investment department? In each case, my finding would be: Guilty as charged.
Such a closet indexing strategy is, in my view, more pervasive than most investors realize. But, whether it permeates a portfolio or takes place at the margin, I’ve never seen it disclosed in a fund’s prospectus. (The handful of quantitative funds with a specific goal of adding incremental returns to a specific market index, however, ordinarily disclose their strategy.) In fairness, when it applies, it applies primarily to the managers of funds investing in large-capitalization stocks. Closet indexing is a relatively simple process when the 10 largest stocks in the S&P 500 Index represent nearly 20 percent of the Index. Even if it creeps into the small-cap side of the business, closet indexing seems unlikely to permeate that side. In the Russell 2500 Small Cap Index, the largest 10 stocks constitute 2.4 percent. But the fact is that large-cap stocks dominate the financial markets, with the 500 large-cap stocks constituting the S&P 500 Index accounting for some 75 percent of the total value of all U.S. stocks. Large -cap-dominated strategies account for roughly three-fourths of the assets of all equity mutual funds, and an even higher proportion of institutional assets.
Closet indexing may well be having an impact on stock returns. I never ascribe causality to any of the myriad factors that affect the price of a stock, but it seems more than coincidence that from 1996 through June 1998 the largest gains among the blue-chip stocks whose capitalizations dominated the market came to those stocks in which mutual funds held the smallest relative positions. The five largest stocks in the S&P 500 Index that were most underowned by mutual funds returned almost 50 percent annually, compared to an average gain of roughly 24 percent for the remaining 495 stocks. In other words, the Lucents and Microsofts—so large that even the enormous mutual fund industry owns just a modest percentage of their equity—have led the market forward.
Could it be that active managers, in their passion to compete with the passive S&P 500 Index, are primarily responsible for driving up the price of the underowned large stocks, giving it, over the past three years, when it surpassed 95 percent of equity funds, the most formidable record of outpacing active fund managers in history? Are managers forcing their portfolios to become more Indexlike, so as to avoid serious shortfalls in the quarterly comparison sweepstakes? And, if so, are managers sowing the seeds of their own performance inferiority today? Stranger things have happened.
The overarching goal of this era of investment relativism seems to be the avoidance of inferior short-term returns relative to the S&P 500, rather than the achievement of superior absolute long-term returns. If this industry ever had a chance to produce another Peter Lynch, or perhaps the next Warren Buffett, that chance is disappearing fast. Since quantitative science entered the business of mutual fund performance in the mid-1980s, relativism has become the basis of a comprehensive performance measurement system. Beta (risk, measured by the fund’s price volatility relative to the S&P 500 Index) and alpha (the fund’s rate of return, adjusted for risk, relative to the Index) have entered our lexicon. We also have the Sharpe ratio, which measures a fund’s excess return over a Treasury bill relative to its risk (standard deviation)—not to be confused with the Selection Sharpe ratio, an information ratio that measures excess return over a benchmark standard—conventionally, of course, our devilish friend, the S&P 500 Index. And these formulas, once the exclusive domain of professionals, are even discussed by individual investors at coffee breaks and cocktail parties. I do not believe that this focus on simplistic mathematical precision is a healthy state of being for managers, nor for their clients, nor for the market itself. Yet there is no end in sight—no omega on the horizon to the spread of closet indexing strategies. In fact, as industry assets grow, their growth is almost sure to accelerate.
“If It Looks Like a Duck ...”
Given the focus on measuring large-cap funds, in particular, against the Standard & Poor’s 500 Index, many large funds have clearly become closet index funds, emulating the Index, albeit not so closely as to abandon all hope of surpassing it. Just when a
casual focus on the weightings of portfolio holdings in industry groups and individual stocks relative to the S&P 500 Index becomes an
obsession, and then crosses the line to become a firm (if undisclosed)
policy will rarely be clear. But there are several pieces of evidence for investors to consider in evaluating whether a fund has become a closet index fund. (Each of them can easily be found in
Morningstar Mutual Funds.)
1. Asset size. When large funds grow very large, they inevitably become less flexible in their policies, concentrating their portfolios on stocks with large capitalizations.
2. Portfolio composition. Funds with 80 percent or more invested in large-cap stocks, similarly weighted to the industry groups in the Index.
3. Individual portfolio holdings. Funds with, say, more than 15 of their 25 largest holdings among the 25 largest stocks in the Index.
4. Correlation. An R2 statistic of 0.95 or more, meaning essentially that 95 percent of the fund’s return has been determined by the return of the Index.
The managements of the funds that become—to all intents and purposes—closet index funds, of course, vigorously deny that such is the case. An executive for one huge fund company put it this way: “It’s okay for a manager not to own Microsoft [now the largest stock in the 500 Index] but I don’t want someone doing that inadvertently or unconsciously.” Read: “If the stock is going up, that manager had better have a darn good reason for not owning it.” Another form of denial is “Less than half of our stocks are in the Index,” without acknowledging that 80 percent of the value of the fund’s portfolio is. Self-serving denials by management may be less useful than the wisdom of the old saw: “If it looks like a duck, and it walks like a duck, and it quacks like a duck, it is a duck.” Or at least an odds-on candidate to be a duck.
The Index Fund: Villain of the Piece?
The most important reason for the defensive reaction of fund managers to index comparisons and the rise of closet indexing is the index fund itself. The S&P 500 Index is a mean adversary, but the index fund is the real villain of the piece. Once upon a time, managers defended themselves by using a simple retort: “Yeah, but who can buy the market?” Later, the more sophisticated response was: “Yeah, but the index is theoretical, and it would cost a lot to buy, so you wouldn’t be able to nearly match the index.” By making it possible for even the smallest of investors to buy the market, low-cost index funds have given the lie to these foolish makeweight arguments. But even though I founded the first index mutual fund way back in 1975 (perhaps the Bogle goblin really was the data devil), index funds did not begin to catch the fancy of investors and become a formidable competitor for their assets until the late 1990s.
To the extent that it is becoming the investment of choice, the index fund is taking its rightful place within the mutual fund industry. It is the odds-on favorite to outpace three of every four managers. For the market as a whole, low-cost investing in a highly diversified portfolio of stocks—a loose but accurate description of an index fund—ineluctably beats investing in a diversified portfolio of high-cost funds over the long run. Admittedly, the S&P 500 Index has had a particularly good run over the past 15 years. But the S&P 500 stocks also make up 75 percent of the total market’s value. In the long run, their aggregate return should parallel the total market. An index fund targeted on the Wilshire 5000 Index, of course, will match the market over the long term and the short term alike. In any event, the index fund marketplace, now dominated by S&P 500 strategies, is increasingly moving in the direction of all-market indexing. Over time, this broader strategy may well become the principal choice for institutional indexers and fund indexers alike.
The time must also come when investors, analysts, and the media use indexes from market segments as the standards for funds with particular investment styles (i.e., large-cap value, small-cap growth, and so on). As I pointed out in Chapter 6, the advantages of an index strategy are equally apparent in all market-cap categories and in all investment styles. As a result, market-segment index funds are likely to take their proper place in the marketplace, and indexing in all its forms should continue to gain even greater acceptance by investors.
We’re All Quants Now
There is more bad news for fund managers. Another form of indexlike competition—quantitative investing—is emerging, and I’ m confident that it, too, will take its place in the field. The widespread use of quantitative techniques and computers to screen and value individual stocks and stock groups in the traditional security-analyst-based management process has spread to what is called quantitative investing, computer-driven investment policies that rely rigidly and exclusively on mathematical formulas to set strategy or to select stocks for investment portfolios. (“We’ re all quants now.”) Current industry estimates place the assets managed by quants at $100 billion, and the growth rate has been strong.
Some of these quantitative strategies might fairly be described as the ultimate forms of investment relativism. But they must not be confused with closet indexing. With fully disclosed policies and strategies, they are hardly hidden in a closet. Their strategies are rigorous and controlled, not random and intuitive, and their costs are often well below conventional norms. It’s far less costly to run a computer program than to employ a large portfolio research and management staff.
Through a strategy typically known as enhanced indexing, such funds seek explicitly to outpace a particular market index, all the while attempting to severely limit variations from the index return (so-called tracking error). Most use sophisticated computer models to select a diversified portfolio of stocks whose characteristics are closely aligned with the target index in such areas as industry sectors, and market characteristics in such areas as price-to-earnings and market-to-book ratios. The first mutual fund in this category, begun in 1986 and operated at a cost far below industry norms, has bettered the index itself, but only slightly. The margin it achieved, however, was sufficient to give it a meaningful edge over an index fund (by reason of its costs, low as they were) in long-term accumulation. The overall evidence of success in such disciplined and/or sector-neutral strategies, as they are known, is quite mixed, but my guess is that these strategies will ultimately prove attractive to investors who realize the value of indexing but can’t quite enter an index fund and abandon all hope that they can identify in advance active managers who will outperform the index results. Provided that quantitative funds become available at costs competitive with those of index funds—and succeed in providing extra returns—enhanced indexing may also represent an important challenge to the status quo.
TEN YEARS LATER
Quantitative Investing
While we’re not “all quants now” (as I wrote a decade ago), quantitative investing has carved out a huge niche in the strategies of money managers over the past decade. While a, well, unquantifiable number of mutual funds rely heavily on mathematical models, the amounts invested in strategies described in the previous edition as “enhanced indexing” have exploded.
By mid-2009, the amount invested in enhanced indexing strategies (which were not even tabulated at the decade’s start) had grown to a remarkable $174 billion in domestic and international stocks, and another $46 billion in bonds. But as (Continued) this asset base grew, the enhanced returns earned by the quants declined. By 2007 and 2008, anecdotal evidence suggests that the positive margins of the prior decade had in fact turned significantly negative. That pattern of performance—winning strategies becoming the mode of the day, attracting many dollars, and then no longer working—is hardly without parallel in the long history of the financial markets.
Measuring Managers—Where Does Your Manager Stand?
Faced with the new competition from index and quantitative funds, how should traditional managers respond, and what issues should shareholders consider? If closet indexing is a wrong or even a counterproductive response—as I believe it is—what is the right response? First, a given: Advisers should freely acknowledge to investors that they should be expected to outpace an agreed-on market performance standard over the long run, and that they will strive to do just that. What else is an adviser supposed to do? How else can we measure whether the economic value being created is sufficient to justify the cost of retaining the adviser in the first place? The all-embracing standard need not be—it should not be—the S&P 500 Index, although it obviously would seem to be for large-cap funds that are a blend of growth stocks and value stocks. For managers who purport to have open charters to invest wherever they wish, broader all-market indexes seem most appropriate. They should no longer be virtually ignored.
Other index styles are appropriate standards for other types of funds. Indexes measuring returns for each style/market-cap box will also become part of our world. It is simply unrealistic for small-cap or mid-cap managers to replicate (that is, to parallel) the long-term record of an all-market index. Their performance should be measured against the market segment(s) in which they choose to participate. Weighted indexes combining appropriate levels of large-cap and small-cap stocks, value and growth stocks, and international stocks surely make sense for funds that define their investment policies in these terms. Blame the fund investor if he or she selects a fund with a small-cap strategy that fails to outpace the return of the total market over the long term, even though it outperforms the small-cap universe. But blame the fund manager if its small-cap fund fails to outpace the small-cap universe, even if its long-term return surpasses the return of the total market.
Both investors and managers should consider the role of bonds and cash reserves in the asset mix of the target index. Stock indexes (and index funds), to state the obvious, hold neither. A balanced fund should be measured against a balanced mix of stocks, bonds, and reserves. And it would not necessarily be foolish for an adviser to an equity fund that, in order to moderate risk, holds a fairly consistent 5 percent to 15 percent position in cash reserves to use a similarly adjusted stock/reserve benchmark.
It is important for investors to understand that it is next to impossible to market-time a changing cash reserve position. The mutual fund industry, in fact, tends to hold reserves in a thoroughly counterproductive fashion, with large reserves at market lows and small reserves at market highs. (Paradoxically, some market timers use fund cash reserve positions as a timing indicator; they believe it is a reliably contrary indicator.) Most important of all, given a positive stock market over time, investors must understand that whether a fund has a steady reserve position or a varied one, they will pay a commensurate price in the rate of return they earn. To be sure, the volatility of the fund may be marginally reduced. But investors must understand, as I have noted, that over the long run a percentage point increase in volatility is meaningless; a percentage point increase in return is priceless. The sharp contrast between those two powerful, and I think virtually unarguable, axioms should give advisers and investors ample food for thought.
“If You Can’t Beat ’Em, Join ’Em”
Faced with the competition of index investing and quantitative investing in this age of investment relativism, too many managers are responding in the most ineffective manner possible: closet indexing. But shaping an inchoate and undisclosed policy around the structure of an index is, ultimately, managerial suicide. It is the ultimate concession to the unarguable economic value of a low-cost, passively managed index fund over a high-cost, actively managed traditional fund. That this policy is undisclosed, or even denied, is not its primary failing, however. The problem is simply that the more a fund’s fees and expenses exceed index fund levels (say, 0.2 percent per year for the low-cost index funds) and its portfolio turnover surpasses nominal levels, the more likely its attempt to emulate the index will result in failure. (Low expenses, low turnover, and a fully invested participation in equities are the hallmarks of index fund excellence.) In short, today’s chance of victory, as small as it demonstrably is for active managers, will become tomorrow’s certainty of defeat if managers offer tacit index funds with high fees, high portfolio turnover, and even a modest position in cash reserves. And it is mutual fund shareholders who will pay the price.
Relativism suggests that managers are becoming more similar to the enemy: “If you can’t beat ’em, join ’em.” But, in the long term, being different gives an individual manager at least a fighting chance to win the battle for extra market return. Holding to a clearly differentiated strategy—and keeping a tight lid on fees and other costs—to cope with the realities of index competition is better than just standing there and hoping, as Mr. Micawber did, that “something will turn up.”
Fortunately, not all fund managers subscribe to the new relativism. Indeed, some of the better mutual fund managers find it repugnant. A recent article in
Money magazine suggests that investment relativism is caused by “aggressive marketing executives who see short-term numbers as the best way to attract new shareholders.”
1 One top portfolio strategist says: “That’s the marketing side of the business talking, not someone with a fiduciary duty.” Another portfolio manager asserts: “Relative investing is ridiculous.” Still another routinely consults what he describes as his Eleventh Commandment: “Thou shalt not do relative investing.” Warns yet another: “Relativity worked well for Einstein, but it has no place in investing.”
Mutual fund managers who elect to be different (I wish there were more of them) need to make it absolutely clear to shareholders that their returns will not closely track the quarterly returns, nor even the annual returns, of a market index. They should make it equally clear that their expectation is to outpace the market over the long run (or alternatively, that they don’t expect to outpace it, and why they don’t, which would be an interesting statement indeed). Today’s pervasive short-term comparisons are merely noise—a discordant element that ill serves managers and investors alike. In this context, I borrow a phrase from William Shakespeare to describe the short-term noise in the market: “A tale told by an idiot, full of sound and fury, signifying nothing.”
Relativism is the triumph of process over judgment. I believe that it is possible for some managers to apply judgment born of wisdom and experience in the selection of a stock portfolio that will outpace the market over time, without assuming undue risk. Those managers will be extraordinarily difficult to identify in advance, but investors have a fighting chance to win if they seek experienced professionals with individuality, training, experience, savvy, determination, contrarianism (or sheer iconoclasm), and a capacity for hard work. The Puritan ethic is not all bad! Importantly, these winning managers will limit the assets of the funds they manage, relative to the market capitalizations of the asset classes in which they utilize their expertise, and suppress their proclivity to actively trade the portfolio rather than to analyze, buy, and hold stocks for the long term.
Some successful managers, rather than being concerned with short - term relative risks, will run fully invested equity positions with relatively low portfolio turnover, in order to capitalize on the fundamental long-term opportunities offered by investing in carefully selected equities. Rather than slavishly relying on short-term standards, others will succeed simply by investing according to the courage of their convictions and holding cash reserves when they judge market risk as excessive. Both groups will manage their funds at reasonable costs, allocating their fee revenues toward human talent and investment productivity, not marketing profligacy designed to advance the management company’s own profitability rather than to improve investment returns for fund shareholders. To be successful in an environment where indexing and perhaps quantitative strategies will become increasingly pervasive and fully competitive, the successful mutual fund investment manager must serve the shareholder’s interest—first, last, and solely.
Dickens Returns
In another Charles Dickens novel, A Tale of Two Cities, these famous words come first: “It was the best of times. It was the worst of times.” For the past 16 years, we have witnessed the best of times for the stock market: a bull market of unprecedented magnitude, creating happiness and wealth beyond measure for both fund managers and fund investors. But it also could be seen as the worst of times (though it is hardly perceived that way yet) for fund owners, who will surely be filled with misery when they realize what might have been—the wealth that might have been created for them if their funds had generated returns approaching, or even exceeding, the returns generated by the stock market itself. The record of the age that has brought investment relativism to the fore and left common sense in the dust has been less than a ringing tribute to the implied promise of professional managers to their shareholder-clients: to provide superior long-run returns.
TEN YEARS LATER
Investment Relativism
To believe that the higher mathematics of the brilliant quants that now permeate—directly or indirectly—our system of financial markets can consistently add value to investor returns is to fail to understand the self-correcting nature of the markets. Worse, the rise of mathematical models can easily give rise to an illusion of value creation that belies reality.
We were warned about this problem a long time ago by one of the wisest of history’s investors. In 1958, in his inaugural address as president of the New York Society of Security Analysts, the great Benjamin Graham minced no words:
Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom. . . . Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience and usually also to give to speculation the deceptive guise of investment. . . . Have not investors and security analysts eaten of the tree of knowledge of good and evil prospects? By so doing have they not permanently expelled themselves from that Eden where promising common stocks at reasonable prices could be plucked off the bushes?
Now, more than a half century later, Graham’s message seems remarkably prescient. This time around, let’s take heed.