Opinion

Felix Salmon

Why guru ETFs beat human gurus

By Felix Salmon
November 21, 2013

Wall Street is no place for shrinking violets, but even by New York standards, Jason Ader has some serious chutzpah: he said today that “the proliferation of index funds and exchange traded funds” helps activist investors like himself make money.

These big investors are rarely holding “management accountable for underperformance and are not pressuring boards to hold management accountable for underperformance,” Ader said at the Reuters Global Investment Summit.

Funds run by well known activists, including Jeff Ubben of ValueAct, Barry Rosenstein of Jana Partners, and Carl Icahn, have returned roughly 14 percent on average so far this year, twice the amount that the average hedge fund has delivered, partly because they cajole businesses into running their operations better, the activists say.

In principle, this makes sense. One common criticism of passive investing is that if everybody did it, then there would be no price discovery — and that the more passive investors there are, in a market, the easier it becomes to take advantage of them with a little bit of sophisticated analysis and/or activist investing.

But the point at which passive investing becomes self-defeating is a bit like the point at which the gradient of the Laffer curve turns negative, and tax hikes cause revenue losses rather than revenue gains: both points are far beyond any state of the world that obtains in real-life America. Passive investors are still a minority of all stock-market investors — and, what’s more, they could easily become a majority without doing any harm to the markets’ price-discovery abilities. The only thing that matters is that there’s a reasonably large number of active marginal price-setters. Since there always will be a reasonably large number of active marginal price-setters, no one ever need fear that the rise of passive investing is going to become self-defeating.

In any event, it’s a simple mathematical truth that activist investing has not outperformed passive investing this year. That 14% return looks downright miserable, if you compare it to the 25% year-to-date return on the S&P 500, or any index fund which tracks it.

Of course, if your dream is to beat the market, then you’re going to have to invest in something other than a passive index fund. But don’t kid yourself that the rise of the passive-investment gospel is going to make your life any easier: it isn’t. And don’t kid yourself, either, that paying 2-and-20 to anybody is a sensible way to try to achieve your goal. Indeed, there’s an increasing number of relatively low-fee ETFs which aim to replicate the results you’d get from investing with some of the biggest-name investors in the market. (Or, of course, you could just buy stock in Berkshire Hathaway.)

These “guru” ETFs, as they’re known — one of them even trades under the GURU ticker symbol — are an outgrowth of the hedge-fund replication industry, and have varying degrees of sophistication. Charles Sizemore does a good job of comparing them: ALFA is incredibly complex; GURU is simpler; the forthcoming iBillionaire ETF (plugged by Tim Fernholz under the headline “How to copy a hedge fund billionaire’s investment plan”) is downright naive, based as it is on a strategy of simply looking for S&P 500 components in the 13F filings of certain billionaire investors.

It’s easy to laugh at these things — 13F filings, for instance, are lagging indicators which don’t give any indication of how hedged an investor is, or whether they’re putting on some kind of relative-value trade, or what their exit strategy might be. But never mind all that: iBillionaire has lots of pretty charts showing consistent outperformance over various time periods from one month to 8 years. This is “hypothetical” outperformance, of course — and surely the index has been structured, and the billionaires in it carefully chosen, so as to make the index look as attractive as possible from today’s perspective. Here more than ever, buyer beware: it’s all but certain that the index’s outperformance will start to disappear now that its immune to selection bias.

But the fact is that not all ETFs need to be passive cap-weighted index-trackers, and buying one of these guru ETFs is no sillier than buying a typical actively-managed mutual fund. In fact, it’s probably more sensible, since the discipline of the ETF strategy is baked in to its structure, and it’s harder for an all-too-human manager to make silly mistakes. On top of that, no matter how high the fees on these ETFs might go, they’ll never come anything close to the kind of fees being charged by Jason Ader and his ilk. The ETFs just sit back and follow a predetermined strategy, rather than feeling the need to do the rounds of media organizations, spouting random “conviction trades for the coming year”. Cheaper and quieter? It’s a winning combination.

Comments
2 comments so far | RSS Comments RSS

http://www.ritholtz.com/blog/2013/11/the -wyatt-earp-effect/?utm_source=feedburne r&utm_medium=feed&utm_campaign=Feed%3A+T heBigPicture+%28The+Big+Picture%29

“In numerous studies (most prominently those by Edwards and Estes, as reported by Philip Tetlock in Expert Political Judgment), the stated task for observers was predicting which side of a “T-maze” held food for a subject rat. Unbeknownst both to observers and the rat, the maze was rigged such that the food was randomly placed (no pattern), but 60 percent of the time on one side and 40 percent of the time on the other.

The rat quickly “gets it” and waits at the “60 percent side” every time and is thus correct 60 percent of the time. Human observers, however, kept looking for patterns and chose sides in rough proportion to recent results. As a consequence, the humans were right only 52 percent of the time. They (we!) are much dumber than rats. Overall, we insist upon rejecting probabilistic strategies that accept the inevitability of randomness and error and upon rejecting the idea that randomness is a crucial component of our success (on account of self-serving bias, randomness is seen as only being behind our failures).”

Obviously, the best thing to do is look for a “rat” guru or better yet, a “rat” ETF…
;)
More profound is that little thing of statistics and framing the question properly: out of all the mutual funds, how many would you expect to “outperform”?

“More to the point, the odds of such a streak happening are not actually all that long when the question is examined properly. As Leonard Mlodinow has explained, the proper question, given the number of mutual funds that have existed in the modern era, concerns the odds that any of them would have beaten the market over any 15-year period of time due to chance alone? That answer is an extremely surprising one: almost three out of four.”

Posted by sacramentodan | Report as abusive
 

“One common criticism of passive investing is that if everybody did it, then there would be no price discovery — and that the more passive investors there are, in a market, the easier it becomes to take advantage of them with a little bit of sophisticated analysis and/or activist investing.”

This is somewhat true, but more important is the quality of others that you are competing against. Even if the market is 90% passive, that share in a sense is immutable – they simply do not partake in price discovery. It is the other 10% whom you are competing against. You only “outperform” when you guess better than they do.

http://www.wisebanyan.com

Posted by ArCaMa | Report as abusive
 

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