Market Efficiency Q

[devo]

Alright,
I am a relatively new student of the markets and investing. I've found this board to be a great resource. I've read a handful of books(thanks for the suggestions by the way), and done quite a bit of online reading.

I think I "get" the idea that there "is no free lunch." I buy the whole market efficiency idea. I also understand that most of us opt for the indexes (at least on large cap, mathj) to ensure that we realize market returns. The drag of management expenses results in performance that most often trails the benchmarks. Got it. There are so many people studying these companies that it's all in today's price.

My question is how the markets would be affected if a large majority of investors worked the way "we" do? What if all investors refused to pay the ER that accompanies the managed funds? If there was no one paying all those "chimps", as Bernstein calls them, it seems they would lose some of that efficiency. If I understand it right, there are more managed funds out there than stocks for them to buy. With all those funds employing analysts, it seems that the managed funds are a necessary part of the efficiency puzzle. Us DIYers are benefitting on the backs of the uninformed masses that are buying the Street's hype. What if education gets to every investor and no one is willing to pay for management anymore?

I realize I'm speaking in universals here that will never happen. I know there are indexes available in every 401k and the like. Clearly, Vanguard and Fidelity and many others have millions of clients investing in indexes. They're no secret. I'm also certain that there must be some dynamic of the market that I've left out due to ignorance. Then again, that's why I'm here. How do it work?? Is the managed fund a critical piece of the efficient market?

devo
O0

 

[Cb]

Absolutely...indexers get a free ride on the research and analysis that active investors do. It's a bit of a paradox.

I wouldn't worry about it coming to end though, human nature is such that a significant percentage of investors will fancy themselves to be above average in their ability to spot bargains, and others will (illogically) opt to "swing for he fences" via individual equities or star fund managers rather than settle for growing rich slowly via DCA'ing into index funds year after year.

Cb
PS: I personally believe markets are "pretty efficient"...meaning a schmuck like me isn't able to reliably make abnormal profits, but the best 1-2-3% of investors probably are.

 

[brewer12345]

Even if all the retail investors get religion, there will always be professionals like me who will keep the markets efficient.

 

[Nords]

Is the managed fund a critical piece of the efficient market?

Nah, it's a critical tool for the blissfully ignorant investor.

I like the Barney-the-Purple-Dinosaur metaphor. Just about every two-year-old in America has discovered this marketing juggernaut and bought at least one product. If you've spent any time with a toddler you know how intense the Barney fascination can be. Yet by the time they're six years old, Barney is for babies and they wouldn't be caught in public with him.

So why isn't Barney bankrupt? Because every year he gets a fresh crop of two-year-olds. This has been happening for well over a decade with no end in sight.

Same with investors-- every year there's a fresh crop to scalp harvest. They sign up for their 401(k), pick whatever looks good at the moment, and move on with their lives. A few years later they learn how badly they've chosen (haven't we all?) and get more involved in their investor's education. (Or not.) By the time they've become hard-core low-expense index-fund investors, a fresh new crop of the blissfully ignorant has come along to keep the high-fee companies in business.

Here's an interesting article from a Bay Area writer:
"One would think, with that kind of advice floating about, that the whole country would by now be in index funds. But in the three decades since Wells Fargo kicked things off, only about 40 percent of institutional money and 15 percent of individuals’ money has been invested in index funds. So why is indexing catching on so slowly?
A big reason, according to Geddes, is that putting investors into index funds is simply not in the interest of the industry that sells securities. 'They just won’t accept indexing’s minuscule fees,' he says. By now, most major brokerage firms offer index funds in addition to traditional mutual funds, but money managers typically don’t mention them at all. You usually have to ask about them yourself."

As for the author's comments about Google's employee-education program, I'd like see how many of those Googlaires own index funds today.

I'm surprised that no one's quoted Warren Buffett on efficient markets yet...

 

[FinanceDude]

Nords, you make some valid points. When you look at bundled 401K/403B programs, how many managed fund guys are in there? ALL OF THEM.

Think about it........who is the largest 401K provider out there? Principal. What do they sell? A 401K annuity porduct with managed funds in them. ING, John Hancock, AIG, others. They ALL use managed fund subaccounts in their 401K/403B programs.

Next point? What do the employees PAY in ER in their 401K? If you asked 100 people, maybe 1 would know...........

So, the managed funds are "fed" by the big 401K machine. Wonder if anyone has split out the assets in managed funds between retirement and non-retirement investments.

Also, the rep/reps assigned to the 401Ks are tyoically notified by HR when someone retires, and the rep would offer the "convenience" of "leaving your 401k/403B with Principal", but "self-directing" it.........into an annuity..........

Most of the plan sponsors think since they're not PAYING an upfront fee that the 401K is "free"..............

 

[Hamlet]

Bingo. Buffett said something along the lines of "because the market is often efficient, people started believing it is always efficient."

Anyone with half a brain should realize the market is not ALWAYS efficient. The foolishness of the dot.com bust showed that.

I think that the average investor can occasionally find situations that are inefficient to take advantage of. I think alot of people would have solid results by sticking to index funds for the bulk of their investments, and investing in the 0-3 companies that they understand better than the market.

An example from my investing -- After 9/11, the stock market was going down, and a few stocks got silly cheap. I was able to buy Intimate Brands (Victoria's Secret) for about 9 times earnings. For the life of me, I didn't understand how terrorism was going to affect the amount of fancy underwear women buy. The market was dead wrong, and the stock doubled very quickly before being reaquired by the company that had originally spun it off (The Limited). I sold at that point, since I did not have the same confidence in The Limited's other businesses.

PS: I personally believe markets are "pretty efficient"...meaning a schmuck like me isn't able to reliably make abnormal profits, but the best 1-2-3% of investors probably are.

 

[brewer12345]

I think that Hamlet is on to something. Large cap companies that are widely followed are usually pretty efficiently priced. Stuff that lurks in the corners, has no analyst coverage, small institutional ownership, etc. is often not efficiently priced.

 

[kcowan]

I agree with Nords. In fact, there are lots of Barney fans who are older in the capital markets. When I talk about MERs to people who should be wiser, they say they meet with their FA/Broker once a year and go with their recommendations. I ask whether they track the gains themselves, and they say "No the FA presents them to them once a year."

You know, pie charts and overall fund performance versus some arbitratrary benchmark. Would these people pay the asking price for a new car? Most would not. The problem is the misinformation that appears in the press regularly. And all the vested interests that want to keep it that way.

 

[FinanceDude]

I think that Hamlet is on to something. Large cap companies that are widely followed are usually pretty efficiently priced. Stuff that lurks in the corners, has no analyst coverage, small institutional ownership, etc. is often not efficiently priced.

I believe this arena is where guys like Peter Lynch made a killing...........

I owned Magellan when he was there.............those were the days...........

 

[Martha]

I agree with Nords. In fact, there are lots of Barney fans who are older in the capital markets.

 

[Patrick]

My eyes!

 

[ats5g]

Since we're discussing EMH, I'll just link to Burton Malkiel's The Efficient Market Hypothesis and Its Critics.

As far as the stuff that lurks in the corners, like small caps or EM stocks, go, I have yet to see ample evidence that active investors can consitently earn excess returns.

I think the more important question than "Are markets efficient?" is "Should you invest as if markets are efficient?"

- Alec

 

[HFWR]

I've decided to be a passive owner/investor of/in a broad range of US and international companies, with a bit of commodities and bonds thrown in for diversification...

 

[Gone4Good]

From my experience as a professional investor in one small corner of the market, the market is not perfectly efficient . . . but it is largely efficient. Too efficient, in my opinion, for any part-time investor to have a realistic shot at generating market-beating, risk-adjusted returns. However, the market is inefficient enough to compensate the best, the brightest and the luckiest just enough to keep them in the game. For the rest, the illusion of even greater inefficiencies keeps millions chasing snake oil, making the salesmen wealthy at the buyer's expense, but also aiding market efficiency in the process.

 

[brewer12345]

From my experience as a professional investor in one small corner of the market, the market is not perfectly efficient . . . but it is largely efficient. Too efficient, in my opinion, for any part-time investor to have a realistic shot at generating market-beating, risk-adjusted returns. However, the market is inefficient enough to compensate the best, the brightest and the luckiest just enough to keep them in the game. For the rest, the illusion of even greater inefficiencies keeps millions chasing snake oil, making the salesmen wealthy at the buyer's expense, but also aiding market efficiency in the process.

I think that is mostly true. You have to want to put time and effort into generating excess return. Simply saying "this looks good" and clicking the "submit order" button won't cut it.

The biggest opportunities I see (big enough to put hundreds of million or a few billion into) are when a whole industry/sector goes out of favor. There are times when you couldn't give some of these companies away, and the financial media jumps on the bandwagon with lots of stories goading the herd on. But most of the time things sort themselves out over time and the industry gradually becomes less hated. If you are lucky, the sector comes back into favor.

3 years ago, nobody wanted anything to do with airlines. Now they are printing money and trying to buy each other because they are the only ones who realize how much cash they are generating. The market is catching on and the valuations are rising. I'm sure ina couple of years there will be the chance of a lifetime to buy homebuilders, subprime lenders, etc. at firesale prices. A couple years later, they will no longer be investments non grata...

And the cycle goes on. But it takes a willingness to sort through the wreckage to find good deals, and (even tougher) you must have the psychological ability to buy stuff that EVERYONE hates (and they will repeatedly tell you how muchthey hate it and why you must be an idiot for buying it).

 

[Delawaredave]

Here's an interesting article from a Bay Area writer:
"One would think, with that kind of advice floating about, that the whole country would by now be in index funds. But in the three decades since Wells Fargo kicked things off, only about 40 percent of institutional money and 15 percent of individuals’ money has been invested in index funds. So why is indexing catching on so slowly?

Is it true that a greater percentage of institutional money is in indices than individual investors ?

That's interesting. I would have guessed the opposite - figuring that institutions have the "research power" to create a competitive advantage by active investments, and that "Joe individual investor" would be better off in passive indices.

Could it be the self-serving interests of the finanical services industries steers individual investors into active investments/funds to maximize their fees ?

 

[unclemick]

What - nobody's mentioned hormones yet!

There is one other thing that suckers in each new generation: luck - alluded to in the 'Postscript' chapter of Ben Graham's Intelligent Investor, Bernstein's old Efficient Frontier article 'The 15 Stock Diversification Myth', and Buffett's few forever stocks - aka Coke et al.

Like that great investment guru Clint Eastwood's character Dirty Harry:

"Do ya feel lucky - well do ya punk?"

heh heh heh heh heh - 15% of portfolio here. Never say die.

 

[Gone4Good]

The biggest opportunities I see (big enough to put hundreds of million or a few billion into) are when a whole industry/sector goes out of favor. . .

Although absolutely true, this also falls into the category of "easier said than done." Not only do you have to be right on the long-term fundamentals, you also have to get the timing pretty close to perfect. I've seen a lot of folks who were right on the long-term outlook but messed up the timing and got smoked. Some people seem to have a knack for it, and then, there is everyone else.

But even for those few who can pull it off, it's not always clear whether it is skill or luck. The guy who blew up Amaranth generated $1 billion in profits the previous year. Should 'a quit while they were ahead.