The Art of Streetplay

Tuesday, June 27, 2006

Poking Holes in Bogle's Pro-Cap Weighting Rationale

Surprise surprise... John Bogle is putting down fundamental indexing in favor of, you guessed it, what has made him rich-- cap weighted passive indexing. And he got Burton Malkiel to back him up and give him a sense of credibility-- not too different from WisdomTree getting Siegel on board. Must be right if they've got an academic on board!

I thought I'd hone in on a few aspects of his argument and then share some personal thoughts.

Aspect #1:
"First let us put to rest the canard that the remarkable success of traditional market-weighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalization-weighted indexing would still be -- must be -- an optimal investment strategy. All the stocks in the market must be held by someone. Thus, investors as a whole must earn the market return when that return is measured by a capitalization-weighted total stock market index. We can not live in Garrison Keillor's Lake Wobegon, where all the children are above average. For every investor who outperforms the market, there must be another investor who underperforms. Beating the market, in principle, must be a zero-sum game."

This does make some sense-- it is true that (1) the market return from one instant to the next is, technically, the return generated by a capitalization-weighted total stock market index. It is also true that (2) beating the "market" is a zero-sum game. If one makes the claim (as they did) that the market is inefficient, though, the flaw in the logic above is that claims (1) and (2) imply the market must be the an optimal investment strategy. If, for whatever reason, there are at times deviations from intrinsic value, and one is able to, probabilistically or otherwise, construct a strategy which takes advantage of mean reversion of stocks to their intrinsic value over time, then one could theoretically outperform the market (with a few more conditions). Because beating the market return is zero-sum, yes, you would be earning a profit at the expense of another market participant, and yes, it is notoriously difficult to beat the market after fees over time. The only thing I am saying here is it is a logical fallacy to say that given (1) and (2) are true, then even if the market is inefficient, cap weighting must be an optimal investment strategy-- it is NOT a logical fallacy, however, to make the deduction that cap weighting MAY be an optimal investment strategy.

Aspect #2: Expenses-- Management Fees, Turnover, Taxes (Capacity)
"Purveyors of fundamentally weighted indexes also tend to charge management fees well above the typical index fund. While index funds also incur expenses, they are available at costs below 10 basis points. The expense ratios of publicly available fundamental index funds range from an average of 0.49% (plus brokerage commissions) to 1.14% (plus a 3.75% sales load), plus an undisclosed amount of portfolio turnover costs."

"
Fundamental weighting also fails to provide the tax efficiency of market weighting."

Later in the article they delve into some of the conditions which would allow one to make the claim that investing in cap weighted indexes is the optimal investment strategy. First off I would say that again, they are definitely right. Cap weighting has a bunch of natural advantages. They are easy to construct, they require no turnover and hence no transaction cost and no manager who takes a fee for himself, and they are tax efficient.

The question I ask again is, does this lead to the natural deduction that cap weighting MUST be the optimal strategy? Perhaps I'm wrong, but I don't believe so. What it implies to me is the crux of the argument for active management-- as one deviates from investing in the market to increase your portfolio's allocation to a security you believe to be mispriced, you run up against a number of frictions: (1) all the time you are spending to figure out whether that security is, in fact, mispriced-- the cost of time (which you may or may not outsource to a money manager for a fee); (2) transaction costs to invest in that security; (3) tax inefficiencies; (4) other (ie. market impact, etc). These are real costs.

So the fundamental question is: in the face of probabilistic inefficiency (which is all Arnott and Siegel claim), is "market noise" of a large enough magnitude and does it mean revert quickly enough for it to be worthwhile to incur the incremental costs necessary to generate those returns?

I am not saying anything which hasn't been said a million times in all likelihood. Arnott's paper in the FAJ allocated large chunks of space to the time series of the returns relative to the market returns, how "market-like" those returns were, what capacity was available to the trading strategy, the effect of the trading strategy on volatility, and the incremental costs involved assuming turnover at a certain rate.

In other words, he was making an apples to apples after-transaction-cost comparison between his strategy and the market return, and he found that his trading strategy outperformed over time robustly enough that the probability of overfitting was minimal. That is pretty valid-- this article applied no such rigor. I don't blame it (this is the WSJ we're talking about), but nevertheless, it does not conclusively disprove the assertions made in Arnott's paper.

Aspect #3: Increase in Efficiency
"We concede that there is some evidence, based on numbers compiled by Ibbotson Associates, that long-run excess returns have been earned from dividend-paying, "value" and small-cap stocks -- albeit returns that are overstated by not taking into account management fees, operating expenses, turnover costs and taxes. But to the extent that investors are persuaded by these data, the premiums offered by such stocks may well now have been "arbitraged away" in the stock market, as price-earnings multiples have become extremely compressed."

This is a valid point, not out of line with the logic in the fundamental question: in the face of probabilistic inefficiency (which is all Arnott and Siegel claim), is "market noise" of a large enough magnitude and does it mean revert quickly enough for it to be worthwhile to incur the incremental costs necessary to generate those returns?

It isn't enough to make the claim that the market is noisy-- the noise must be large enough and mean reverting enough. If, through the influx of hedge fund investment and everything else, the market is more efficient than it was, then perhaps even though a risk-reward favorable trading strategy existed in the past, we wouldn't see returns nearly as large going forward-- especially after fees.

I have commented on the outperformance of value of late in Commentary on The Trouble With Value, based on GMO's piece a while back. It is true- the run value has had of late is now getting long in the tooth. The outperformance of value relative to growth has averaged out to a certain level over time, and we are now well above that average. Reversion to the mean would imply value may have a more difficult time going forward.

Claim #4: New paradigms don't tend to last

"We never know when reversion to the mean will come to the various sectors of the stock market, but we do know that such changes in style invariably occur. Before we too easily accept that fundamental indexing -- relying on style tilts toward dividends, "value" and smallness -- is the "new paradigm," we need a longer sense of history, as well as an appreciation that capitalization-weighted indexing does not depend on efficient markets for its usefulness.

While we have witnessed many "new paradigms" over the years, none have persisted. The "concept" stocks of the Go-Go years in the 1960s came, and went. So did the "Nifty Fifty" era that soon followed. The "January Effect" of small-cap superiority came, and went. Option-income funds and "Government Plus" funds came, and went. High-tech stocks and "new economy" funds came as well, and the survivors remain far below their peaks. Intelligent investors should approach with extreme caution any claim that a "new paradigm" is here to stay. That's not the way financial markets work."

This is theoretically a slightly different, broader slant from Aspect #3. This isn't necessarily making the claim that markets have secularly gotten more efficient in general. It is more making the claim that over time, two things tend to happen at different points in time for a variety of reasons-- (1) fads develop and (2) systematic statistical patterns form. Neither persist over time, and it is so unlikely that you will be able to know when they pop or decrease to statistical insignificance that it isn't worth the costs necessary to act on the information. They give a bunch of examples of (1). I would posit an example of (2) to be the incredibly large serial autocorrelation detected in the market indices by Andy Lo. It really did exist. They pointed it out, people got excited and probably traded on it a bunch, probably made some good money, and then over time, it decreased in absolute value to the point that it is no longer profitable to trade on relative to sticking all that money in an index fund.

Fair enough. What is the "truth"? Will the magnitude of this aberration decrease over time, as more people catch on, to the point that it isn't worth the incremental costs, or not? You know, they very well could be right.

Personal Thoughts
My belief is that this is less a statistical anomaly than the Andy Lo autocorrelation phenomenon was. It is lower resolution, it takes longer to realize the abnormally positive returns, it requires patience and a smidge of contrarianism. These are all qualities which would allow it to persist longer than other phenomena would. The big irony of it all, however, is this-- if Siegel is able to convince enough investors that he is, in fact, on the right side of this debate, the influx of capital may itself cause the anomaly to disappear! This stems from one unquestionable truth-- beating the market return is a zero sum game, and the market return is the return on the cap weighted total stock market index. If the majority of investors believe they will beat the market return by investing in fundamental indexing, they will have to earn their above market return at the expense of other market participants-- but those market participants aren't anywhere to be had. Those abnormal returns exist because the "market" has allocated funds in a particular way over the history of the stock market. If the "market" were to no longer allocate funds that way, perhaps we would have the indirect benefit of an overall better functioning economic system, but directly, the market, as a whole, cannot escape the market return. If everyone believes something to be true, you cannot earn abnormal returns off of it.

The other aspect which I personally grapple with is Aspect #3. As trite as it may sound, we have seen a hell of a rally in value relative to growth. The outperformance of value is now above the mean. Has the influx of capital to professional money managers made the pricing of stocks relative to each other more efficient? If so, the returns of an investment strategy which worked when the investing landscape was not riddled with value managers may not be applicable to the world we will see over the next 20 years.

I no doubt believe that the market is noisy, as Siegel puts it. But that alone is not enough to make fundamental indexation "work". For it to "work", there needs to be sufficient noise and mean reversion to compensate for the costs incurred. From the point of view of someone today investing over the next 10 years, that is a difficult tradeoff for anyone to say definitively will go one way or the other, in my opinion.

Money Managers Have a Place in This World
A final thought is in order on the topic of market efficiency, and professional money managers. They do have a place in this world. Just think about it: if all money was invested in index funds, who would set the value of the individual stocks which comprise the S&P? We need stock pickers! More than that, they deserve compensation for providing efficiency to the price of stocks! Without individuals estimating the intrinsic value of stocks, the market system breaks down, because its whole purpose in the paradigm of the financial markets is to allow companies to raise capital efficiently. If they did not do that, there would be no need for the stock market at all.

The question is not whether they should exist or not-- the question is what is the just compensation they deserve relative to the amount of efficiency they can provide to the market.
With all this talk of index investing, I get a good feeling inside knowing I might have a place in this world-- as an allocator of efficiency capital. Great.

7 Comments:

  • Theory is missing from the data-driven analysis of portfolio weighting and indexation, whether based on non-market-cap fundamentals or on market-cap. The fatal problems with dividends and certain other so-called fundamental metrics for either selecting stocks or weighting stocks in a portfolio have been analyzed with theory in mind. To avoid excessive repetition here, the full analysis can be found at the following webpage.

    At www.numeraire.com/download.htm there are documents about the fatal fallacy of dividends and other factors: WSJ letter; WSJ article comment; WSJ.com article comment, and blogs comments. The WSJ letter to the editor is a response to the WSJ Op-Ed article, which in turn is a response to the WSJ.com Commentary article. These documents, in turn, are supported by two published articles also available at the numeraire.com webpage: IJEB in June, 2005; and AEF in May, 2006.

    To facilitate fair, open discussion about this matter among interested persons, one of the linked documents (labeled "blogs") at the numeraire.com webpage includes comments by bloggers. I trust this conforms to fair use pursuant to The Chicago Manual of Style, 14/e.

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