A Stroll Down Memory Lane

“The deeper one delves, the worse things look for actively managed funds.” – William Bernstein.

Despite the title, this post is not about nostalgia, about the simpler times of pillow fights, water balloons, and The Lone Ranger.

It is about the education of an investor: me.

My last post discussed the risks of investing using individual stocks.  My point was that you simply cannot get enough diversification that way; therefore, you have unnecessarily increased your risk.

If you’ve been reading my posts, for example here and here, you have probably noticed that an underlying theme of this blog is my conviction that the right way to invest is to use mutual funds, specifically those that follow a “passive” approach.  I have believed this for 40 years.

How did I come to this belief?  Forgive my stroll down “memory lane,” but I actually went through something of a conversion process.  You see, back when I was in school I decided that I wanted to become a securities analyst.

Being a securities analyst meant that I would become a specialist within a particular industry and, through rigorous and comprehensive analysis, I would choose the “good” companies to invest in within that industry.  By the way, when I said “school” I meant high school; even at the tender age of 17, I had already set my path to fame and fortune (at least, in my own mind).

My plan, all those years ago, was to attend a liberal arts school and study Economics, because I thought that was the discipline that would be most useful to me.  I figured that I would major in Economics and then go on and get my MBA in Finance. Was I a precocious, or merely delusional, 17 year old?

Well, I graduated with an undergraduate degree in Economics from Lafayette College, and in an exit interview with a career counselor, I was asked what my future plans were.  I was steadfast in my conviction that I was going to get an MBA in Finance and then work on Wall Street.  Even four years of studying Economics and Accounting had not changed my plan.

But a funny thing happened on the way to Wall Street.  What I learned in graduate school changed my mind and also my career path.

Perhaps my professors were that convincing or the theory and evidence were just too persuasive. For I learned that, because of competitive markets, it was nearly impossible to identify undervalued stocks and therefore “beat the market.”   I recall one professor, George Benston, remarked that you could beat it (the market) with a stick but not as an investor.

Who believed such things in the 1960s?  Followers of the Chicago School of Economics; in my case, at the University of Rochester.  This is not the time to discuss the relative merits of the Chicago School, but suffice it to say that such economists as George Stigler and Milton Friedman were held in very high esteem at the U of R.  In particular, Friedman was considered a “minor” deity (and I’m not so sure about the “minor” part).  To diminish the hero worship I remember that Benston irreverently but still affectionately referred to Friedman as “Uncle Miltie.”

The Finance I studied in the 1960s was so new that it was not covered in any textbook.  Instead, we read primary documents (journal articles) by such pioneers as Harry Markowitz, William Sharpe, and the team of Modigliani and Miller, known as M&M.  These were the people who would later win Nobel prizes in economics.

One professor, Michael Jensen, had just written his groundbreaking Ph.D. dissertation on the performance of mutual funds.  Eugene Fama was his thesis adviser.  Jensen actually coined the term “Alpha,” which is a measure of excess returns achieved by investment managers.  More formally it is a statistical estimate of “how much a manager’s forecasting ability contributes to the fund’s returns.”  When you hear someone on TV talking about “creating Alpha” you now know where that term came from.  I’d bet that 90% of investors don’t know that.

But the punch line is that Jensen learned that mutual fund managers could NOT create Alpha, i.e. they could not “beat the market.”

His research was published in the Journal of Finance in 1967 and here are his conclusions:

The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.  It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free).  Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses.  (Emphasis added.)

Since 1967, there have been many, many follow-up studies and, they have confirmed his basic finding that active investment managers cannot “beat the market.”  Neither can stockbrokers or “experts” on TV.  And reading articles about hot mutual funds or “10 Stocks to Buy Now” is a waste of time.

If mutual fund managers and pension fund managers– some of the so-called experts – cannot use securities analysis or trading strategies to “beat the market” why would you, an individual investor, even want to try?

Now there’s the real lesson that 90% of investors do not know.