I hope they forgive me.
FT August 4, 2013:
Passive parasites do not cure all financial ills
HT: Abnormal Returns
By David SmithDavid Smith is a fund manager at Hargreaves Lansdown Fund Managers
Warren Buffett is undoubtedly an intelligent man and “the Sage of Omaha” has a reputation as the world’s finest active investor. I am not sure then whether it is odd or inevitable for him to be quoted by so many champions of passive fund management.
In Berkshire Hathaway’s 2005 letter to shareholders Buffett introduces the imaginary Gotrocks family, as 100 per cent owners of corporate America. He then explains how the financial services industry damages the growth of their wealth with unproductive fees. He encourages the Gotrocks to eschew assistance from financial “helpers” and passively own corporate America.It is a neat story and nicely told. Unfortunately, it is also deeply flawed. While investing in a closed stock market might be a zero-sum game, the reality of the business world is not. The overall market return is not a given, it is the complex result of millions of people’s interactions. Their decisions can and, I contend, do add value in aggregate. The Gotrocks family, sitting back in their rocking chairs, might find their assumption that corporate America will grow equally successfully without active involvement and oversight lacking solid foundation.....MORE
....It is not a popular view in the post-financial crisis environment but the reality is the financial services industry adds value to the economy. A world without active fund management would be poorer, not wealthier. Passive management is, inevitably, a parasitic industry – Mr Bogle appears to endorse this view on page 88 of his book – and every smart parasite knows a healthy host is crucial.Mr Buffett’s plan for the Gotrocks is impossible – everybody cannot be a successful passive investor. Indeed, tracker funds are only an intelligent strategy if you believe active managers keep the market broadly efficient. I do not, and I am amazed there are still people who do, despite episodes such as the technology, media and telecoms bubble. Hugh Young, Aberdeen Asset Management’s Asia guru, summed things up well in his Ten Golden Rules of Equity Investing: “The efficient-market hypothesis is nonsense. Markets are driven by humans, humans are irrational, thus markets are irrational.”
To suggest the aggregate opinions of thousands of irrational individuals will coincidently lead to a rational answer rather than one of many million shades of irrational outcome is astounding. We could hope people’s irrationality will cancel out, but humans mostly suffer the same behavioural biases, so they compound each other rather than offset each other.
If “Mr Market” is a manic depressive because humans (both individually and in aggregate) are flawed, it must surely be possible for active managers to take advantage. It is not easy but managers able to recognise flaws in themselves and rival investors can benefit from others’ irrationality.
Does this mean Mr Buffett is completely wrong? No. There are too many financial intermediaries and they are subject to irrationality (not to mention “dumb, unlucky or occasionally crooked”, as Mr Buffett suggests). They may also take too big a slice of the pie relative to their contributions.
Certainly, I would join Mr Buffett in deploring the prevalence of “heads I win, tails you lose” performance fee structures but I cannot advise the Gotrocks to fire him.
HT: Abnormal Returns
