
An overlooked statistical concept shows why it’s so hard to beat a benchmark - bookbild
https://www.bloomberg.com/news/articles/2017-04-09/lopsided-stocks-and-the-math-explaining-active-manager-futility
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peterbonney
Skewness alone can't explain it, either. Imagine there are 100 stocks of equal
weight in the index, and that 99 are going to underperform over the next year
with only 1 outperforming. If there are 1,000,000 managers (with equal
capital) each picking just 1 stock randomly to hold over that year, then yes,
99% of them will underperform the index and just 1% will outperform. But the
aggregated performance of the managers will exactly match the index, minus
fees.

For skewness to factor into manager underperformance it must be coupled with
adverse selection. I.e. it must be the case that the factors that contribute
to that 1 stock outperforming are correlated with managers not wanting to own
it just before it outperforms. _That_ seems plausible, but goes against the
argument that a truly random portfolio of stocks will underperform the index
because of skewness (because truly random stocks are by definition _not_
adversely selected).

~~~
cortesoft
I don't think that is the argument the author is trying to make. Obviously,
the 'aggregated' performance of the managers will match the index, minus the
fees (assuming every stock is in the index, and there is no adverse
selection).

So basically, the argument is that having an active fund manager is increasing
your risk while also increasing your potential reward. The expected value is
average, while the volatility is higher. While you might think this is an
insignificant conclusion, I don't think this fact is obvious; most people
aren't expecting that choosing an actively managed fund is increasing their
risk.

~~~
OJRbberg
Knucklehead author here -- happy to see all the smart discussion on this
thread here. Your point here is indeed one of the main takeaways. For all
practical purposes the sum of active manager performance = the index. But
given the probability that the active manager you pick won't beat the index
(in large part determined by skewness, the academics cited would argue), is
indeed the risk you introduce by taking this route.

Thanks to all for reading and arguing.

O

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nugget
Active managers play a critical role in price discovery. We have traditionally
had, and definitely still have, far more active managers than needed, but some
number of them must survive in order to have a healthy market. Sometimes we
lose sight of this in the (well-deserved) celebration of passive index
investing. I'm interested in a few questions that only time will answer.
First, what % of the market needs to be active rather than passive in order
for healthy price discovery to occur? Is there an efficient frontier or
stabilization point? Second, as passive indexes become the vast majority of
public equity dollars, are there more opportunities for smart active investors
to out-perform? (Given enough passive indexes as counterparties, it's
theoretically possible for every remaining active manager to out-perform the
market.) Third, in aggregate, what % of out-performance (if any) will active
managers be able to take, as fees, in the future? (And what does it say about
human psychology if it's >100%.)

~~~
jessriedel
In the ideal case, the answer to your second questions seem to be obviously
"yes"; the market in active managers will hit an equilibrium where their
salary is paid by the additional info they bring. However, it seems clear from
the current situation that the market is far from ideal since there have been
too many active managers for decades. Whatever it is that allows them to
persist (human overconfidence, salesmen, principal-agent problems) has not
been eliminated, even if "word has gotten out" so that investors have began to
develop a partial immunity against them. Knowing exactly where the new
equilibrium will be requires a detailed understanding of that mechanism, which
I don't think anyone has.

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soVeryTired
Their argument is that most stocks are mediocre, with a handful of big winners
mixed in: that means building a portfolio of hand-picked stocks is likely to
underperform since it will probably miss the best stocks.

But there's a symmetry argument there that the article misses. Surely I can
make a portfolio that tracks the market, but excludes a handful of stocks I
think are going to be lousy. Because I have most of the market in my
portfolio, I'm likely to hit the big winners, and with high probability I'll
ditch losers.

To build on their poker chip analogy, what if there are four $10 chips, one
$100 chip and I pick four chips each time instead of two?

~~~
madcaptenor
But the distribution of returns isn't symmetric. With the losers, you can lose
at most 100% of your investment; with the winners, you can make a lot more.

~~~
sten
That's for stocks. You can always short and potentially have no limits for
your loss.

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hal9000xp
Popular theories that investing in indexes is the best possible strategy are
not self-sufficient. If there were no active traders, then nobody would trade
individual stocks. In this case, there would be no indexes to invest.

So markets stay in permanent equilibrium where active and passive investors
are balanced out. More precisely, if there were too many active traders, it
would be attractive to become a passive investor since markets are very
efficient. If there were too few active traders, it would be attractive to
become an active investor since markets are not very efficient.

Yet despite of this simple truth, I constantly hear from seemingly serious
people that only index investing is worth doing (i.e. random walk theories pop
up regularly in the press).

Beating index should be hard because it's a competition! And everybody is not
supposed to be winner.

~~~
jessriedel
You're talking to the wrong people. The idea isn't that all investors should
be index investing, the idea is that all investors _without special expertise_
should be index investing. This is a non-trivial statement because one might
think (and people often argue) that active managers with expertise can beat
indices, and therefore unsophisticated investors should just hire those
people. The problem with this is that unsophisticated investors can't tell the
difference between active managers who have a real edge (be it special
insight, better computers, bigger brains, etc.) and those who do not. Insofar
as an active manager can demonstrate convincingly to an unsophisticated
outsider that they have an edge, the manager will be able to capture the
excess value by commanding larger fees in the marketplace for managers.

This would be a fine equilibrium for wise unsophisticated investors, but
unsophisticated investors are not all wise. Various human biases and market
failures mean that there are an _excess_ number of active investors (i.e., a
number above the equilibrium value in an efficient market), many/most of whom
are leeches. This is the state we find ourselves in today. The reason the
number of active managers is decreasing is because wisdom is diffusing, but we
are not done.

It goes without saying that "special expertise" involves a lot more than
reading financial newspapers and considering yourself a smart person. It's
about as hard to be able to compete at that level as it is to compete in
professional sports. The big difference is that the heavy dose of randomness
involved in investing allows more people to convince themselves that they are
able to compete with the big boys, when almost none of them are. (The evidence
that you can't compete with LeBron James at basketball is harder to ignore.)

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savanaly
This is a lot of words to say a very simple thing: if you measure a stock
picker's performance on a binary scale (did they outperform the market, yes or
no?) then you'll get different results from if you measured them on a scale
that includes _how much_ they under or outperformed the market by. It just so
happens that for the stock market the former yields a result that makes the
stock pickers look worse than the latter.

The original paper, as far as I can tell, is saying nothing more brilliant
than that for stock picking results, the median is lower than the mean. Hence,
the "average" (aka median) stock picker underperforms an index (which is,
after all, the mean).

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rdlecler1
In short, the same principles driving VC returns are driving public market
returns with the exception that amongst top teir VCs there is effectively
insider information which is illegal in public markets, hence no information
asymmetry to bias returns.

~~~
Nomentatus
Great point - actually, what the article leaves out is that investors are
_always_ competing with vast holdings held by insiders who by definition have
insider information; and most of their trades based on that insider
information are perfectly legal (inevitably.) Such as selling their positions.
Passing on insider information other than to the public at large is what's
legislated against.

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rodionos
> equity benchmarks are so reliant on gigantic gains in just a handful of
> stocks that missing them

Perhaps we're witnessing a shift towards an industrial model where a small
number of players control disproportionate amounts of value added in their
respective industries. I'd be interested to see historical data for Herfindahl
indices for key verticals in the U.S., and globally.

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knowno
If many portfolios are similar, which a small group of values as a best
candidate to appear in those portfolios then it is likely that they are not
going to hit the big performers since they are playing a lottery. The
soundness of the argument relies of what percentage of different values
compose the typical portfolio.

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andrewprock
This reads a lot like:

"The losers pay the winners.

Not really a surprising result given that really good arbitrageurs will
extract a lot of value until the game is discovered by the wider world.

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beezle
Have to call BS on this article. The same failure to beat will apply to RSP,
an equal weight s&p 500 that has outperformed the traditional cap weighted
index.

~~~
DennisP
The article's main claim is that if you want to do well, you need to buy a
large number of stocks. It used the S&P as an example but didn't claim that it
was the best possible large portfolio.

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tgb
Huh this seems like a poor explanation to me. It doesn't argue that active
investment will be worse than index over the long run, just that it will be
worse most of the time in the short run. But I'm not investing in the short
run, so I don't really care. What does this say about their long term expected
behavior?

I suspect the usual argument about fees will prove more relevant over the long
term.

