A slightly off-center perspective on monetary problems.
Here’s another article showing the efficiency of markets:
Warren Buffett made a friendly bet four years ago that funds that invest in hedge funds for their clients couldn’t beat the stock market over a decade. So far he’s winning.
The 81-year-old Buffett, who is chairman of the holding company Berkshire Hathaway Inc. (BRK/A), ended last year neck and neck with the ProtÃ?©gÃ?© funds as the Vanguard fund climbed by 2.1 percent and the ProtÃ?©gÃ?© hedge funds lost an estimated 3.75 percent.
The first two months of this year pushed the Vanguard fund ahead as stocks returned 9 percent, more than twice the gains of hedge funds.
If you do the math the performance gap is around 10%, even larger than four years of the 1.25% annual expense ratio for mutual funds that invest in hedge funds. They’d have been better off throwing darts.
But before Buffett gets too cocky, he might want to consider the final sentence of the article:
Berkshire Hathaway shares have slumped almost 17 percent since the end of 2007.
Ouch! Three years ago I argued that even if markets were perfectly efficient, they would look inefficient. That’s because for every 1,000,000 investors you’d expect one guy to outperform the market for 20 consecutive years. The masses would call that lucky guy a genius, even if he was just an average bloke from Nebraska.
I predicted that after the lucky guy became the richest investor on Wall Street, his returns would no longer look so impressive. So far I appear to be right. That doesn’t mean the EMH is precisely true (it’s not), but I’m having more and more trouble finding any useful anti-EMH models for investors.
And while we are at it, how about those bearish stock market comments by Nouriel Roubini in May 2009? And why wasn’t Robert Shiller screaming “buy” in March 2009?” One by one all the anti-EMH arguments that have been thrown at me seem to be melting away. The EMH is widely ridiculed, but will outlive all its critics.
PS. In fairness to the other side, I did a post bashing Keynes as an investor about a year ago. It now looks like his decisions managing the Cambridge University endowment were substantially better than those managing his personal investments. Oddly, he wasn’t able to market time, rather he was a successful stock-picker. One would expect a macroeconomist to win through market timing, if they had any advantage at all.
HT: Cyril Morong
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34 Responses to “It’s even worse than Buffett thinks.”
Why did the Berkshire Hathaway shares went down 17 percent since the end of 2007? Because Warren Buffet was wrong about macro.
Previously he was boasting that value investors can ignore macro, but in his latest annual report he wrote “Wise monetary and fiscal policies play an important role in tempering recessions, but these tools don't create households nor eliminate excess housing units.”
Like the financial markets, the market for academic ideas is also perfectly efficient. No academic can consistently outperform over the long term. Take for instance, this blog’s somewhat mediocre habit of repeating the same EMH blog post each month. Meh. Underperforming. That doesn't mean the EMH is precisely true (it's not),but I’m having more and more trouble finding any useful anti-EMH models for academics.
“Ouch! Three years ago I argued that even if markets were perfectly efficient, they would look inefficient.”
Even if markets were inefficient, wouldn’t they look efficient if investment skill was incredibly rare? And from a practical standpoint, does it make a difference which is true if the implications are the same? You say EMH is approximately true therefore don’t try and beat the market. Buffett says investment skill is too rare, so don’t try and beat the market.
Buffet’s been outperforming the market for 56 years, not 20. He opened his first investment fund in 1956.
Largely what has happened is that Berkshires price to book ratio has declined. The market used to expect an excess return and no longer does.
One common claim is that this is due to the absence of any clear succession, but regardless, buffet claimed that the book value reflected intrinsic enterprise value. If that is true, then projecting the last ten years gives a return over twenty to be about 9%.
The benefits of hedge funds and conglomerates like Berkshire are pretty severely understated by these arguments. Leverage and large illiquid investments amplified their losses (valuation losses for BH. Revenue increased 50% from 2006-2011, but EPS fell from ~$7 to ~4. Railroad business has very high operating leverage, so EPS will outpace revenue growth once [if] NGDP picks up). Ask yourself what would have happened had the Fed been doing NGDPLT. Leverage and low-liquidity investments can boost returns, but they also increase sensitivity to systematic (i.e. monetary policy) risk. The Hedgefund/Berkshire/Equity Market comparison is a bit of a false dichotomy regarding the EMH as it is, because they all have very different risk/return expectations, and often try to exploit areas where market information is particularly incomplete. Absent monetary policy risk Hedge funds/Berkshire should outperform the broad equity market.
1) Some of the best evidence that would be consistent with EMH is that log changes in individual equities and the market can be approximated by a random walk and that prices in liquid securities adjust very quickly changes in information. However, EMH can’t be tested due to the joint hypothesis problem. 2) Buffet can’t still produce outsized returns because he is too big and well-known. If he began again with a $1mn portfolio, I would still bet that he could outperform the market over a twenty year period (if he stayed alive and working). After twenty years of 20% returns, he would only have $38mn, far from his current portfolio. 3) Buffett’s counter to the lucky investor out of a 1mn every 20 years in the Superinvestors of Graham and Doddsville was that if you have several investors with the same investment philosophy and all have strong returns over time, then it is hard to say that it was luck that drove their returns. 4) I never found that 1mn every 20 years argument very convincing. On a strictly mathematical basis, its obvious that only 50 percent of the money invested in every year can outperform the market. However, that doesn’t mean that it holds for specific investors since not everyone has the same initial endowment. Further, the only people who care about beating the market every year are braggarts and marketing people. After 20 years, the investor should care about the total return of their portfolio versus the total return of the index. If you underperform in a few years by a small amount when the market is up, then this isn’t really a big deal so long as you produce outsized excess returns in other years. 5) The better argument is the empirical facts that most mutual funds after fees do not add significant alpha. The same can be said for your point about investing in a portfolio of hedge funds. An EMH world would show the same result, but the evidence of it doesn’t necessarily mean that EMH is true. Nor does it mean that investment management can’t add alpha. It is possible to find a handful of funds that have produced very strong returns and it is unlikely that these returns were due to luck (for instance, Renaissance’s Medallion fund). The hard part is finding these funds before they are successful and when they are willing to take money. To do so is likely just as hard as choosing a stock that will outperform over the next twenty years.
Scott, On Keynes for Cambridge: As you point out, Keynes could have been lucky, or, in that position, given some market-advantage real inside information.
The EMH is broadly and mostly true. Sure, people working fiendishly for years might devise profits in nooks and vortices of the huge current. The analogy falls apart, but those people make the current even more EMH.
BTW, on Buffett: His company actually has made a lot of purchases of other whole companies, often in private transactions. This may not be stock-picking as much as finding good companies with so-so management, and bringing in fresh management and leverage of all kinds–financial, operational, connections.
The returns should be higher for active hands-on management of companies, than in passive ownership through stock picking.
“I'm having more and more trouble finding any useful anti-EMH models for investors.”
This got me thinking about two things. First, about some models "value" investors have advocated using for the public equity markets. They say stick to smaller cap stocks. Or illiquid special situations. Or beaten up companies from which most buyers have fled. In general, they say look for areas where there is little competition because that’s where the excess returns are (indeed, as Berkshire has gotten bigger and bigger, Buffett has admitted that its returns will become worse and as he’s forced away from these more fertile sub-markets). This seems to me the same conclusions that a pro-EMH investor would arrive at. Saying you want to focus on markets with less competition is the same as saying you want to stay away from markets where EMH is more likely to be (approximately) true. In fact, these strategies are a big area of focus in the Columbia MBA program (where Buffett studied under Graham). So I think you are right that EMH will outlive its critics as it's already put to practical use by them, whether they know it or not.
This leads to a second point, which is that the "stock market" is not a single, homogenous market. Yet when people debate EMH, they're often imprecise and miss that nuance. The market for Microsoft is not the same as the one for Northeast Community Bancorp. When an investor tries to debunk EMH he'll usually point to a company like the latter ($70 million market cap), but there's no reason that proves anything about the efficiency of Microsoft's stock.
Scott,
Have you read Berk and Green? I wonder what your thoughts are about this paper and efficient markets?
The basic idea is that the lack of persistence is exactly what you would expect if investors in mutual funds are knowledgeable Bayesians and managers have skill, or stock picking ability. The gains from trade go to the managers not the investors.
123, From that quotation it looks like he’s wise to ignore macro.
JP, Touche.
MP, I agree.
Mike, You said;
“Buffet's been outperforming the market for 56 years, not 20. He opened his first investment fund in 1956.”
That fact would only be important if he’d outperformed the market in all 56 years. But he hasn’t.
Jon, I’m not sure I followed your argument.
Cthorm, I accept that these may be false comparisons. I’m just reporting all the arguments that were thrown at me; “Hedge funds do great, Warren Buffett is smarter than the market, etc.”
John Hall, I agree with most of what you have to say, but don’t see it as refuting my claim. I don’t believe the EMH is literally true, just that anti-EMH models are not very useful, and the EMH is useful.
You said;
“3) Buffett's counter to the lucky investor out of a 1mn every 20 years in the Superinvestors of Graham and Doddsville was that if you have several investors with the same investment philosophy and all have strong returns over time, then it is hard to say that it was luck that drove their returns.”
Maybe, but not if their investment periods overlapped.
Ben, Good point about the returns to hands-on management.
MP, Good points.
Jason, I don’t see how that could explain mean reversion in returns, but I haven’t read the paper. How do they explain the fact that the skilled manangers aren’t able to consistently beat the market?
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