Good reads from around the Web.

Diehard Warren Buffett fans like me probably already know that the octogenarian outperformer’s latest annual letter will be released today at 1pm UK time (8am EST in his native US).

This year even passive purists who see Buffett as a six-sigma sideshow might be curious, however. Because rumour has it that Warren will be going deeper into why he champions index funds.

Update: The 2016 annual later is here. Here’s an except:

There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.

There are no doubt many hundreds of people – perhaps thousands – whom I have never met and whose abilities would equal those of the people I’ve identified. The job, after all, is not impossible.

The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well.

Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”

Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years.

Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.

Nothing really new then, but always class to hear one of the world’s best ever active investors not spinning the line.

Lots else for Buffett fans to dig through too, of course.

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According to Vanguard, passive funds are set to double their market share in Europe. Vanguard believes that over the next 10-15 years, passive’s slice of the pie will swell from 15% to more than 30%.

Yum, yum, says the indexing giant. The company already manages $4 trillion of our money but it wants more. It’s now calling for regulators to slap ‘health warnings’ about high fees onto expensive funds.

Maybe we should go whole hog, and insist on gory fag packet-style horror photos inserted into swanky fund literature? Emaciated and impoverished pensioners eating discount pot noodles in the rain, splashed by Cityboys screaming past in sports cars – that sort of thing?

Reuters recently quoted Vanguard’s chief investment officer Tim Buckley in colourful form:

“Active is dying from its own disease, it’s dying from its own greed. It’s high-cost against low-cost, and high-cost is the dinosaur.”

Ouch! Don’t ask Mr Buckley if your bum looks big in those.

Zero mercy

Tighter regulations such as MiFID II are set to further increase the cost of running funds. Ironically, this will probably also decrease competition by making it harder for new entrants to get started.

My own cursory look into the costs of setting up a little fund manager has persuaded me that to get rich running other people’s money, I’d have to be rich to begin with.

Low costs mostly come from economies of scale. So it will be left to the current incumbents – active and passive – to slug it out in a price war.

Vanguard has feet in both camps. Few realize Vanguard manages around $1 trillion in active funds. Low fee active funds, of course.

And costs matter because active investing is a zero sum game.

Well, almost a zero sum game. Probably. There are a few quirks that muddy the waters.

Previously we’ve not had to pay these too much attention. Some make your brain hurt. But as passive investing grows and eats up the investing landscape like a sci-fi blob from the 1950s, people are going back into the footnotes of the passive thesis and looking for caveats.

I’ll do so too in a future post. I’m no professor of economics, but for what it’s worth I believe these quibbles are of academic interest at most to the average investor, and don’t change the main argument for using market cap weighted index funds.

Zero tolerance

Anyway, many people even haven’t grasped the main argument yet. Let’s have a quick reminder.

Investing in itself is not a zero sum game. You and I can both make money in the stock market, without competing against each other.

As the economy expands, the total sales and profits of listed companies will grow. As owners of companies – whether through active or index funds – we’ll benefit as the market puts a higher value on our firms churning out ever heavier wheelbarrows of cash. We’ll also get dividends from the companies we own, whether via direct shareholdings or through funds.

So far, so good for everybody.

Here’s the zero sum bit. In order for £1 that’s invested in an active fund to win against the market – that is, to outperform the market – somewhere £1 of active money has to lose. ¹

That’s because ‘the market’ consists of only passive indexing and active funds.

And passive funds follow the market, so we can net those out.

This leaves the active funds (which includes smart beta ETFs and the like) trading amongst each other.

They profit at one another’s expense, but in aggregate they earn the market return.

And as they also charge higher fees, they must therefore do worse than trackers.

This logic was established more than quarter of a century ago by Nobel Prize-winning author Bill Sharpe. Read his paper, The Arithmetic Of Active Management, and see for yourself.

However be warned you might still feel befuddled afterwards.

I don’t blame you. It took me years to properly wrap my head around this stuff. I’m sure there are old articles on this website that aren’t completely on-point.

Active investors say the funniest things

You see passive investing is a weird concept. It feels wrong compared to our everyday experience. I’ve noticed even many financial professionals don’t really understand the theory behind it.

You might have heard journalists or fund managers say things like:

“Now is the time when stock picking funds will prosper over passive.”

Or perhaps:

“In this particular area of the market, active funds will always beat index funds.”

If you follow the zero sum logic of investing, you know such statements must be false. Maybe you’ve even rolled your eyes at their self-serving deception.

However I’m confident that in some cases those people don’t actually understand the active/passive arguments.

Here are some other wrong-headed things I’ve heard recently – in person and in the media – that I’m pretty sure weren’t meant as deliberate falsehoods:

As more people invest passively, it’ll definitely be easier for active funds to beat the market.

Active funds will do much better than passive when markets are falling because they can get out of expensive stocks.

Active funds can prey on the dumb money in index funds.

Index investing is Marxist.

The growth of passive investing has made markets less efficient and more volatile.

Index funds are poor performers, but at least you don’t pay much for their poor performance.

When you want the best brain surgery, you pay for the most expensive surgeon. Same thing applies with investing.

Passive investing is dangerous, because the dotcom crash / financial crash / whatever proved markets are not efficient.

Or: Markets need to be super-efficient for passive investing to work – and they’re not.

A hard-working fund manager can always beat the market.

You should invest in index funds because no active managers can beat the market.

The advanced version: You should invest in index funds because no active managers can beat the market over the long-term.

I haven’t got time to watch CNBC for 10 hours a day, so I just invest passively. It’s better than nothing.

Most of these dubious statements stem from not understanding the zero sum argument or not thinking about what it means to say markets are efficient. People also forget the huge role of luck.

But rather than debate each point myself, I’m going to direct you to a podcast on Bloomberg. (Unfortunately I can’t embed it here.)

Poker, passive investing, and a podcast

The latest episode of Bloomberg’s Odd Lots podcast – How Poker Explains The Battle Of Active And Passive Investing – centers on a paper by Michael Mauboussin, a bigwig at Credit Suisse who has long been unpicking the role of talent and luck in investing. (See his book The Success Equation).

The hosts of Odd Lots are smart, and I listen to their show most weeks.

However to illustrate my point, at least one of them doesn’t seem to understand the zero sum aspect of active investing at the start of the interview – and I’m not sure about the end, either.

But Mauboussin is patient and convincing, and well worth listening to. He’s interested in the game of active investing as well as the remorseless logic of passive. (A kindred spirit!)

Mauboussin also briefly mentions a couple of those edge cases that people sometimes bring up to contest the zero sum thesis.

As I say these – and the others he doesn’t mention – don’t change the best practical approach for everyday investors, as far as I can see. Certainly not right now, in 2017.

They will also not support a multi-trillion dollar active management industry.

After all, even if there are loopholes in the theory, the woeful market-lagging performance of most active funds in practice means such caveats are barely relevant in the real world:

Vanguard found 64% of active funds underperformed in the 15 years to the end of 2016.

Source: Vanguard/CityWire

Pretty compelling. Still, the arguments raised against the pure ‘zero sum’ mathematics do stretch your brain a bit. I’ll take the pain in a future post.

For now, get up to speed with the Bloomberg podcast. It’s a good listen.

1. Those caveats notwithstanding.[↩]

Fair warning! This long article involves comment etiquette and moderation on Monevator. Yawn! Most of you don’t comment, and many don’t read comments. You can safely ignore it.

Fun fact: You are reading the oldest investing blog in the UK, according to a new directory from Rockstar Finance.

We kicked off back in 2007. This was before the financial crisis and in a very different world where bankers were still assumed to be masters of money, UK politics was thought to have moved decisively leftwards – and the overwhelming majority of Britons, including the professionals, believed it was best to invest your money with active funds.

Younger readers might be surprised to hear that last one. But as Tadas Viskanta pointed out this week, it’s only recently that indexing has become to the masses the sort of no-brainer that even Homer Simpson would slap his head with a “Doh!”

Passive investors used to be the outsiders. Statistically, index funds still represent a minority in terms of funds invested, even in the US. But the momentum – and the mind share – is clear.

I’m proud of the small part we’ve played in this revolution in the UK.

However it also presents a problem for a multi-hued site like Monevator.

The last war

It’s many years now since I found myself battling persistent commenters – borderline trolls, really – endlessly repeating that the market was overvalued and that passive investors were going to be toast because they didn’t use cyclically-adjusted investing methods to allocate capital.

Or else that this, that, or the other active fund managed to beat the market over the past 10 years, and so the whole passive investing superiority thing was a myth.

Eventually I had to ban two of these individuals. I even removed a bunch of archived comments from one, when I decided he was partly hitting the site repeatedly for self-publicity.

Their comments were misleading, dangerous, and they rarely seemed to read the articles, or acknowledge the caveats. Worse, they ignored explanations from myself or @TA. They just repeated the same stuff the next time we posted.

Enough was enough.

People often cry “censorship!” when you delete comments. But you don’t labour away at a website to try to inform others year after year, only to see it derailed by 20-second quips from random strangers.

I have seen numerous sites ruined by an anything goes approach to discussion. And the comment sections of the mainstream papers are essentially unreadable. Indeed from my perspective, the UK made a foolish choice last year and the US a substantially more ludicrous one partly because of unmediated opinion and often incorrect information relentlessly propagated on the Internet.

So my site, my rules. Hence I’ve always been happy to censor, to try to foster a sustainable and informed community. (Writing long-winded articles strewn with multi-syllable words sets the bar high for trolls, too!)

26,459 comments and counting

If you leave aside the political discussions – which reliably bring out racists, xenophobes, and the abusive – I’ve not actually chosen to delete many comments over the years.

There is a constant flow of spam or similar that is both automatically and manually blocked from ever making it onto the site.

Back when it comes to comments from readers, back out Brexit and the aforementioned trolls and you’re probably talking just four or five deleted comments a month.

But it’s still a fair bit of work. There are now over 26,000 comments on this site, and I’ve read at least 25,000 of them. All new commenters need to be manually approved, as do comments with certain other traits. On top of that I check into the active comments five or six times a day to see how things are progressing.

The reward has been a very high standard of discussion by any measure. Articles like the broker table have particularly benefited from consistent reader input. But readers often say they find nuggets in other feedback, too.

Sure, it’s not perfect. There’s the reader who until recently has griped within minutes of every new article for more than five years. Another patronizing fellow who is so irritating that – true fact – he has prompted three or four others to email asking me to implement a ‘block this person’ feature.

Also I have a pretty good memory (and obviously a proprietorial interest) which means I remember things some regulars say better than they do.

All of which means that I know I seem to fly off the handle at some seemingly innocuous comments sometimes. You’d have to have read the previous 26,469 comments to know why!

By and by though we’ve rubbed along – with one glaring and growing exception.

Active angst

This takes me back to the start of the article. You see, the persecuted have become the persecutors, from my perspective as someone who has a wide (fanatic) interest in all kinds of investing.

And who invests actively, unlike my co-blogger TA.

Final quick bit of history. We used to always post our passive articles on a Tuesday, and more active or off-the-wall articles on a Thursday. But with The Accumulator spending so much time writing his book these past two years, that routine has been blurred.

This probably hasn’t helped what’s increasingly frustrating to me, which is – to paraphrase – that whenever we post anything that isn’t “buy a global tracker fund” we get a barrage of comments saying “buy a global tracker fund.”

Things came to a head on Thursday, when The Greybeard shared his thoughts on using investment trusts instead of income-generating ETFs to provide a retirement income. His previous articles have explained why he prefers to focus on natural yield to selling down capital. This one was about the mechanics.

We have debated why many times on his previous articles. Most non-fundamentalists can see it comes down to personal choice. The article was not claiming that income investment trusts were preferable to passive funds for all investors, or total return index beaters or anything like that.

It was taking as granted the notion – as I say, debated before and widely understood in the financial world – that many people prefer a hands-off approach to income in their older years, if they can afford it. It’s something I intend to do. And it was exploring the options.

Well, out came the fundamentalist arguments, for the nth time. That anything but selling capital was irrational or stupid. Worse, even when I politely asked people to desist, they kept coming.

Even when the author of the article pointed out they were attacking a straw man. And even when I asked again!

My memory doesn’t help here. As I say, I know in several cases exactly the same people have derailed the last few times we tried to explore this topic, too.

You might say “so what?” But you perhaps do not have experience of moderating discussion on the Internet. Repeating the same point of view over again crowds out any on-topic or nuanced discussion. And this is what happened again.

It’s tricky, because unlike the active-championing trolls of yesteryear, there’s nothing fundamentally wrong with the views being expressed. Nor are the people anything like abusive – they are trying to be constructive, I know that. The regulars involved are smart and well-informed.

But their comments were still unhelpful – on THAT post – from my point of view of trying to have a vibrant site that discusses all aspects of investing.

I say potato, you say passive investing

Several years ago I suggested to The Accumulator that we might make Monevator passive-only, as that was clearly where we’d established a foothold and where the need was greatest.

Surprisingly to me, he urged we kept things as they were. Besides my own clear interest in other stuff, he said he found the active articles interesting – it wasn’t like they were saying “buy this winning fund and double your money!” – and he thought a passive-only site would be dull and stagnant.

I decided he was right. As an aside, one of the reasons the regulars are notable is because most people come to Monevator, learn about indexing, buy their ETFs or LifeStrategy or whanot, and then disappear. (Thinking about it, that probably explains why those who return seem the most determined wing of passive investors.)

Anyway we didn’t go passive-only. Yet I still curbed my own active output, despite requests to do otherwise. I never really write about shares here any more, for example, and only rarely about collective vehicles or active strategies. The cognitive dissonance for the site and for readers, and the resulting comments isn’t very fruitful. (A reader asked me the other day why I don’t write about my own active investing in more detail. Gallows humour, I presume).

However the comments on Thursday’s post was a camel and straw situation.

Perhaps the site shouldn’t have different kinds of content on it for different readers, but it does. And there’s no point doing so if one group is going to repeatedly jam up conversation about the points raised with their own – tangential at best – perspectives.

I mean, virtually every article I’ve ever written about active investing includes a prominent pointer to our passive archives! This site is 75% passive, and clearly and regularly says that’s the best first port of call for nearly everyone. That’s good enough for me.

Off-topic? Then out it goes

So starting this week or next – when I hope to resume our series on dividend investing from my old friend The Analyst – I am going to delete comments on Thursday posts that I deem off-topic.

In time I hope to find a plug-in that will simplify letting readers know why the comment has been deleted. But I haven’t had time to explore this yet, and so it’s just going to be a nuking.

I’ve tried engaging and requesting and it doesn’t work.

This move will only directly affect the approximately 0.05% of readers who comment. But it will also affect those who read the comments, both positively and negatively.

Specifically it will definitely involve deleting stuff that isn’t technically incorrect, but which in my opinion is off-topic.

An analogy would be if a camping magazine saw its articles followed up every time by comments extolling the virtues of living in a house. Sure, houses are great. But it was an article about camping.

I know this isn’t ideal, and as I say this is a very different problem from the trolling or whatnot you get online. I like nearly all the readers who would have been affected by this new deleting policy on The Greybeard post.

But I have to try something. And so apologies in advance then for any feathers ruffled.

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