Monevator: The UK's leading website for private investors

Is active investing a zero sum game?

by The Investor on January 22, 2015

I have previously explained that investing in equities does not need to be a zero sum game.

Now that doesn’t mean you’re guaranteed a positive return in any one year of investing – or even over many years.

Stock markets go up and down a lot in the short-term.

But even the long term – while a much more appropriate time frame to talk about when it comes to the expected returns from shares – is unknown.

Perhaps we’ll go into some terrible 20-year economic depression, who knows? Or maybe shares will simply turn out to have been too highly rated and they’ll fall for a long time as they readjust to reality, similar to what happened in Japan.

The important point for today’s article is to understand there’s nothing inherent in investing in equities that means that for you to earn the market return, another investor must lose by the same amount.

If you’re not sure why – or if you don’t understand what ‘the market’ is, or the investing terms alpha and beta – then please read the previous article so we’re all on the same page.

Market makers

Investing in a broad stock market to achieve the same return as the index (minus costs) is not a zero sum game.

However once you try to do better than the market, it’s a different kettle of fish.

Specifically, active investing is a zero sum game.

The reason is obvious once you get it, but from experience it can take some time to do so.

First off, we talk about ‘the market’. Key to understanding why active management must be a zero sum game is understanding what the market is.

When we talk about the market, we may mean different things.

We might mean the sum total of all shares listed in all stock markets around the world.

We might even include other kinds of assets, like bonds and commodities.

More commonly we might mean a specific market – such as the UK stock market – or a further subset of that market – such as the FTSE 100 index of the top 100 largest public companies in the UK.

Let’s focus on that FTSE 100 index for a moment.

Who owns this market?

Well, pension funds, hedge funds, mutual funds, and also individuals who buy and sell stocks.

How do they own the market?

They take a stake in three different ways1:

Firstly, they may be passive investors who buy index funds. These funds basically own a little bit of every company in the index, in proportion to its size in the index2. If a company’s share prices rises or falls, so does the value of the fund’s holding. If companies exit or enter the index they track then they take action, but otherwise they just aim to track the market to get the market return.

Alternatively, the investors may have invested via actively managed funds. These are funds that own more than the index weighting of some shares and fewer of other shares. For example, the manager of a fund may believe that Tesco has better prospects than other investors seem to think, while also being less convinced about BP. In response, they buy more of Tesco than the market weighting of that company, and they own fewer or even no shares of BP.

Finally, the investors may directly own the shares themselves. Again, if they do so they are unlikely to own exactly the same holdings as a FTSE 100 index fund (because it would be a lot more costly and fiddly, compared to just investing via a tracker). Most likely they own a portfolio of 15-30 or so individual shares, some of which are in the FTSE 100. These investors are effectively their own active managers.

The first kind of investor is only aiming to get the market return – the beta – which is why they have invested via index funds. By definition, they track the market, and hold shares in proportion to the market’s ownership.

If some shares go up and others go down, then so will their holdings. They can do no better, but also no worse. They will get the market return (less holding costs and any tracking error).3

That leaves the non-passive investors, who may be invested in active funds or actually running the active funds, stock picking their own portfolio of shares, or maybe owning a mix of passive and active funds.

For simplicity I’ll label them all as active investors from here, as it doesn’t matter exactly how they’re actively investing for this discussion.

Note: Sometimes people will say they are not trying to beat the market when non-index investing, but rather they are trying to be defensive, or ethical, or focused on income, or one of a gazillion other variations. That’s all fair enough – whatever floats your boat – but it amounts to the same thing from the market-beating zero sum game perspective.

Actively different

So what does it mean to be an active investor?

It means your shareholdings in a particular market are different to the market’s weightings.

But the ownership of that market is comprised entirely of…

Passive investors + active investors

…so if you want to take a different position to the market, then by definition you are going to have to do so by trading with other active investors – since passive investors just hold the market, and they ain’t giving you diddly squat if it distorts their market weightings.

An example might help.

Let’s say you own the market via a tracker fund, but also you’re keener on Tesco and so you want to own more than a market-weighting of its shares.

You therefore buy shares off an otherwise identical investor who is less keen on Tesco’s prospects than you are.

You take ownership of some Tesco shares off this investor, who now owns fewer Tesco shares. In place of the Tesco shares, let’s say they increase their holding of the market.

Now let’s imagine that was the only trading any active investors did in the FTSE 100 this year. (I think that’s what they call a quiet year!)

Recap:

You own the market plus your extra Tesco shares.

The active investor you bought them off also owns the market, except she owns fewer Tesco shares.

In our hypothetical example all other investors in the world are passive investors.

So what happens next?

Well, the market delivers the market return.

So far so obvious.

However Tesco shares either return more than the market’s return, the same as the market, or less than the market.

All passive investors earn the market return.

You and the other active investor get the market return, modified by your position in Tesco.

If Tesco shares beat the market return then you will do better than the person who sold you the Tesco shares – and they will do worse than you.

If Tesco returns the same as the market, then everyone earns the same return.

If Tesco returns less than the market, then you’ll do worse then the person who sold you the the Tesco shares – and they will do better than you.

Except in the unlikely event of Tesco delivering exactly the same return as the market, one of you must do better, and the other lose by the same amount.

That is why active investing is a zero sum game.

Note this has nothing to do with the discussion of whether some active investors can or will beat the market over the long-term.

In fact, it shows it’s trivial to create a market-beating fund over any one year – just hold the index plus shares in one company in one fund, and the index and a short position (i.e. bet against) the same company in the second fund.

One of the two funds is guaranteed to beat the market that year, before costs4. But sadly, the other is guaranteed to do worse.

Indeed, in aggregate – netting winners off against losers – active investors as a group earn the market return, just like passive investors.

They must do, since together they own the market.

What really does for investing in active funds overall is high costs.

Why active investing is worse than a zero sum game

Imagine the two fund managers who took different positions in my Tesco example charged 1% for their services.

Let’s also suppose that all that furious Tesco share trading cost them 0.5% in expenses. (Heck, it’s an expensive business in this hypothetical world of low volume trading…)

This means the total cost of their active investing is 1.5%.

In contrast, an investor in the passive fund might pay say 0.25% in annual charges.

Before taking into account these costs:

The passive investor earns the market return (beta)

The winning manager earns the market return plus their Tesco gains (beta+alpha)

The losing manager earns the market return, minus their Tesco loss (beta-alpha)

After costs:

The passive investor earns: beta minus 0.25%

Investors in the winning active fund earn: (beta+alpha) minus 1.5%

Investors in the loser earn: (beta-alpha) minus 1.5%

Schoolboy algebra tells us that combined, the active funds earn…

Beta minus 1.5%

… since the +alpha and -alpha cancel out.

Therefore in aggregate the passive investors beat the aggregate active investors, because of the latter’s much higher charges.

So in practice, active management is worse than a zero sum game.

The zero sum game writ large

While the example I gave above is obviously as simple as it can be, exactly the same principles hold true on the grand scale of real-world markets.

The fact is it must hold – ‘alpha’ cannot be magicked out of thin air.

The only place an active manager can go to get more or fewer shares than are held by the market is by dealing with other active investors in that market. (Because the passive investors by definition hold the market).

And then you have to subtract those higher costs.

This is summarized by Vanguard in this handy graphic:

Click the link to Vanguard in the paragraph above for full-sized image.

Click the link to Vanguard in the paragraph above for a full-sized image and PDF.

In this graph, the green vertical line above the ‘0’ on the x-axis is the return from the market.

You can see that there’s a bell curve of returns on either side of this market return.

This indicates how all the money that beats the market is offset by money that loses to the market.

Finally, there are costs, which are indicated by the gap left to the dotted line.

This has the affect of moving the bell curve of returns to the left – lowering average returns – as indicated by the curve in red.

Note that particular active funds do not necessarily deliver negative returns just because it’s a zero sum game. As a group they get the return from the market on average, before adding or subtracting alpha and costs. (They must get the market return as a group, because summed up active funds are the market, alongside passive investors).

So even though beating the market is a zero sum game, it’s not like poker, where a winner-takes-all.

The ‘beta’ delivered by the market goes to active managers as well as passive investors.

It is the ‘alpha-chasing’ part of their business that is a zero sum game.

And as shown above, it is a costly game since their higher costs mean that in aggregate, investors in active funds see lower returns than passive investors.

Is there always a winner for every loser?

Like other writers, I have often written that “for every winner there must be a loser” when it comes to active fund management’s attempts at beating the market.

This is convenient shorthand, but it is not strictly accurate.

It’s not that one active investing individual or active manager must lose for every one that wins.

It’s that the total amount of winning money (the total excess return over the market, the alpha) must be offset by the same amount of losing money.

The Vanguard article cited above puts it as follows:

The concept of a zero-sum game starts with the understanding that at any one time, the holdings of all investors in a particular market make up that market.

As a result, for every invested pound that outperforms the total market over a given period, there must by definition be another pound that underperforms.

Another way of stating this is that the asset-weighted performance of all investors, both positive and negative, will equal the overall performance of the market.

Incidentally, this is a big reason reason why many active investors poo-poo the idea of index investing.

“I’ve done fine with my funds,” they say. “I have made £12,343”.

They have no idea what the market return would have been if they’d just invested passively. And even if they did beat the market then they do not really understand that they risked losing to the market in order to do better.

I’m not saying don’t actively invest if you know what and why you’re doing it, and you also appreciate the nailed-on headwind from higher costs and the other potential downsides.

It’s a free world. Heck, I’m a stock picker myself.

But time and time again people who have a dangerously small amount of knowledge about investing – that masquerades as a deep understanding – will tell you:

“Why bother with index funds when the Something Or Other Fund did 22% last year and the market only did 12%.”

The statement might be factually correct, but there’s typically an iceberg of ignorance and misconception beneath it.

We’ve written over one million words on Monevator trying to address these misunderstandings.

We’ll keep at it!

But if for some reason you want a second opinion, you might try reading Noble prize winners French and Fama’s thoughts on the zero sum game:

Suppose we define a passive investor as anyone whose portfolio of U.S. equities is the cap-weight market portfolio.

Likewise, define an active investor as anyone whose portfolio of U.S. equities is the not the cap-weight market portfolio.

It is nevertheless true that the aggregate portfolio of active investors (with each investor’s portfolio weighted by that investor’s share of the total value of the U.S. equities held by active investors) has to be the market portfolio.

Since the aggregate portfolio of all investors (active plus passive) is the market portfolio and the aggregate for all passive investors is the market portfolio,the aggregate for all active investors must be the market portfolio.

All this is obvious. It is just the arithmetic of the fact that all U.S. equities are always held by investors.

(That is why we call it equilibrium accounting.)

In short, total actively invested money cannot beat the market because it is the market, together with neutral passive funds.

Remember that the next time someone says “Stock picking has the edge in a bear market” or similar nonsense.

It’s mathematically impossible.

Some stock pickers might have the edge. If they do better, then an equivalent amount of actively invested money will do worse.

To repeat myself, this doesn’t mean Warren Buffett isn’t Warren Buffett.

Some tiny number of managers might have skill (I personally think some do) or luck, and they deliver years and years of market-beating returns.

If you have a way of finding these needles in a haystack, good luck to you.

But be sure you understand that their excess returns – their alpha – must come at the expense of the poor schmucks in active funds that are doing worse.

What if I invest actively for some other reason?

Most private investors who invest in active funds do so out of ignorance, and the rest because they want to beat the market.

However there are other reasons for investing in active funds.

For instance, you may value lower volatility in your portfolio, and for some reason you don’t want to achieve that by holding more bonds.

Or you may be trying to invest more ethically, and so you don’t want to exactly mirror the market for that reason.

These are personal choices, and if they have value to you then you can argue you’re not participating in a zero sum game.

Remember in part one I said that a zero sum game was one where everyone valued their ‘slice of cake’ equally?

Well, in this case you’re valuing certain shares for more than their market beating return potential. So arguably, you have stepped out of the mathematics of the zero sum game.

True, I think this discussion is investing’s equivalent of existential philosophy! But I mention it for completeness.

It is specifically active investing to beat the market that is a zero sum game.

Wait, I invest for dividends – who am I hurting?

I’ll also just mention this briefly, as it’s a very frequent retort from British stock pickers with their affinity for buying and holding shares for dividend income.

They’ll typically say something like:

“Sure, but I don’t get involved in all that share trading shenanigans. I’m not a gambler, I just buy and hold shares and pick up the income.

Who is losing out here when I’m not even trading?”

There are two parts to understanding why you’re still playing in a zero sum game (leaving aside the caveat just mentioned above).

Firstly, while we talk about ‘the market return’ mostly in terms of indices and share prices, we should really think of it as capital gains or losses plus dividends.

That is, we should think about the total return from the market.

If you own a bunch of high-yield shares instead of (or in addition to) the market, then by definition you own a different weighting of shares to the market.

For you to have this different weighting, some active investors somewhere else (or as discussed above, ‘some money’) must have an underweight position in the same shares.

It doesn’t matter whether you trade the shares after you take this position:

You get the capital gains or losses plus the dividend income every year.

The market gets its share of the same.

The ‘person’ who is underweight your shares gets less of both from those shares.

It’s still a zero sum game in terms of beating the market, although by not trading you do reduce the cost of playing it.

Again, this is not to say you should or shouldn’t invest in a portfolio of dividend paying shares.

Each to their own, and I’m rather a fan of income investing myself.

You may beat the market return over the long-term. You may do worse.

But from that perspective it’s still a zero sum game.

Similarly, people say “who cares what the market does, I am just concerned about my own finances.”

Agreed, a very healthy attitude to have towards income investing. But it doesn’t have anything to do with whether active investing is a zero sum game.

I don’t care less about the physics of fluid dynamics when I take a shower, but that doesn’t mean the laws of physics don’t apply when I lather up.

If you’re buying different shares to the index for their dividend income5, then you’re taking a position versus the market, and you’re playing in the zero sum game.

That’s not bad or good – if you know what you’re doing. It’s a calculated risk.

But as Warren Buffett has said:

“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

Don’t be an ignorant patsy.

I’m ignoring shorting here, although it’s really just a special category of temporary ownership via active investing. [↩]
So called synthetic ETFs may track an index without owning the shares, but they can be set aside for the purposes of this article. [↩]
Someone pedantic may point out in the comments that tracker funds may move prices when they are forced to buy or sell shares when they enter or leave the market. This is true, but the impact is irrelevant in the context of this discussion. [↩]
One will do so just so long as the company returns more or less than the market, as opposed to exactly the same return [↩]
Remember that you could sell some shares after they rise to generate an income instead. [↩]

{ 43 comments }

How to find Exchange Traded Funds

Updated by The Accumulator on January 19, 2015

Searching for suitable index trackers often feels like speed dating a roomful of double agents – it’s not easy to find a good match. But having outlined my strategy for finding the index funds of your dreams, let’s tackle how to find exchange traded funds (ETFs).

Experience has taught me that no single fund comparison site should be wholly relied upon:

Fat fingered data entry means inaccurate information is rife on public sites.

Sites often lag behind recent developments.

Many sites skip out entire chunks of the market.

I don’t trust brokers to give me a reliable picture, either, so I always hunt for ETFs using a minimum of two independent fund-finding sites. This enables me to cross-reference key facts and sweep as much of the market as possible in a three-stage process.

Stage 1: Morningstar ETF Quickrank

Morningstar’s ETF Quickrank takes about 30 seconds to use. There are two things to watch out for when selecting your options:

London Stock Exchange – Leave this menu alone unless you know what you’re doing. Trading on foreign exchanges can lead into murky tax and trading fee waters, so stick to the London Stock Exchange.

Morningstar Category – Choose the asset class you’re interested in, such as inflation-linked bonds.

Hit search: Morningstar coughs up its findings and you can rank ‘em by Ongoing Charge Figures (OCF).

Unfortunately Morningstar does have blind spots, such as missing categories for emerging markets small-caps, momentum, and low volatility.

It’s always worth getting a second opinion.

Stage 2: JustETF

JustETF is an excellent ETF hunting-ground. It blends accuracy, ease-of-use, and respectable design with relevant information.

I dislike using the search box because it’s a key-word guessing game. Instead, it’s quicker to find the right ETFs using the advanced search function.

Using the left-hand column you can quickly focus your choice by choosing categories such as:

Asset class
Geographical region
Strategy (e.g. dividend, equal weight, value)

Searching by categories is obviously more old-fashioned than tugging on the tabs of a fund screener but it’s also much more effective. Like a 10-pound lump hammer.

Click on the UK in the country category and you’ll see a list of ETFs divided by index, such as FTSE 100, FTSE All-Share, FTSE 250.

Click on the index name and you can drill down into just the FTSE 250 trackers, for example.

Check other categories in the left-hand column to narrow the field still further:

Use of profit – How the ETF treats dividends, either accumulating or distributing on your behalf.

Replication – Does the ETF track its index using a physical or synthetic process?

Fund domicile – Choose Ireland or Luxembourg to avoid withholding tax problems.

There’s also a nice drop down menu that enables you to check if the ETF is into securities lending.

I do use the search box to find ETFs that don’t fit with the available categories.

For example, JustETF doesn’t currently include qua lity as an equity strategy. But if you type quality into the search box then the relevant ETFs turn up.

It’s possible that you could find all the ETFs you need purely using JustETF, but I’m as fond of a belt and braces approach as any menswear assistant, so I always use Morningstar as well.

Stage 3: The ETF provider

Appearances can be deceptive in the investment world and facts can change. So once I have my ETF shortlist, I round off my search by visiting the product provider’s website to review the latest literature for the ETFs I’m interested in.

And that’s about it!

Finding the right exchange traded fund doesn’t take long once you’ve nailed your system and got the hang of tools like JustETF.

Please do share any tips or sites that work for you below.

Take it steady,

The Accumulator

{ 27 comments }

Weekend reading: Volatility and the Swiss swoon

by The Investor on January 17, 2015

Good reads from around the Web.

What a week it’s been in the markets! If you’re (sensibly) a passive investor, then hopefully the turmoil has passed you by.

But if like me you’re an active dabbler, then you probably know what I’m talking about.

The short summary is the US market has become much more volatile on a intra-day basis (though pretty flat on a weekly view), the oil price fell further than almost anyone thought possible, and to top it all the Swiss National Bank removed the cap on its currency – a dramatic and unexpected move akin to an elephant parascending onto a crowded kid-strewn bouncy castle.

The chaos left made some big name FX brokers reeling if not insolvent.

So the first lesson of the week is relevant for everyone, which is that things fail.

I’ve said before I would never have all my money with one fund group (not even Vanguard) nor one broker. This week shows why.

I still meet or read about people with nearly all their money in 1-2 shares, which is insanity unless you founded and run the company. Even then it’s extremely unwise.

But I’d also question the wisdom of running your entire diversified passive portfolio on just one cheap online platform.

Many do it. I wouldn’t.

Sure, the 50-1 leverage used by traders on those FX platforms was a clearly outsized risk compared to an online broker or platform with segregated accounts that supposedly keeps your money safe.

And yes there are investor compensation schemes.

But things can go wrong, and they’re always unexpected things. The fail-safes may fail.

As The Accumulator wrote in one of those articles on the subject:

Does it matter? Can the worst happen?

It’s rare, but yes it can.

It’s a personal choice, but for me paranoia is a price worth paying.

It doesn’t hurt to look, does it?

As for what you should do in light of this recent volatility, the house view is that most people are best off being passive investors and doing nothing.

Fiddle, and you’ll probably make things worse.

(Of course I’m assuming here that you’ve got an appropriate asset allocation for your temperament and long-term goals in the first place.)

At times of scary headlines, the best thing to do is often to just look the other way, as Morgan Housel said this week at the US Motley Fool:

Go do something else.

Maybe read more books and fewer articles.

Be more choosy about who you’re willing to listen to.

The amount of financial information available has exploded over the last decade, but the amount of financial information that you need to be informed has not.

You have to learn how to sift through the news, and filter out what you don’t need.

“A wealth of information creates a poverty of attention,” Herbert Simon said. It also creates a dangerous tendency to lose self-control over your ability to be a patient long-term investor.

Just look the other way.

It’s great advice. If you’re a passive investor then I suggest you skip straight down to the links below!

The gnomes of Zurich

Still here? Really? After seven years and ever fewer articles about active investing on Monevator, you still haven’t got the message?

Oh well, I can’t be a hypocrite. So for what it’s worth I’ll offer up a very brief bit of frothy speculation.

A few crazy long-time readers even asked me what I thought. (Careful! I am just a bloke on the Internet!)

To start with, I don’t think the heads of the Swiss National Bank suddenly woke up lobotomized. They knew the chaos their action would cause, and they knew it would inflict a lot of hardship on their own economy.

We also should keep in mind that there was only recently a (failed) referendum on returning Switzerland to a gold standard of sorts. Clearly a significant chunk of the Swiss population was growing wary of trying to fight the plunging Euro.

So I think it’s pretty much nailed-on that the ECB is going to announce full-blown quantitative easing in the next few days.

Either the Swiss got a heads up from Mario Draghi or took their cue from a recent EU lawyer’s decision on the legality of European QE, or else they spend all their days thinking about such things, and they’ve divined it ahead of the market.

(Of course people will say the market already expects QE from the ECB, too. But if certainty was really a widespread view, then we wouldn’t have seen the storms we saw following the Swiss move. I think more money would have already been positioned ahead of it, and hence the volatility would have been lower).

2015: A year of living dangerously

And what of the US intra-day volatility?

A few things are going on, I’m guessing.

Firstly, the collapse in energy prices was unforeseen, and it has wide macro-economic consequences as well as an impact on pretty much every listed company. So everything needs to be repriced in light of this development.

That is even leaving aside the fact that it may be telling us global growth is rolling over, because it’s really a demand shock. (I doubt it, but it is a risk).

Secondly, I suspect money is repositioning itself ahead of ECB action, possibly by buying into Europe (optimistic investors) or even more into bonds (pessimistic investors).

Thirdly, “everyone knows” (see Swedroe in the links below) that the US is an expensive stock market. So no wonder they dump it if they worry about the above.

Fourthly – and this is a gut feel thing – I think markets, including oil, are more illiquid or certainly less buffered than they used to be.

Perhaps it’s down to investment banks scrapping trading desks. Perhaps there’s less leverage in the system at hedge funds or similar. I can’t quantify it and it might be a misleading path to go down – because things have been so placid for so long, as volatility has been smothered by low interest rates, that we may have just forgotten what real volatility feels like.

But with that caveat, I think something has changed.

Fifthly, related, the Swiss National Bank move, the role of leverage at the brokers, and the associated fallout gives us an insight that you can’t regulate away risks, which regulators seem hell bent on trying to do.

As I’ve written before, risk cannot be eliminate, it can only be transformed.

Fifth-and-a-half-ly – It also gives us an insight into what happens when risk is effectively taken out of the markets and placed with Central Banks. Calmer most of the time, but the ever-present danger of big Central Bank initiated dislocations.

Finally, I don’t want to scare anyone but when stock markets crash, it’s my belief and experience that they behave in the way that the US market has been acting over the past six months.

Leadership narrows (fewer stocks go up) and at the end of the run you get violent swings up and down.

The US market has had a terrific six years. We don’t need to see a massive bear market crash, but a significant correction is well overdue, in my view.

It may be as I say that money is repositioning itself out of expensive US shares and into European equities ahead of the ECB move. It may even be that the volatility doesn’t presage a crash, but rather a lurch higher – that’s possible.

Think of an old engine juddering and coughing as it either roars to life or else conks out. I suspect that may be where we are with the US bull run at the moment.

Don’t do what I do

What have I been doing?

With most of my portfolio – nothing.

At the margin, at a portfolio level: Reducing US exposure, trading energy stocks, building up a position in commodity producers (from near-zero!), and adding more European exposure. (I waited a long time to buy more into Europe as I was and still am fearful of the currency risk).

Caveat: The active share of my active investing is active. This might all be different by next Saturday!

The bottom line is that if you aren’t a well-diversified investor because it has seemed pointless in the past few years of placid markets, you might consider this a wake-up call.

Or at the least, know all the risks you’re taking, however you’re invested.

[continue reading…]

{ 24 comments }

Is investing a zero sum game?

by The Investor on January 15, 2015

One problem with writing an educational sort of blog is you never know who you’re talking to.

The same is true with a book or a movie, but the difference with blogging is a reader usually pops up right in the middle of things, having been sent to some article on the whim of Google.

This means you can’t assume anyone knows anything just because you’ve written about it before. And you can’t assume they’ll ever come back.

It all presents some challenges, including the one I am going to discuss today, which is how to answer the question: “Is investing a zero sum game?”

On the one hand, I might be talking to someone steeped in years of active fund propaganda, who genuinely believes it’s smart to pay up for a portfolio of actively managed funds because they think that clever active fund managers who work hard will obviously beat a dumb ‘buy everything’ strategy.

It sounds so logical. Whereas passive index investing just feels wrong.

To these people, we need to explain that while it’s certainly true that many active funds will beat the market in any given year, it’s impossible for a majority of actively managed money to do so, and also that vanishingly few funds have long-term records of outperformance. (Just 1% or so, according to some studies. Good luck picking them in advance!)

On the other hand, we might be visited by a new investor who wants a better return than from cash, but who has got the impression from movies and newspapers that the stock market is a winner-takes-all casino – that it’s like playing poker against Gordon Gecko and The Wolf of Wall Street.

To these people we need to explain that passively investing in equities gives you a stake in the growth and output of productive business.

Investing need not have anything to do with trying to pick winners or with regularly making bets – trades – unless you want it to.

The super market

At the crux of it all is the ‘market return’. This the return that a particular market returns in a particular year.

For instance, if the UK’s FTSE 100 index of the top 100 largest companies goes up 10% this year and pays out 4% in dividends, then the market return would be 14% for the year.

You can get the vast majority of this return by owning a cheap passive fund that tracks the index (with a little bit deducted for the costs of running the fund).

At financial cocktail parties, the lingo for this return from the market is beta.

Any additional return you get that beats the market – from stock picking or borrowing to invest or what have you – is called alpha.

Let’s say you own an active fund that delivers an 18% return by investing in a superior selection of FTSE 100 companies in the same year the UK market goes up 14%.

In this case, 14% of the return was beta – the market return – with another 4% (that is, 18 minus 14) chalked up to alpha.

On the other hand, if your active investing does worse than the market, then the return reduction is sometimes called ‘negative alpha’.

Let’s say another active fund you own achieves 10% in the same year.

In this case, the alpha is negative 4.0 – this time the fund manager’s decisions (and/or costs) reduced the return you got from the market (beta) by 4%.

(Note: I am necessarily simplifying here for brevity. In particular I am ignoring risk. We’ll look at that more deeply in a future article.)

Alpha, beta, and beating the market

While introducing Greek isn’t usually a recipe for clarity (there’s only so many Popadopolouses that an Anglo-Saxon mind can process) in this case I think it’s worthwhile in attempting to explaining what investing is, and what it isn’t.

Because what we’re really talking about when it comes to the zero sum game question is alpha, not beta.

As I say, you can get beta from a tracker fund, or via the market-mirroring elements of an actively managed portfolio.

But where does alpha come from?

At someone else’s expense, that’s where.

What is a zero sum game?

Let’s go back to first principles. Wikipedia describes a zero sum game as:

…a mathematical representation of a situation in which a participant’s gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s).

If the total gains of the participants are added up and the total losses are subtracted, they will sum to zero.

Confused?

Luckily the author swiftly appeals to our stomachs:

Cutting a cake, where taking a larger piece reduces the amount of cake available for others, is a zero-sum game if all participants value each unit of cake equally

There’s only so many pieces of cake to go around. If eight of us divide a cake into eight pieces and you swiftly gobble down two pieces, then someone will go without cake.

That’s a zero sum game.

Is investing a zero sum game?

A lot of people have the impression that investing in equities (shares) is a zero-sum game.

They hear about Wall Street and the City of London’s winner-takes-all mentality, and they think investing must be like a poker game.

In typical poker games, everyone brings the same wodge of cash to play. As they win and lose their money, it is redistributed around the table between the players.

Often players bow out of the game when they run out of money, leaving fewer players to compete for that same total ‘pot’ in circulation. Often one player goes home with everything – that is, they take home all the money the players together brought to the table.

Poker is a zero sum game. You win money by taking it from someone else.

And that is is not necessarily what happens when you invest in equities.

Equities are small slivers of ownership of companies.

To simplify for the sake of today’s discussion, in any particular year a single company may do badly or do well, but over the long-term you would expect companies as a whole – the ‘market’ – to grow their earnings as the economy expands and companies become more productive, and also because inflation boosts their sales numbers in nominal terms.

This is the reason why stock market indices – a measure of the value of all the companies listed in a particular stock market – have overwhelmingly tended to increase in value over the long-term, provided those markets haven’t been struck down by hyper-inflation or a communist revolution.

For example, the following graph shows how the total value of stock market listed US companies has increased in real terms over the past century or so – i.e. even after backing out the illusory growth from inflation:

Click to enlarge

The black line rises as US companies have collectively become more valuable, although the spikes and troughs show it hasn’t been a smooth ride.

Sometimes people get carried away and pay too much for companies. Sometimes they are frightened and prices plunge.

This kind of volatility is another reason why some people think investing in equities is like gambling, incidentally. Over the short-term, luck does play more of a factor as a consequence of these gyrations.

But over the long-term, the growth in value is clear.

In addition, as well as this rise in the long-term value of their shares, investors in equities also benefit from dividends – regular payouts of cash.

You can see in the following graph that reinvesting dividends (the green line) makes an enormous difference to long-term returns, as well as dampening down that short-term volatility.

Click to enlarge

As an investor in equities then, you expect to benefit from the growth in the value of your shareholdings, and also from receiving those regular cash dividends.

This is because you own stakes in businesses. It’s exactly the same as if you owned a pub or an ice-cream van or a buy-to-let property. You are making your money by investing in productive businesses, not by trading or gambling.

Earning a beta return from the stock market

A quick look at the long-term record shows that the UK stock market has delivered an annualized real1 return better than 5% over the past 100 years or so.

Now, this does not mean you are guaranteed to get a 5% real return in the next 12 months from the UK stock market – as we saw in the graphs above, in the short-term anything can happen.

But it does mean that over the long-term – say 30 years of saving for a pension – then if history is a guide you might expect an annualized 5% real return from UK shares.2

If you own the market (via a tracker fund) then you will get the market return.

You can hopefully see therefore that investing in equities via an index tracker fund is not a zero sum game.

All investors in the UK market in aggregate can expect that long-term 5% annual real return3, before costs, provided the economy keeps growing and stock market listed companies get their share of that growth and the investors are invested in such a way as to capture the return from the market (the beta).

Everyone’s a winner! No zero sum game here.

Reminder: A cheap and easy way to capture the return from the stock market (minus modest costs) is via passive investing in index funds.

The confusion arises because active investing is a zero sum game when it comes to trying to beat the market.4

To learn why read the follow-up post: Is active investing a zero sum game?

That is, after taking out the illusory growth in value from inflation. [↩]
I am not going to get into the various caveats about prospective returns or whether we’re in a environment of low returns or what have you right now. That is irrelevant for the purposes of this article. And also I don’t believe it’s true. [↩]
Or whatever the long-term annualized return for UK shares turns out to be. [↩]
You can argue that you’re happy to take less risk for a lower return, say, but then you’re not beating the market so that’s a different question. [↩]

{ 0 comments }

Next Posts Previous Posts