If
you want to be successful, emulate successful people. And of course, for every
investor, the big “M” for million is the pinnacle of success. But nowadays, “M”
doesn’t cut it. Success is no longer measured by the millions but rather the
billions and trillions. Big amounts for one man but that is just the secret.
The new age of investing, particularly bond investing, isn’t dependent on a
million dollar man but rather a trillion dollar machine.
Let’s
look at two funds within the VanGuard Index family. These Funds have a
staggering $209 billion in assets. The primary fund, which is often referred to
as Vanguard Total Bond Market Index I, is responsible for $124 billion.
Vanguard Total Bond Market II has an equally impressive $84.7 billion. For the
most part both of these funds operate under the same regulations as regular
bonds funds. Both funds have similar benchmarks and strategies but holdings can
differ depending on cash flow. Similarly, like other index funds, the two
VanGuard Bond funds have a portfolio manager. But here is where the story gets
interesting. The choice of investments isn’t dependent on the portfolio manager
at all. Rather the portfolio holding is tied to an external index of bonds and
is monitored using computer optimization models that build a portfolio that
tracks the performances of indexes to the utmost precision. This, of course,
begs the overly redundant question of the 21st century. Has technology made
human capital obsolete? In our case, what advantage do professional managers
have over complex algorithms?
From
an efficiency point of view, there is no doubt that the computer has certain
advantages over the age long dilemma of man vs. machine. Let’s look at the
statistics provided by the Hulbert Financial Digest. If we take 51 advisors who
beat the market in the decade long period that ended in April 30, 2012, we will
note something rather alarming. Of this group, just 22% or 11 advisors have
outperformed the market since then. In simpler terms, going with a reputable
advisor who has beaten previous odds just doesn’t cut the butter anymore. While
talking to Mr. Tint, chairman of Quatal International, Mark Hubert of the
Hubert Digest concluded that the computer donated era has made it relatively
more rigorous to identify the good and the bad. “Before the era of
computer-dominated trading, it was slightly easier to identify winning advisers
in advance, because you could more easily understand and evaluate what they
were doing,” says Mr. Tint.
A
major factor that gives sophisticated computer technology its cutting edge is
its ability to process a substantial about of information that is unfathomable
to most portfolio managers. When you previously bought or sold a stock, there
was a certain level of interaction amongst you and another human being on the
other side of the trade. Now it is a supercomputer that you have to compete
with. Emotional discharge is certainly another dominating factor. Portfolio
managers may look at the same sets of data as a machine but may arrive at
different conclusions when emotions dominate intellect. This has been studied
to a large degree by many scientists and economists. One of those being
Professor Daniel Kahneman, who teaches psychology at Princeton University. He
reports that man repeatedly loses to a machine on a wide variety of endeavors
including economics, business, psychology,and even sports.
“In most cases, the accuracy of experts was matched or exceed by a simple
algorithm,” says professor Kahneman.
From
a realistic point of view, Wall Street has shown us that there is another
element to the man vs. machine model. And that, of course, is luck vs. ability.
Once an advisor turns in an impressive performance, naturally there is hordes
of money following him. In the short term, the advisor may be able to play
another hot game but his performance is not sustainable in the longer run. This
is best exemplified by the downfall of renowned portfolio manager Bill Miller,
who at the end of 2005 had one of the best performing results in U.S. mutual
fund history. His record was unbeatable for the 15 years preceding 2005.
Naturally, he came across a lot of money entering his fund and found it
extremely difficult to maintain his remarkable record. Just 3 years ago, Mr.
Miller retired as a fund manager. In an interview with the Wall Street Journal, Mr. Miller said “It is mathematically true
that there is a portfolio size beyond which it is difficult, if not impossible,
to beat the market… the primary cause of my hot hand turning cool was bad
decision making.” Mr. Miller’s words emphasizes on two of the advantages of the
machine as discussed above. Emotional pragmatism and mathematical superiority.
There are those who are skeptical of this. The prime example being Mr. Buffett
who has consistently beaten the market in the past couple of years. Still with
a portfolio of his size, most would argue that his rate of growth won’t be too
extraordinary hence forth. Mr. Buffett himself has said that he expects his
future returns to be only slightly better than that of the S&P 500.
So
what’s the verdict? Well this is a situation that is worth looking into in two
regards. The short run and the long run. In the short run, it is quite simple.
Don’t trade. Wall Street computers have dominated short-term trading. Expert
investors and professional managers don’t stand too great of a chance. In the
short run, what most would recommend would be to hold a diversified Index Fund,
which of course gives the advantage of low expenses. In the long term, even
machines are not perfect. What gives human intelligence the upper hand is the
ability to think outside the box. One aspect that the computer lacks is
identifying a vulnerability of a reoccurring pattern. Chances are that a
computer is so fixated on a single algorithm that it fails to make sense of the
patterns emerging. Thus, if you can’t understand a pattern, you are more
vulnerable to focusing on a mindless algorithm, which at some point is quite likely
to perform poorly.
Disclaimer: This article was
posted with the permission of a third-party contributor and the opinions
contained therein do not necessarily reflect those of Smallcappower.
Smallcappower does not endorse any investment advice provided by
these third-party contributors.
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