Modern Portfolio Theory

[Shuie]

Is there anywhere I can go online to see a few different points of view on passive MPT investment strategy vs. actively managed investing. Preferably, something that is credible. I can google and wikipedia all of this, but I really don't trust the things I find randomly on the interweb as much as I trust the community here. Can anyone recommend a good book on the topic?

Are the concepts of active vs. passive trading a six of one vs. half a dozen of another thing? Is it more of a philosophy question where the answers are really difficult to measure?

TIA

[scottmandue]

I can barely understand what you are saying but I forwarded the question to one of my buddies with a MBA?

[Rich76_911s]

What exactly are you trying to learn?

I can look tonight in my CFA textbooks for the references in the MPT section.

My feeling is that contrasting the MPT to active management is pretty much an academic exercise without a ton of practical usefulness, but that is just my opinion.

Maybe search the CFA website, you might find something:

http://www.cfapubs.org/action/doSearch?func=showSearch&action=runSearch&type=within&result=true&startPage=0&prevSearch=subjectcodefield%253A%2528K%255C-110%255C-160%2529&text1=&field1=&logicalOpe1=&text2=&field2=&logicalOpe2=&text3=&field3=&sortBy=date&searchText=&saveSearchName=To+save+search%2C+enter+a+name+here ...&alertme=true&searchalert=Weekly

[Shuie]

Originally Posted by Rich76_911s

What exactly are you trying to learn?

Exactly this kind of thing.

My feeling is that contrasting the MPT to active management is pretty much an academic exercise without a ton of practical usefulness, but that is just my opinion.

I just want a few different points of view. I'm getting more involved in investing and I just want to hear what some of the investor types here think about these kinds of methods and strategies. Im not so interested in the math behind it, I just want to look at it from a few different angles.

[TheMentat]

I could talk about this stuff for hours...

MPT is really just a theoretical framework. It is taught today because it makes some nice graphs, but more importantly, because it results in some useful and practical implications:

• Risk vs. Return Relationship
• Effects of diversification
• Usefulness of risk-free assets for risk mitigation or leverage

However, as an investment management tool, it doesn't really add value. The problem stems from some big assumptions that are "baked in" to the framework. These assumptions result in some formulas that are nice to work with, but unfortunately don't reflect the real world.

I could go on, but I think I've already answered your question...

[TheMentat]

With that being said however, "MPT" is not the only passive investment strategy out there...

[Aggie93]

This book was (maybe still is) on the CFA curriculum and I recommend it.

Amazon.com: New Finance, The (4th Edition) (9780136036043): Robert A Haugen: Books

I wrote a commentary several years ago arguing against passive investing. It's over 10,000 characters and I don't have time to edit it down right now. I'll try to do a readers digest version tonight. I have a philosophical problem with passive investing that is probably more than you are asking for.

[Shuie]

Aggie, please, post or PM me a pruned down version if you get time.

[RWebb]

Originally Posted by TheMentat

It is taught today because it makes some nice graphs...

so true of so many things

[RWebb]

Shuie - search here in OT for "Vanguard" - you'll find some worthwhile threads with inks & book advice

[dan88911]

Check out Bobbrinker.com
Investor education section.

[Aggie93]

Deleted some parts to get down below 10k. For reference it was written in 2002 when Wall Street research was being scrutinized. I think led by Spitzer.

I also recommend this to anyone interested in investing: http://www.tweedy.com/resources/library_docs/papers/WhatHasWorkedInInvesting.pdf

Index Investor's Free Lunch

Index investing has become a major force in the investment community. Not only is the amount in index funds growing quickly, but the number of managers resorting to "closet indexing" is growing as well. Index investing is universally praised as the low cost way to capture market returns and outperform the majority of actively managed funds. Last month, Jesse Eisinger, writer for the Wall Street Journal, took index investing to task and Jack Bogle, founder of Vanguard and index investing's leading cheerleader, took exception to Eisinger's comment and wrote a response, which launched a point-counter-point discussion that was published in Eisinger's column.

Bogle's initial response centered on the, "staggering costs of financial intermediation." Among these costs are research costs. Bogle claims that, "research, for all it probably contributes to liquidity and market efficiency, creates negative value for the system as a whole."

Eisinger's best counter point was:

"Indexing is great if very few people practice it. The more popular it gets, the worse an idea it is. Indexing and its cousin, shadow-indexing, drive money into stocks not when they are undervalued, but when companies are included in some index. The practice prevents people from selling stocks that are overvalued, because they are in an index. As more and more money hugs a benchmark, fewer people make decisions about what stocks prices should be. Prices start to diverge from their fundamentals. Indexing and shadow-indexing create inefficiencies because the investors are not trying to make money and prevent themselves from losing money. They are simply interested in relative performance. In the long-run, the more investors index, the more opportunity there is for a good long/short hedge fund doing solid fundamental research to exploit it."

Bogle replied:

"Yes, it's at least possible that the more investors who index (or closet index), the more opportunities that are created for "solid, fundamental research to exploit it." But the eternal mathematics of the markets inevitably insure that, in effect, for each hot shot that succeeds in exploiting it by, say, 5 [percentage points], there is a cold shot that must lose by, well, 5 [percentage points] per year -- before costs. After costs, the winner wins by 3 [percentage points] or so. But the loser loses by 7 [percentage points]. That symmetry doesn't appeal to me."

A couple weeks later, John Bogle wrote an editorial for the Wall Street Journal. In his editorial, Bogle further discussed the virtues of index investing. Bogle said, "There is not evidence that research - even the research of the Institutional Investor all-stars - adds value… The stock market is highly efficient, and that stock prices incorporate virtually all information." To be fair, there is a chance that he is only referring to Wall Street research since later he argues:

"If fund managers were willing to put their money where their mouth is and move to incentive-penalty fee schedules, the additional investment in research could be accompanied by far higher profits, for managers and fund owners. Under this scenario, the responsibility for most security analysis and research would gradually shift from the sell side -- with its present conflicted motives and unsatisfactory outcomes -- to the buy side, independent and proprietary."

It has been my experience that most buy-side firms have internal research analysts and use Wall Street for detailed or industry type information rather than stock specific research. But that is another soapbox.

Bogle returns to his main argument in concluding his editorial:

"for the market as a whole, research is a dead-weight cost that turns a zero-sum game into a loser's game. While the billions spent by Wall Street and institutional managers on research doubtless elicits useful information, stimulates trading activity, and fosters liquidity, its costs, along with all of the other -- and even higher -- costs of financial intermediation, guarantee that for investors as a whole, beating the market will remain a loser's game."

Eisinger got real close to the central issue against index investing when he argued that as more investors participate in indexing, prices start to diverge from their fundamentals. But, he missed the systemic issue.

Bogle said, "research is a dead-weight cost that turns a zero-sum game into a loser's game." It is true that active managers on average will earn less than the market return due to costs. This is Bogle's main argument for indexing since an index fund does not incur research cost and can generally save money on transactions because turnover is minimal. In a world where index funds exist side-by-side with active managers, index funds will always outperform the average actively managed fund. But, research costs provide a valuable service. It is research that maintains the system and while it might cause managers to under-perform an index, research allows the game to exist. I submit that these costs are necessary to foster a financial system that efficiently and effectively allocates capital.

In his editorial, Bogle quipped, "Never think you know more than the market. Nobody does." Bogle obviously believes in the efficient market theory, which can be debated. But lets look at what Eugene Fama wrote in his Ph.D. dissertation when he coined the term efficient market in the 1960s:

"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."

With a large number of market participants following index investing, there is a lack of "profit-maximizers actively competing, trying to predict future market values of individual securities." Without these market participates, the central premise of efficient markets is thrown out the window.

Bogle also seems to dismiss "the role of the security analyst as a financial statesman," as Benjamin Graham wrote in "Security Analysis," Granted, analysts have not acted as statesman during the past several years, but shouldn't we attempt to rectify that problem instead of compounding it by adding an additional problem? Financial analysts and money managers have an obligation to the financial system to allocate capital where it will be most beneficial. This clearly cannot happen when money managers invest in an index.

In an article earlier this year in the Investors’ Business Daily, Gus Sauter, managing director of Vanguard's Quantitative Equity Group, which runs $205 billion in 32 index funds, said, "Diversification is the big lesson on the Enron situation. If you have concentrated positions in stocks, you're subjecting yourself to the risks of just a few holdings." This shows just how far the mentality of indexers is removed from actual investment decision making. How about realizing research is the biggest lesson, or footnotes should actually be read? Perhaps the lesson from index managers is, make sure your bad investments are no worse than anyone else's.

Perhaps an even greater evil is "closet indexing." Even Bogle admits that closet indexing is "pernicious." Unfortunately, it is also widespread. Closet indexing has grown as portfolio managers learned that they will not be fired for providing returns similar to their benchmark. There is no easier way for an investment firm to lose assets than to significantly underperform its benchmark, especially now with all the consultants and other purveyors of performance monitoring.

Bogle claims that, "indexers accounted for 4/10 of one percent of stock market volume last year, so it's hard to imagine that tiny tail wagging the giant stock market dog." The trading volume of pure index firms might be that low, but the amount of assets controlled by indexers and closet indexers is enormous. A Financial Times story from early this year said, "Large index-tracking investors, who account for 10 to 12 percent of the world markets." In the article it estimates the S&P 500 is followed by almost $11 trillion. This is not the amount indexed, but the amount that is benchmarked to the S&P 500.

The ratings that Wall Street uses should be a big indication of how widespread "closet indexing" is. Several firms use the ratings: over-weight, equal-weight, and under-weight. If the firm thinks the stock is fully valued or overvalued why recommend any position in it. It can only be to cater to those trying to closely mimic an index or utilizing an enhanced indexing strategy. Enhanced indexing involves sticking to index weighting for the majority of the portfolio and tweaking slightly to fit personal investment merits. Enhanced indexing is usually done by maintaining the industry weightings of an index and taking a few bets on specific companies, either by over-weighting them or by including companies that are not part of the index.