Loser’s Math

On Tuesday, the excellent Josh Brown wrote a post called Math isn’t an Edge.  In it he argued that math isn’t an investing edge, important though it is.  I countered with Math is a Major Edge, in which I asserted that since math is so often misinterpreted and ignored, it does indeed provide a major edge. Josh clarified his point in Math is a Foundation, Not an Edge to be clear that while nearly everyone in the field knows the math — it’s an important and necessary foundation — it’s the analysis that sets people apart.  I replied  to note that while I agree that good analysis can provide a major edge, there is a foundational problem too. 

Ignoring the facts we know is practically and effectively no different from not knowing.  Ignoring the math we know isn’t an analytical problem.  It’s much worse than that.  It’s a moral problem.  Knowing and using the “math” (broadly interpreted to include basic investing principles) is thus a major edge.  Otherwise, how could such dreadful investment management performance be so commonplace?

• As we are all well aware, managers generally fail to beat their benchmark indices.  In 2010, only about 25% of active managers outperformed.  2011 was even worse.  Among 4,100 funds that invest in large-cap stocks, only 17% beat the S&P 500 for the year.  Moreover, according to Bianco Research, 48% of equity mutual funds underperformed their benchmarks by more than 250 basis points. Those few managers that do outperform in any given year have a very hard time (more here) keeping up the good work.
• Hedge funds – despite (and in part because of) enormous fees – have also badly underperformed.   Since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved simply by investing in Treasury bills. Performance thus far in 2012 has lagged too. 
• The Global Market Index (GMI) —a passive, unmanaged but well diversified mix of all the major asset classes weighted by market values — has outperformed nearly everything else over the past decade, providing a 6.0% annualized total return for the 10 years ending December 31, 2011. That puts GMI in the 89th percentile relative to the roughly 1,200 multi-asset class funds with at least 10 years of history (and thus makes it an even better performer overall than the 89th percentile suggests once survivorship bias is factored in). GMI’s rebalanced and equal-weighted counterparts did even better. 

I concluded by stating the obvious:  “the real bottom line is this – whether the key problem vis-a-vis the math is foundational or analytical, our industry is failing consumers and failing them in a big way, over and over again.  That’s about as foundational as our business gets.”

I thought Josh and I had a healthy exchange and don’t think we disagree all that much overall.  That was that, in other words.  But then my final post in the series received this comment by “Matt”:

Can you provide any specific examples as to how your math edge has generated sustained alpha? Thanks.

Just about the right blend of self-satisfied smug and snark, don’t you think?  But more to the point, the predicate to Matt’s question demonstrates why and how simply using math (and not ignoring it) provides a major investing edge.

Investing is a loser’s game much of the time (as Charley Ellis first noted and as I have also noted before) – with outcomes dominated by luck rather than skill and high transaction costs.  To illustrate, for most of us tennis is a loser’s game. We do not possess the skills to play well consistently.  Trying harder to make great shots only makes matters worse.  Most of us are far better off simply trying to keep the ball in play rather than trying to outclass an opponent.  If we keep the ball in play we give the opponent the opportunity to make errors.  That’s a loser’s game — the results are dominated by what the loser does.  On the other hand, professional tennis is a winner’s game, with the outcome based predominately upon the winner’s better shots.  A pro generally needs to do more than just keep the ball in play to succeed.  In other words, if I avoid mistakes I can win a lot of matches at my local club.  But I can’t win Wimbledon that way.

Sadly, unlike professional tennis, even professional investing is predominantly a loser’s game.  Those who avoid mistakes will generally win (as the statistics above amply demonstrate).

Therefore, Matt, I don’t need to generate sustained alpha to gain and maintain an edge.  Hedge funds have underperformed T-bills for over a decade — by a lot.  Roughly 90 percent of investment managers fail by any reasonable standard.  Simply not screwing up (based upon the math) means that I will have a major edge.