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OPINION

Second-best trackers

Second-best trackers
August 6, 2015
Second-best trackers

Let's concede - for the sake of argument - that my interlocutor is correct and that investors are irrational in many ways with the result that shares are mispriced.

But it is not just others who are irrational. We are too; a lot of the pieces I write on cognitive biases are memos to myself. The idea that it is others who are irrational and us who are rational is monumental arrogance, reminiscent of Homer Simpson's statement "everyone is stupid, except me" - uttered just before he fell asleep smoking a cigar and set his house on fire. It's an example of what Nobel laureate Daniel Kahneman has called the most damaging of biases, overconfidence. It's this that causes us to lose money by trading too often; taking on too much risk in the belief that we have found safe stocks; and spending too much on fund managers' fees because we think we have found a skilful manager.

Let's remember the big facts here. Economists at Vanguard have shown that most actively managed funds underperform their benchmarks, and Brad Barber and Terrance Odean, two California-based economists, have shown that most retail investors do too. (These claims aren't contradictory. Dealing costs are like the zero on a roulette wheel; they mean the game is a negative-sum one.)

These facts tell us either that markets are efficient after all, or that if markets are inefficient, most of us are unable to profit from these inefficiencies because of our own errors of judgement.

And herein lies the case for trackers. They protect us from ourselves by stopping us making these errors. Maybe the market is not an optimal portfolio. But so what? Pretty much nothing is optimal. Trackers are, however, good enough. And as the late Herbert Simon said, "satisficing" is sometimes the best we can do.

In fact, this is true in another sense. One problem long-term investors have is the danger that even their best stocks will eventually be on the wrong side of creative destruction; changes in technology, markets and strategy can transform good companies into bad. Of the original FTSE 100 members in 1984, only 29 are still in the index today. And several of those erstwhile blue chips subsequently collapsed, such as Ferranti, GEC, Exco and British and Commonwealth.

This tells us that you cannot be both a stock-picker and a long-term buy-and-hold investor. If you are, you risk ending up with a portfolio like that of Montgomery Burns in the Simpsons, comprising Amalgamated Spats, the Baltimore Opera Hat Company and Confederated Slave Holdings.

Stock-pickers must therefore rebalance their portfolios occasionally. But this runs into two problems.

One is that the losers from creative destruction are unpredictable. Bridget Rosewell and Paul Ormerod of Volterra Consulting have shown that company bosses cannot predict their own company's demise. So what chance do outsiders, who are generally less informed, have of doing so?

The second problem is that when we try to rebalance to avoid creative destruction we might fall into one or more of the countless traps that can cause stock-pickers to underperform. The disposition effect might lead us to hang onto losing stocks in the hope they will break even. Underreaction might cause us to underrate some warning signs about our favoured stocks. Lottery-try preferences might cause us to pay too much for speculative stocks. And so on.

Tracker funds, which automatically rebalance to cut losing stocks and buy emerging ones, save us from these errors and uncertainties. They allow us to back the field rather than particular horses.

In this sense, tracker funds are a form of commitment device, in two separate senses.

One is that they help commit us to regular investments, simply because it is very easy to invest in them via direct debits. This both gets us into the habit of regular saving, and helps us buy when prices are low, when we might not feel much like investing.

The other is that they protect us from ourselves, by ensuring that we don't make errors of judgment.

In this context, we should distinguish between passive investing and market tracking. Even if you believe markets are inefficient, you can be a passive investor, because there are ETFs that allow you to track momentum or high-yield factors. If you believe that market inefficiencies take the form of value and momentum outperforming, you can hold these ETFs. You don't need to pick stocks.

The question of whether markets are efficient, and the question of whether you should be a passive investor (and if so, in what form) are very different questions. You don't need to believe markets are efficient to be a passive investor.