Index Funds or Managed Funds Again

If something is easy to verify, testable, then most people would agree that it is true. They would understand the system and have a clear idea about how specific inputs affect outcomes.

If it is untestable, statistical evidence can provide a place to look, but correlation and causation only sometimes connect. Statistical knowledge, by itself, should be suspect and unquestioned belief in its absolute truth is risky.

When people know the knowledge is incomplete they seek more and they do new experiments, seek previously un-examined data and devise new testable hypotheses.

There comes a problem when people have great faith in incomplete knowledge.  When consensus of belief exceeds the knowledge available to support the belief, there is a problem. Authority minimizes research. It becomes a career ending path. No funding.

Reliance on received wisdom is risky.

A question arises in respect to the Efficient Market Hypothesis.  (EMH)  The belief that the market price of a security includes all of the information about that security.  Given that price is the result of the interaction of a willing buyer and a willing vendor, we must come to believe either that it all averages out, or the participants are all-knowing.  I have met other humans and I know none who are all-knowing and I do not trust averages.

The tendency when data is “messy” is to average it so the messiness goes away.  Averages disguise more than they explain.  As an example, the Black-Sholes method of calculating the price of an option includes a term for variability (sigma) and the formula implicitly treats it as a constant.  No security that I am aware of has constant sigma.

There is a consensus for EMH among academics, but the hypothesis is untestable.  No one knows the market in detail and that together with human psychology means the market is much too complex for a reliable test.

Statistical past events are interesting but provide no certainty:

  • The statistics do not include all of the information that may be relevant.
  • Current information is substantively different from information in the dark past.
  • People rely on emotion in addition to factual information.
  • Few of the market participants understand how the underlying economic value of a business and the price generating mechanism of the market connect.
  • Some successful active market practitioners (Buffet, Klarman, and others) dismiss the hypothesis as useless and no one has yet explained their success using EMH as a basis for their argument.

EMH is the basis for the idea that index funds are a reliable investment.  Why pay a manager when the market is efficient?  What if it is not efficient?

The efficient idea has appeal.  Average results work for most people.  That is not evidence that EMH is correct, but rather that it is simple. Possibly better than any other easy choice people can make.  Can they rely on it indefinitely?

The simplicity hides logic bombs.

  1. The index has rules governing its content.  As content changes, non-economic price effects appear. Artificial demand for some stocks and the dumping of others no longer in the index are not market or fundamental driven.
  2. What if index funds keep growing and eventually own all, or even just a significant share, of the securities that are represented in the index?  What would price mean?
  3. Index funds are not infinitely scalable and that has to mean something.  Certainly as the float outside those funds shrinks, scarcity will drive up prices.

Unquestioned acceptance of pseudo-knowledge is dangerous. As Richard Feynman has said. “I prefer questions that cannot be answered to answers that cannot be questioned.”   Be skeptical.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  866-285-7772

4 Comments on “Index Funds or Managed Funds Again

  1. Oh my goodness! I have felt what you have expressed succinctly. How does your brain work? Let’s figure that one out while we are at it. I’m afraid that because of neuro-plasticity we will not be able to do that.

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