In 2015, Ted Seides accepted defeat.
“For all intents and purposes, the game is over. I lost.”
He was a fund manager at Protege Partners LLC – a hedge fund.
After accepting defeat, Ted left his job as a fund manager.
He wrote about this 'defeat' in 2017 in an article.
What he was referring to was a bet he had placed – and lost.
In 2008, Warren Buffett challenged hedge fund managers that most of them would not be able to perform better than an index (S&P 500) over a period of 10 years.
The betting amount – $1 million.
Protege Partners had accepted the bet.
10 years were not even over but Ted realised he was not going to win the bet.
An investor would have made more money by investing in an S&P 500 index fund than most hedge funds.
Warren Buffett has long maintained that most investors should simply invest in index funds.
Why does Warren Buffett believe this?
To get into that, we will have to first understand a few basic things.
Index
An index is a group of stocks. They are usually chosen to represent a certain market, theme, industry, etc.
Their weight on the index can be equal, market-cap-based, share price-based, etc.
Example: Nifty 50 is made up of India’s 50 biggest companies by market cap. And the weight of each company is decided by its market cap.
We will not go deep into the exact calculation of an index.
Index Funds
In 1976, the first index fund was launched – the Vanguard 500 fund.
This index fund invested in the stocks of an index called the S&P 500.
S&P 500 is an index that is made of 500 of the biggest companies in the USA (it’s like an American Nifty 50).
This concept was quite revolutionary back then.
This index fund would not have a fund manager deciding which stocks to buy or sell. Instead, it would simply invest in the index – in proportion to each company’s market cap.
The idea behind it was simple.
Mutual funds invest in stocks. They need to research and analyze stocks. For this, they need large teams of skilled professionals.
Managing a large team costs money (salary, office, etc).
John Bogle – the inventor of index funds – believed that most mutual funds were not performing well despite the research and analysis.
His pitch was that an index fund would give better returns than many mutual funds.
Over time, his belief proved to be mostly true – in the USA.
The Vanguard 500 index fund performed better than a majority of mutual funds.
Benchmark
This comparison was a test for mutual funds.
Can a mutual fund perform better than an index fund?
If it can give better returns than an index fund, it is a good mutual fund.
If not, people should just invest in the index fund.
This holds true for Indian mutual funds too – they are compared to the returns from index funds.
The challenge however is that not all mutual funds invest in large company stocks.
For example, many mutual funds are dedicated to investing in small-cap stocks.
Such mutual funds often end up giving returns much higher than an index like S&P 500 or Nifty 50.
This is a wrong comparison.
Small-cap stocks are a greater-risk investment than stocks of large companies.
This is why, each mutual fund is compared to an index that is similar in risk.
In India, many small-cap mutual funds are compared to Nifty Smallcap 250 Total Return Index.
Earlier, mutual funds used to compare their returns to an index to show how good they were.
Now, it is mandatory for each mutual fund to declare the benchmark index at the launch of the fund.
Likewise, there are different benchmarks for different categories/subcategories of mutual funds.
Mutual funds aim to give higher returns than their benchmark or index returns.
Alpha
This is where the concept of alpha comes in.
What is alpha?
Alpha is the return above the benchmark.
Say a large-cap mutual fund gave a return of 16%. And during the same period, the relevant index fund gave a return of 14%.
Here, the mutual fund gave a return 2% higher than its benchmark index.
So we can say this mutual fund generated an alpha of 2%.
If the mutual fund gave 10% and the index gave 12% over the same period, we say the mutual fund gave a negative alpha of 2%.
Alpha is the name of the game.
It is why any investor invests in a mutual fund – or picks stocks on their own.
Efficiency
So, we understand the terms involved here.
What Warren Buffett is saying is that most investors (including fund managers), cannot produce an alpha.
Why is that?
This comes down to something called ‘market efficiency’.
More efficiency means results in quicker changes in stock prices. This is a very simple way of describing efficiency.
Let’s say some good news about a stock has come in. This means its share price should be higher.
In a less efficient market, this share price would take a long time to go up.
More investors would gradually know about the news. Then they would start buying. The share price would move up slowly.
That would allow all investors more time to buy those stocks.
In a more efficient market, this share price would go up much faster. Which means, very little time to buy those shares.
This prevents more investors from being able to generate higher returns.
Only the investors who have access to information very early will be able to buy shares before they rise.
In an extremely efficient market, almost nobody would be able to do this consistently.
Warren Buffet’s argument is that the USA’s share markets are very efficient.
There are many smart investors. Information is very readily available. So the share prices change very fast to the latest available information.
This is why very few investors are able to make high returns there.
In such extremely efficient markets, Warren Buffett says that it is best to just buy index funds – and grow exactly as the overall stock markets are growing. Not faster. But not slower either.
India
Now, we have to note, it is not necessary that an investor or mutual fund is generating alpha all the time.
In the short run, ups and downs happen.
But in the long run, alpha must be made.
This is why Warren Buffett’s bet was placed over a 10-year period.
Still, Ted Seides failed to generate an alpha.
If you are investing in mutual funds, check to see if your mutual funds have given you an alpha – when compared to their benchmark index returns.
In the US, not many mutual funds have given alpha.
In India, there have been many mutual funds that have been able to give an alpha so far.
This is because the Indian markets are not that efficient yet.
Thanks to the internet and greater awareness, market efficiency is improving everywhere – in India, the USA, and elsewhere.
However, the Indian markets are still quite inefficient.
How long will this continue?
Opinions are divided.
Some fund managers believe that the market will remain inefficient for a long time to come. Which means many mutual funds will be able to give alpha.
Some fund managers think efficiency is increasing fast in some kinds of stocks (large-cap stocks mostly).
Unfortunately, these are just opinions.
Nobody can tell accurately. Only time will be able to tell us.
The concept of alpha applies to individual investors too.
Based on the kind of stocks you are investing in, you should choose an index to use as a benchmark.
That way, you’ll be able to determine if you are generating an alpha or not.
By the way, if you are a new investor who is still learning, you might not be making alpha yet.
That’s fine.
It might take some time to get the skill to generate an alpha.
If even after that, there’s no alpha, you have the option of investing in index funds.
Quick Takes
+India’s forex reserves fell by $8.7 billion to $625.87 billion in the week that ended on 10 January.
+China’s annual GDP growth rate rose to 5.4% in the Oct-Dec quarter (vs 4.6% in the previous quarter).
+The UK’s annual GDP growth rate fell to 1% in November (vs 1.1% in October).
+India’s merchandise trade deficit rose 17% year-on-year to $21.94 billion in December (vs $37.84 billion in Nov). Exports fell 1% to $38.01 billion, and imports rose 5% to $59.95 billion: Commerce Ministry.
+Passenger vehicle sales rose 4.53% year-on-year to 10.58 lakh units in the Oct-Dec quarter. Commercial vehicle sales rose 1.23%, 3-wheeler sales rose 0.85%, and 2-wheeler sales rose 3%. Total vehicle production rose 6.44% in the quarter: SIAM data.
+USA’s annual inflation rate rose to 2.9% in December (vs 2.7% in November). Core inflation (excludes volatile items) fell to 3.2% (vs 3.3%).
+UK’s annual inflation rate fell to 2.5% in December (vs 2.6% in November). Core inflation (excludes most volatile items) fell to 3.2% (vs 3.5%).
+India’s annual wholesale inflation rose to 2.37% in December (vs 1.89% in November). The inflation rate rose for primary articles and manufactured products, while it fell slightly for food products. Fuel and power prices fell at a slower rate: Commerce Ministry.
+SEBI approved JSW Cement's request to raise Rs 4,000 crore through an IPO. The IPO is expected to have a 50:50 share of fresh issue and offer-for-sale shares.
+India’s annual consumer price inflation fell to 5.22% in December (vs 5.48% in November). Urban inflation fell to 5.76% (vs 5.95%), and rural inflation fell to 4.58% (vs 4.89%). A fall in food and housing inflation rates majorly pulled down the overall inflation in December: MoSPI data.
6-Day-Course
Theme of the week: key metrics in every stock sector
We’ve reached the end of this week’s course that started on Monday. Here’s a test you should take. Get pen and paper!
Question 1:
CASA ratio is the ratio of a bank’s current account holders to its savings account holders. A __________ CASA is considered better.
-Higher
-Lower
Question 2:
A higher churn rate is considered better for a tech company.
-True
-False
Question 3:
A higher inventory turnover in the automobile sector indicates that vehicles are selling ___________.
-Slower
-Faster
-There would be no change
Question 4:
Which metric helps measure customer loyalty in the consumer sector?
-Gross margin
-Inventory days
-Net Promoter Score
Question 5:
Revenue from patented drugs is an important metric for pharma companies.
-True
-False
Answers:
Q1: Higher
Q2: False
Q3: Faster
Q4: Net Promoter Score
Q5: True
The information contained in this Groww Digest is purely for knowledge. This Groww Digest does not contain any recommendations or advice.
Team Groww Digest