Odd Lots - How Poker Explains the Battle of Passive and Active Investing

Episode Date: February 17, 2017

Among the biggest trends in the world of markets is the rise of passive investing. Rather than pay high fees to active mutual fund managers (who often fail to beat the market), people are pouring money into passive strategies that track major indices, but with little cost. So what are the ramifications of this trend for investors who choose to remain active? On this week's Odd Lots podcast, we speak with Michael Mauboussin, who heads global financial strategies at Credit Suisse and is not just an expert on the world of investing, but also on the role of luck in success. As he sees it, trading is like a game of poker, and in poker you want to play against weaker, less-skilled players. But as more and more of those less-skilled players opt not to trade (choosing passive strategies) then the game gets harder.See omnystudio.com/listener for privacy information.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another edition of the Oddbots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. So Joe, every once in a while we like to talk about poker on this show, right? That's true. We've had a few poker and gambling episodes.

I think it's one of our popular recurring themes. Yeah. And every time I usually manage to make my complete incomprehension of poker quite obvious. But one thing I do understand, and I think one reason we end up talking about poker so much, is because it's a game that's kind of all about a combination of luck and strategy, right? Yeah, you know what I like? You always point out with these poker episodes that you don't really play poker, that you're not much of a gambler. It's my caveat. But you do seem to intuitively recognize that through the study of poker, there's a lot of interesting stuff there. So even though it's

not your thing, you grasp its power as a metaphor. Okay. All right. Well, here's my... Is that true? I would hope so. I would hope that I'm able to talk about poker in the most basic sense, but please don't ask me about any hands and things like that.

Okay. Wait, Tracy, which is better, a full house or a flush? Uh, uh... Um, a full house? Yeah, that's right. Oh, okay. Maybe I should play poker. Should we play poker together?

Okay. Okay, look, the reason I'm bringing up poker yet again is because there's someone who's actually going to be able to connect poker with one of the biggest trends that's currently happening in financial markets. And that is, of course, the debate between active versus passive investment management. Right. And I think we've also talked about this topic, too, or if we haven't, we really should have, this idea that there's this huge wall of money every month, every day, leaving traditional mutual funds, traditional investing strategies, and opting for more passive strategies that are lower fees, not really intended to beat the market, but at low cost, essentially replicate the market's performance. Yeah, that's right. And so the guy who we're

going to speak with today has actually written, well, he's written a lot about poker. He's written a lot about luck and investment strategy, but he has also specifically written a really great paper about how passive investing, the rise of passive investing, provides both opportunities and challenges for active managers. And he kind of likens it to the idea of, you know, weak poker players either staying at the table or leaving. So it's a really interesting analogy. So should we get started? Let's introduce him. Okay. So we have Michael Mobison. He is, of course, the head of global financial strategies at Credit Suisse. Michael, thank you so much for joining us today. Tracy, Joe, great to be with you guys.

I mean, shall we start with that poker analogy? Why did you reach for poker when it came to describing the dynamic between active versus passive management right now? You know, Tracy, I actually think it's a very, very powerful way to think about this problem. So let's imagine, I say, Tracy, Joe, do you want to come to my house Friday night to play poker? your first question, I suppose, assuming you like to make money, is who else will be there? First of it, for what it's worth, I'm just going to say yes, because I'm a junkie. But yes, if I were smarter and more rational, I would ask that. But I would actually just say, Joe, you ask, you say, who else would be there?

And I say, hey, a couple really rich players who are very bad at poker, you'd be like, I'll be right over, right? Because you could see where your money is going to come from. But by contrast, if I say, hey, the players, like I'm a really great players, they're really sharp. you probably know they're better than you. You probably say, I got, I got better things to do. Right. So to me, there are a couple really big lessons from poker in thinking about this active indexing discussion. One is, it's very important for active managers to recognize for every winner there has to be a loser.

Right. A thousand dollars walks into my house to play poker on Friday night. A thousand dollar walks out. Right. So it's going to get shuffled around. But that's the main thing is there's got to be a winner for a loser for every winner. And second is, if you pay to play. the amount of money walking out will be slightly less than the money walking in.

The house takes a cut. The house takes a cut and we call that fees. So here's the interesting provocation is it might be, might it be the case that as we've seen the shift from active to indexing, that the people who are leaving the table or taking their money away from active managers are going to be our indexers. And so the weaker players, in effect, are leaving the table. And so while it may superficially seem to make sense that if these people are leaving, it's going to make it easier for us, in a sense, it actually makes it more difficult because the people who are remaining at the table are the smart players, the more motivated players, the players of more resources. So in a sense, it doesn't make it easier to beat the market.

It actually makes it as difficult or maybe even more difficult than it did before. And that's somewhat counterintuitive because you say if these people are sort of not participating. Right. You often hear the other, the opposite, it's like, oh, there's all this. dumb money, people are just indexing, people are not discriminating between one stock or the other active's got to be really easy now. But as you explain it pretty nicely there, the remaining players at the table are all really good or are getting better and better. And I'll just say, Joe, in talking to managers, there's a really interesting distinction that behavioral economists make

between the prices right, which means markets are informationally efficient, sort of fancy and what they call no free lunch, which means there is no strategy that consistently beats the market. And here's the thing I think active managers struggle with. If the prices are right, there is no free lunch. I think we'd all agree on that. That's easy. But it could be the case there's no free lunch and prices are not right. So I think a lot of active managers see these sort of inefficiencies out there, but it's very difficult to exploit them.

Let me give you a really sort of trivial example. Let's say you're a hedge fund manager and you're investing in the restaurant sector and you buy the, expensive one, attractive one, and you short the expensive one and not so good quality one. Well, so you like your trade, right? If investors decide we like restaurants, what do they do? The answer is today, they typically go right to the ETF. They buy the restaurant ETF and they all rise together. So there's no discrimination. Likewise, if they say we don't like restaurants, they sell the ETF and they all go down. So we're getting more of these sort of intersector correlations and there's less discrimination between good and bad, which makes it very difficult to express your

skill as an active manager. Michael, can we take a step back? Because I'm trying to grapple with this concept of life getting harder for active managers thanks to the rise of passive. But could you maybe give us your perspective on why passive has proved so popular over the past few years? So it's really been eight, right, eight or nine years, I think, something like our Our data show the last decade, there's been $1.2 trillion taken out of active funds and $1.4 trillion gone into indexing or passive funds, so a $2.6 trillion net swing.

So I think here's the way to think about this. And sort of the centerpiece of this report was work by a very famous paper from 1980 by Sandy Grossman and Joe Stiglitz called On the Impossibility of Informationally Efficient Markets. on the impossibility of informationally efficient market. So in 1980s, an interesting, just as a side note, an interesting date because the 1970s was probably the peak of enthusiasm for the efficient market hypothesis. So having written this in 1980, you could see they were writing it sort of a counter to the prevailing academic wisdom at the time.

And here's the basic argument they made. They said, hey, folks, markets can't be perfectly informational efficient because there's a cost to gathering information and reflected in prices. And as a payoff for that cost, you should get a requisite. it benefit in the form of excess returns in the market. Now, you can argue that these things should be roughly in equal portions, but there's got to be some inefficient. So some academics today have taken to this phrase, markets are efficiently inefficient. So I think what's happened as a confluence of factors, including technology, including things like Bloomberg, this amazing

access to information, dissemination of information, regulatory shifts. Overall, you, cost of computing and so forth, I think markets have simply gotten more efficient. So as a consequence, paying a lot for this price discovery function doesn't make as much sense. So I think there's been that natural pressure that's happened. But just to be super clear about this, the markets can't go 100% indexing, right, obviously. Active managers provide two vital contributions to society. The first is what, I mean, the academics call this price discovery. It's a fancy way of saying they make markets efficient.

And that's a huge societal good, actually. And the second is they provide liquidity, right? So if you need to buy or sell yourself, if everyone's index, no one's moving around, right? So you need liquidity. So those are two really vital things. And the indexing community, I think by their own admission, takes advantage of that positive externality that comes as a consequence of active manager. So they can't go away altogether.

And I think the operative sort of concept here is this efficiently. inefficient. And many factors, not only sophistication, but many other factors have contributed to greater, broader market efficiency. So we can't have a market that's entirely passive, and we're still a long way away from that, which raises the question, and this really gets to trying to distinguish between skill and luck and why poker is a good game because it's a mix of a pure gambling game and also a skill game, it's really hard to tell who's good. You could have someone who has a mutual fund that beats the market for several years in a row, but then they blow up. Maybe they were just lucky. How do you approach this question? And you've written a lot about this, but it seems

like it's the crucial question for identifying who's good at active management. How do you know, how do you start thinking about this question of identifying who's actually a good manager? So it's a great question, Joe. It's a tricky question. Let's take it in three steps. The first step would be something like this. If you and I can't really do that or are not convinced that we should do that, we should be indexed. Right. So let's just be clear that for most people, that's the proper prescription. And I think most people who are thoughtful about markets would be on the same page with that. Second thing is to think about asset classes. So we tend to talk about equities, but of course there are lots of different markets, including fixed income markets, emerging markets and so forth. And one of the of the areas where skill can be expressed more readily is when there's a large dispersion of results, right? So the difference between the very best players and the average players and the poor players is wide versus narrow. And in fact, David Swenson at Yale has this nice passage in his book where he says, what we do at Yale is we look for this dispersion of returns for the asset class. And if there's lots of dispersion, we, Yale, we'll try to find the skillful person,

we're willing to pay them fairly handsome fees. And we go at, so the second question would be that of asset class. And then the third now would be, can we be more sophisticated in assessing the skill of the managers? And, you know, there's a very nice paper by Russ Wormers and Jones about some techniques to do this. And some things you might want to think about would be looking at past performance, but adjusting it very carefully for exposure to factors and things like skewness. It would be looking at the characteristics of the manager, him or herself. So their age, their education, a factor would be the size of the fund, the fund strategy. So there are some ways that you can sort of shade the odds in your favor. Swenson is also a fan of skin in the game, right?

Whether a fund manager, the degree to which they're putting their own money at risk. Yeah, and the skin in the game thing is an interesting one because, and I agree with that, but I also think you can't take it too far. So skin in the game is important in the sense that people care about it and it dampens down principal agent concerns. But by the the same token, if someone has 100% their net worth in a fund, and let's say it's 2008 and 2009, it's going down a lot, they start to worry about their own

livelihood versus the long-term interests of their fund. So I think they have to have enough in there, so they deal with this principal as an issue, but not so much that at some point their objectivity or their responsibilities get distorted based on their own worries about

paying for the groceries. So that's the whole skill luck, and I would just say that you know, having written a book about skill and luck, interesting that last thing I'll say is that that investing appears to be an activity that's luck laden. And I think there's a sort of counterintuitive reason that's the case. And we call it the paradox of skill. And the paradox of skill says in activities where both skill and luck contribute to outcomes, and that's certainly true for investing. It can be the case that as skill increases, luck becomes more important, which seems not sensible, right? But the key here is to think about

skill across two dimensions. The first is absolute skill. And I think if you look around the world, look at the world of investing or sports or business, I think we can say fairly unqualified that absolute skill has never been better. The second dimension of skill, though, is the important one, and that's relative skill. The difference between the very best players and the average players. And that we've also seen in almost every domain has shrunk. So we see that, for example, in batting averages for baseball players. If you look at running races, you see the difference between the gold medal winner and the bronze medal winner is much less today than it was.

a generation or two before. And in markets, that's basically expressed as mostly efficient markets. So as a consequence, markets appear to be mostly luck, but it's actually not because of a lack of skill. It's actually because of a surfeit of skill, right? Too much skill canceling out, right? Even in professional athletics, we can see this, that there's more and more parity in many professional sports. Again, the athletes themselves are absolutely amazing. And you put them back in the 60s and they would clean up. But they're so equal now in their skills. because of selection of players and training and so forth, that it appears to be more random. So it's this interesting thing.

And our world is grinding toward greater skill. And yet luck is becoming more important in many of our outcomes. Well, Michael, on that note, I mean, you're talking about relative skills becoming ever more sort of compressed or the gap between different managers, I guess in this case, becoming ever more compressed. You also mentioned dispersion. One of the big themes that we've had in financial markets, at least since the financial crisis, has been the idea of asset classes moving altogether, correlation increasing, and it basically making life a nightmare for active managers. So how much does that play into the current debate about active versus passive?

No, Tracy, I think that's a huge issue, right? Now, I do think that, and I think that's one of the effects of indexing and ETFs is that, as I mentioned before, my little restaurant example, things do tend to get more correlated. And you need dispersion to express skill, right? That's really the key idea. The other thing, so I think that's exactly right, and you want to look for that. And it is the dispersion's different by asset classes and even within industries and sector. So you have to keep a track on that stuff. But that's, no, I think that's exactly right. The other thing I'll mention to you that's interesting, and it's also one of our, one of my favorite pictures in the report is we show a picture of the standard deviation of excess returns of mutual funds. Right.

So here's what I want you just envision that we plot the excess returns for all mutual funds in a particular year. It looks like a, you know, roughly, it's not exactly a bell shape, but pretend it's a bell shape distribution. And we look at how fat the bell shape is, right? So if you're a skillful manager, it's like my poker analogy, you want a fat bell, right? So you have lots of positive excess returns and lots of negative excess returns. And if you're the smart player, you can see where your profits are coming from.

Well, what we see and we have these data back to 1960s is that that fat bell shape curve has gotten skinnier and skinnier and skinnier over the decades. There was actually a very brief reversal in the late 90s, early 2000s around the dot-com phenomenon, which is really interesting because that coincides with mom and pop coming rushing back into the market. So essentially they were the ones that were the weak players at the table. But as soon as they got shooed back out after the early 2000s, we went right back to trend. So today as it stands, there's very, historically speaking, very little positive excess return, but there's also very little negative excess return. So that's another way. It's speaks to the same issue of correlation.

It's just very difficult to distinguish yourself. Now, there are ways, Joe's question spoke to before. There are ways to do this, shade the odds in your favor of finding skillful managers. but it's just important to bear all these things in mind. It's just like other things in life, just very competitive. That's interesting the idea that for a brief time, the dispersion really widened, is sort of, you know, after the fact, pretty clear evidence that that was a mania or a bubble. Can that be used sort of as a market timing technique or is it just not strong enough of a signal in real time?

Joe, it's a super interesting question. And we have another picture that's related to that, which we're, you know, We show on one axis, mom and pop's participation, individual direct participation in markets. And at the beginning of the series, it's about 50, is 1980, about 50%, and it's now about 25%. So it's drifted lower. So mom and pop are getting the memo, basically, right? That they shouldn't be doing it directly. But even though that long-term trend is down, again, that was that lift in the late 1990s.

So there was a temptation to come into markets, and that was really good for active managers. they could take advantage of that. Okay, so the two other questions would be something like this. One is, are there other signatures of what individuals are doing? And to me, the best lead on that, so if you said, which would be funds flows. Because it's almost always the case, it's true to a lesser degree for institutions, but for sure for individuals, they tend to want to do today what they should have done two years ago, right?

So they tend to inflate certain, you know, not as dramatic as. the dot coms, but you get a little bit of excesses. So the funds flow thing, I think, is probably the place I would be looking at to see if there are signatures of individual performance. The one area, by the way, where it's interesting to take a look at is so-called smart beta strategies, right? So these are factors that academics typically have unearthed to show so-called excess returns. And there's a very interesting discussion that everyone's.

should think about. One is, you know, are these truly just factors, for example, small caps do than large caps or cheap stocks do better than expensive stocks? Are these just measures of risk? In which case, they're not that interesting because you're just getting compensated for risk. You're assuming. Are they behavioral because they arise because people are suboptimal in their behaviors? And the third thing, which is really interesting is, do they work, at least in the short run because people believe they were? Right. And if I come to you, say, Joe, Tracy, low vall's awesome. And you guys, oh, great, you buy low vall. What's your new? reaction? The answer is it does well because you bought it and a lot of other people did as well.

So it's neither of those, it's not behavioral or risk. It's just this sort of funds flow. So there's some very interesting cross currents in thinking about where people are putting their money that to me would be maybe the next derivative signature of sort of, yeah, that question. So Michael, in the battle between active versus passive and indexing, where do you see us actually going from here? Because the standard. accepted argument seems to be that eventually we'll have so much money wrapped into passive that that'll just make life so easy for the active managers that their returns are going to be absolutely stellar and everyone is going to shift back to active managers. But your argument is

actually much more subtle than that. Tracy, 100%. And there is a very important paper, it's well-known, written in 1991 by Bill Sharp, obviously won the Nobel Prize, called the arithmetic of active management. And this is something that needs to be, people have to bear in mind. And the arithmetic of active management basically says that the returns for active and passive in the aggregate will be equal to one another, right? Pre-feas. Now, just think about this for a second. Let's just pretend for simplicity that the market is the S&P 500. I'm just making this easy. And then let's say 25% of our population is indexed against it. So they're going to earn the market return. That's easy to see. But the question is, how will the active managers these other 75% do? And the answer is they have to earn the

market return as well, right? Because the pieces have to equal the whole. So again, it goes back to our core argument that for one active manager to win, someone else has to lose. And that sort of becomes the operative question is, where is the other side of the trade, right? And that's why we call the piece looking for easy games. Where are the easy games if you're the smart player? So rather than saying, hey, here's the ratio, some percentage number, I think the way active managers or people thinking about putting money into active management should think about it. it is, where are there opportunities for me to be the smart player at the table? And I've already

mentioned a couple examples of cases where that might be good. One is, can you compete against individuals? So there's a ton of data around the world showing that when institutions compete against individuals, they tend to do well. A second example would be, are there people to buy or sell for non-fundamental reasons? And sort of the classic example that is the spinoff literature. This has been around for a really long time. Turns out for a lot of spinoffs, they're obviously, the spinoffs themselves tend to be smaller, often more levered. If you're big, some gargantuan mutual fund company, your mandate is not to own these little things. You just sell it without regard to value.

And as a consequence, those things often present opportunities as well. And then the third thing I would say is really interesting is this notion of wealth transfer. So I'm presenting the market as if it's a closed system investor versus investors. but there's another set of entities that interact, the big one being corporations, which buy back stock and issue stock and do mergers and acquisitions, and then governments actually are another participant. So you have to start to think about their motivations, their capabilities and are the ways to take advantage of them or work with them in a way that's constructive.

On the Bill Sharp piece, just to finish up, so active and passive are equal, right? But the second piece is the more is also worth taking consideration, which is active managers will do less for every dollar invested than passive because they charge higher fees. And so active management for fees are about 80 basis points. Passive average is about 20 basis points. So that's a 60 basis point differential. And as a consequence, active management in the aggregate will always underperform the index and we'll under form passive just because the math of that, right?

So that's the people, there's, that has always been true and it will always be true because it's basically the math of it. So I want to sort of take, you know, take this out of investing. And you make the point that it's very hard for the random person to be able to identify who's actually a skilled manager and who's just lucky. But what about sort of the inward looking question and not just in investing? Some people have different degrees of success in all realms, but we only arguably play the game of life one time.

We only have one instance. So how do we know whether one's own success in anything? How do we identify whether we're skilled in something or not, whether we're lucky? How do you sort of even identify those traits within oneself? Super, super interesting question, Joe. So a couple things I'll say on that. One is one of the things I like to think about is what we call the luck skill continuum. And you might imagine a continuum and one extreme would be activities that are all luck, no skill.

So lotteries and roulette wheels. If you win the lottery, you probably don't walk around saying, like, I'm the best lottery player, you know, on the earth. And the other extreme is all skill, no luck. And there aren't that many domains purely over there. But, you know, running races or chess. If you and I play chess, you know, the better player is going to win more time to not. And then almost everything else in life is arrayed between those two extremes. So if you can place that activity, whether it's a sports or business on the continuum, you're going to have a sense of the relative contributions.

So that's the first point. And, you know, for example, we can place professional sports league. And I'll just give you some sense that, you know, the NBA is the sport that's farthest away from randomness. So most skill to determine the winners and losers and things like Major League Baseball much closer to a particular game much closer to random. That's the first thing. The second thing to say is that whenever you look at great performance, we'll call them positive outliers, right? It's almost always great skill plus great luck. And if you think about it for a minute, it sort of has to be true, right?

So it's a right side draw from the skill distribution and a right-hand side draw from a luck distribution. And that's really easy to show for things like sports, like streaks and sports. A guy like DiMaggio hits in 56 straight games in 1941. He's a 325 career hitter. He's a fantastic hitter. But he also benefited from a lot of huge. And he never did it again. He was a one-time thing.

Well, he actually had a bunch of little streaks. But yeah, exactly. So he was lots of skill plus lots of luck together. So it's very important to recognize whenever you see whether it's corporate performance or an individual has done particularly well. And it's interesting. You mentioned sort of this introspection. If you're a successful person, I mean, undoubtedly you've worked hard and so forth. But people have to acknowledge, I mean, we all can sit around here.

You have to acknowledge that luck has almost always been a major source of a contributor to your success. And you have to think about that way. And the other thing is we don't, the people have failed. People got bad luck. we don't, they're just not in our record books, right? We don't know anything about them. So it's a really, it's an important way to think about life because, and it's also, if you've benefited from good luck, you should be grateful for it.

But you have to, you know, I understand that luck plays a role in almost all of our lives. Very good lesson. Michael Mobison, really appreciate you coming on. Fascinating topic, highly relevant to markets these days and everything else. Great conversation. Thank you. My pleasure. Thanks, guys.

So, Joe, I mean, that was a fascinating. conversation, I do think that the role of luck doesn't get as much attention as it should when it comes to investing, but also when it comes to success in life and wealth creation. And, you know, you think of all the sort of circumstances that can contribute to someone either being successful in their career or getting very wealthy. So much of it can be determined by happenstance, right? Yeah. And it's so loathsome and tiresome when you read these articles, someone wildly successful, and here are my 15 tips to how I did it or all these rich people have in common. But here's the real question is the next time you come visit New York,

you take a trip to Atlantic City with me and can we go play poker? Do I feel lucky or do I feel skilled? Well, no, but in all seriousness, this probably isn't going to be the last time we have some odd lots episode that is sort of gambling or poker related. Don't you think it's kind of high time? You actually sort of, you know, see what it's like firsthand so that it's not just theoretical. You know, I think we should do a podcast out of it. We should bring a recording device, go to Atlantic City, and see what happens. Though I don't think casinos love people taking recording devices to the table.

Oh, yeah. That might not be ideal. But let's definitely do it. All right. Well, that's it for this edition of the Odd Lots podcast. I'm Tracy Alloway. You can find me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart.

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