Portfolio’s Scoop: There Are These Things Called Index Funds

I just finished a puzzling 7,000-word article by Michael Lewis for the December issue of Portfolio (The Evolution of an Investor).
The article is about efficient markets—the idea that it’s impossible for a stock-picker or mutual fund to consistently beat the market. Lewis uses the story of Blaine Lourd, a former stock-broker, as the vessel for his article.
The problem is, the idea of efficient markets was popularized 34 freakin’ years ago by Burton Malkiel in “A Random Walk Down Wall Street.” It’s only gone through about a gazillion printings. The original academic paper by Eugene Fama appeared in 1965. Everyone and his brother knows about it. What’s this article doing in a business magazine in 2007? It would be roughly the equivalent of an article on this new-fangled designated hitter rule appearing—mind you, not in Reader’s Digest or People—but in Sports Freakin’ Illustrated!
Does Portfolio think its readers are that ill-informed?
The article doesn’t even present the arguments for and against EMH in any real depth, which could be a more interesting article. In fact, an article attacking EMH would also feel at least 10 years out of date. Closer to 15.
Lewis doesn’t bother touching topics like the gradations of EMH (weak, strong and semi-strong). The frustrating part is that there are lots of interesting angles that could have been explored. Lewis could have discussed developments in fields like behavioral finance and their possible implications for EMH. Or the success of quant guys like Jim Simons. Fuck, even I wrote a post the other day about the astonishing success of momentum stocks, and I’m just an obscenity-using blogger. I mean, what the fuck?
Lewis also conflates the idea of being a good money manager with picking stocks. Money managers do a lot more than that. At least, they should. For example, they may help a client with an investment for a specific time horizon like a college fund. A money manager also helps decide an appropriate risk profile for the client, or how to keep taxes down, or how to plan for retirement. It’s a gross simplification to say these people are worthless because they can’t pick stocks. From personal experience, there were lots of times I talked clients out of exiting the market.
I also have issues with the story of Blaine Lourd, the stock-broker turned cynic turned EMH convert. I don’t think he’s lying, but I get the feeling that Lourd is overscripting his conversion story. Cynical people who grow frustrated by their industries don’t act as Lourd does. Put it this way: He managed his self-loathing well enough to hop to three more firm firms, then to open his own shop in Beverly Hills. If Lourd’s mission is to protect investors, then I wonder who’s covering his rent?
Lewis centers the article on the unusual training ritual (or indoctrination) of indexer Dimensional Fund Advisors. The firm has done very well over the years particularly by pointing out that most mutual funds don’t beat the market. But wouldn’t that mean that the firm’s success is due to a gross inefficiency in the market? Or is that too impolite to ask. Apparently, it is because Lewis never asks it. Nor does he ask any tough follow-up questions.
Later, Professor Fama, a DFA board member, makes an appearance:

Forty years of preaching has taught him that his audience either agrees with him or never will. And so he speaks dully, like a man talking to himself. But he makes his point. In his years of researching the stock market, he has detected only three patterns in the data. Over the very long haul, stocks have tended to outperform bonds, and the stocks of both small-cap companies and companies with high book-to-market ratios have yielded higher returns than other companies’ stocks.
These are the facts. The question is how to account for them. Fama’s explanation is simple: Higher returns are always and everywhere compensation for risk. The stock market offers higher returns than the bond market over the long haul only because it is more volatile and thus more risky. The added risk in small-cap stocks and stocks of companies with high book-to-market ratios must manifest itself in some other way, as they are no more volatile than other stocks. Yet in both cases, Fama insists, the investor is being rewarded for taking a slightly greater risk. Hence, the market is not inefficient.

Wait a second. High book-to-market stocks outperform with no more volatility but that’s due to higher risk? OK, so where is this risk? C’mon Michael, we just saw evidence disproving the whole point of the article. How does Fama support his assertion?
Lewis concludes the article with this:

Blaine still takes great pleasure in describing just how screwed up the American financial system is. “In a perfect world, there wouldn’t be any stockbrokers,” he says. “There wouldn’t be any mutual fund managers. But the world’s not perfect. In Hollywood, especially, people need to believe there’s a guy. They say, ‘I got a friend who made 35 percent last year.’ Or ‘What about Warren Buffett?’ ”
Then he pulls out a chart. He graphs for me the performance of one of D.F.A.’s value funds, which consists of companies with high book-to-market ratios, against the performance of Warren Buffett’s Berkshire Hathaway since 1999. While Buffett’s line rises steadily, D.F.A.’s rises more steeply. Blaine’s new belief in the impossibility of beating the market doesn’t just beat the market. It beats Warren Buffett.

That doesn’t prove any point. Buffett has still beaten the market as whole. It’s that value stocks have done much better. Why are we changing the thesis of the entire story and now comparing Buffett to a value fund? We’re not allowed to pick stocks but we can pick benchmarks? To reiterate my earlier point, what the fuck? Lewis’ article is presented to us as if it’s delivering some wise truism, yet it fails to ask any truly probing questions.
When Portfolio debuted, Elizabeth Spiers of DealBreaker said it “will be the Paris Hilton of business magazines: pretty but vapid, and unlikely to produce anything resembling an original thought.” Perhaps some forecasts do have value.

Posted by on December 10th, 2007 at 10:16 am


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