Why Can’t the Smart Money Beat the Market?

Original post

I’ve written before how hedge funds have underperformed the market since the global financial crisis.

As it happens, I know a lot of folks who run these funds. They fall into two categories…

Either they are overeducated graduates of the same 10 universities in the world (and often with a tenuous connection to Goldman Sachs).

Or they are the opposite – “street smart” graduates of the “school of hard knocks.”

No matter which category they fall into, hedge fund managers are cocky and overconfident. They have the world figured out – and often spend years waiting for the world to catch up to their reality. Like the gold bugs, these hedge fund managers are never wrong. They’re just early.

Though technically not a hedge fund manager, Warren Buffett is an exception to this ubiquitous bravado. He has cleverly cultivated a self-deprecating demeanor shielding him from criticism.

Still, whether cocky or modest, both hedge funds managers and Buffett have one thing in common… They’ve all underperformed a basic S&P 500 index fund over the past 10 years.

At this point, an obvious question arises: Why has the world’s smartest money lagged the market?

Here’s my theory…

More Players Than Ever Before

First, many more folks are playing the trading game now than were 20 years ago. And they are much better at it.

When I trade the market at my computer each day, I am playing the world’s largest “massively multiplayer online game.”

What I’m buying just might be sold to me by a day trader in Seoul, South Korea, or by Brazil’s national trading champion in Rio de Janeiro or by Buffett himself.

Overall, each player’s skill level is much higher than it used to be.

Yesterday’s Investment Strategies

Second, most of yesterday’s investment strategies no longer work today.

When Benjamin Graham published the bible of value investing – Security Analysis – in 1934, valuing a company by analyzing a financial statement was a unique skill. But today, hundreds of thousands of MBAs and CFAs can perform this kind of analysis.

The same logic applies to formerly secretive trading strategies.

Jack Schwager’s classic book, Market Wizards, describes a group of traders trained by trend-following legends Richard Dennis and Bill Eckhardt in 1983.

Dennis and Eckhardt taught this group (collectively known as the “Turtles”) a set of trading rules that often generated 200% annual returns.

These rules were so secretive that the Turtles had to sign a nondisclosure agreement promising not to reveal them.

In 1999, I paid $2,000 for these “secrets.” Today, you can find the Turtle trading rules online for free.

Despite their centuries-long track record, trend-following strategies no longer offer the edge they once did. (Though they do tend to fare well in a new asset like cryptocurrencies.)

That’s why leading trend followers like David Harding are turning away from this much-vaunted strategy.

Disappearing Edges

Third, informational edges have all but disappeared.

When George Soros invested in European stocks in the late 1950s, no one knew anything about them. Soros called himself a “one-eyed king among the blind.”

Today, algorithms arbitrage any edge away in milliseconds.

In short, today’s markets are much more efficient than they were when Soros or Buffett started their careers.

Yes, Soros was a great speculator and Buffett is a great investor. But could either replicate their success today?

Probably not. (Though Buffett insists he could make 50% a year on a small amount of money.)

Only one thing is for sure…

Neither Buffett nor Soros is generating the 30% per annum they did before the widespread adoption of the internet in 1999.

So what’s an investor’s remaining edge?

Human psychology. There is no doubt that machines and algorithms have made the markets more efficient than ever.

But human investors are still not rational.

Like top hedge fund managers, we like to explain the world with our idiosyncratic theories. We are impatient. We overtrade.

Together, we are “Mr. Market,” Graham’s manic-depressive, hypothetical investor who is driven by panic, euphoria and apathy.

Five years ago, Mr. Market fretted over Greece – and its impending exit from the eurozone and the collapse of the European Union. Today, Mr. Market worries about a U.S.-China trade war.

But even the most potent algorithms cannot predict what Mr. Market will be worrying about five years from now.

In theory, a savvy, flexible investor can take advantage of Mr. Market’s mood swings. The tougher task is to find an investor who actually can.

Good investing,

Nicholas

P.S. One of my favorite “street smart” U.K. hedge fund managers is Hugh Hendry, whom I have hosted several times at my events in London. The son of a truck driver from Glasgow, Scotland, Hendry famously dissed Joseph Stiglitz, Columbia University Economics Nobel laureate, in this infamous interview on BBC in 2010. Hendry shuttered his own hedge fund in 2017 after years of trailing the market.

This post is from Liberty Through Wealth. We encourage our readers to continue reading the full article from the original source here.