John Bogle versus hedge funds?
John "Jack" Bogle still likes risky index funds despite the availability of skilled strategies, hedging tools and proper diversification nowadays. After many years below the S&P 500's high water mark and yet another 50% drawdown it is time to review Bogle's new novel "The Little Book of Common Sense Investing". Unfortunately there was little common sense in the book. Investors do not need to risk their retirement on "cheap" long only equity funds. Bogle even thinks people should SPECULATE their savings on the stock market eventually rising! I don't.
Bogle considers EVERY stock to be worth investing YOUR money in. In the real world few equities are "buy and holds". Incredibly he says the largest stocks should get the biggest allocation! There are safer ways to invest than "passively" owning what someone else ACTIVELY decided to include in an index. Why endure massive losses and long periods before a manager makes new profits? An index fund is riskier and more expensive than a real hedge fund. Such a LOW return on HIGH volatility is unsuitable for conservative, long term investors like me. Passive "managers" levy outrageous fees for poor performance, zero skill and devastating drawdowns. Yes investors, you CAN diversify away systemic risk.
Index funds versus hedge funds is about PRICE versus VALUE and good hedge funds have proven their superior value proposition over many decades and after fees. It is time John Bogle looked at modern ways of managing money with an open mind rather than regurgitating misinformed views about strategies he knows nothing about. Why would an investor sign up for the often negative and unstable performance at ABOVE average risk of Bogle's folly when INNOVATION has progressed far beyond the stone age world of long only? Good hedge funds obliterate index funds in terms of risk adjusted returns in ALL market conditions. Index funds simply obliterate peoples' wealth in bear markets. Anyone that knows what they are doing avoids index funds like the plague.
Investing is NOT simple. Bogle cites Occam's Razor where the "easy" solution is supposedly optimal. William of Ockam has been misinterpreted and actually wrote "Entia non sunt multiplicanda praeter necessitatem". It is the simplest choice amongst VIABLE solutions that works. Index funds are too simple to be suitable for such ontological parsimony. The correct answer is multiple strategies within and across multiple asset classes and hedging and reducing risk as much as possible. William of Ockam would have seen quality absolute return funds as the answer not the risky trap of just holding assets. Things are also more complex today; when Sir William entered Oxford University 700 years ago, long only commodities and real estate were the only investment choices available.
Is it really common sense to claim investment skill does not exist and investors should not try to identify good fund managers? I guess not many people would want to ride in a car driven by John Bogle. Maybe he would just place a brick on the accelerator, remove the steering wheel, gaze at the rear view mirror and await the nice destination he anticipates. No need to worry about ongoing risks and economic obstacles in the path to riches when huge capital gains loom in the so-called long term.
Bogle says people should just ride out drawdowns no matter how much money his preposterous products lose. Is it "sensible" to suggest ignoring those 401(k)statements since they will supposedly be fine some day far into the future? John Maynard Keynes pointed out what happens in the long run so isn't it better to GROW and PRESERVE capital in the short run? Is it common sense to own every stock Standard and Poor's actively DECIDED to include in their S&P 500 index regardless of the underlying economic conditions and business environment for each company?
Is it sensible or prudent to passively hold onto value destroying corporations when you could be short selling or actively engaging them? Keynes said: "When somebody persuades me that I am wrong, I change my mind. What do you do?" but Bogle says to buy and hold the constituents of some arbitrary benchmark no matter what. Absurd "advice" that will cost investors dearly WHEN the recession begins.
Successful ACTIVE investors like Warren Buffett join the pro-index brigade despite avoiding index funds themselves. This "Do as I say not as I do" is weird. Why does Warren have a quote on the book's cover supporting index funds when he manages a foreign exchange and commodities trading, merger arbitrage, event driven, distressed securities, bid for Long-Term Capital Management, own a few core stocks, multistrategy hedge fund called Berkshire Hathaway and has outperformed the S&P 500 since the 1950s? In actions, not words, Buffett's performance is an argument AGAINST indexing and FOR actively managed absolute return strategies.
Buffett's mentor Benjamin Graham was also a successful hedge fund manager. Graham wrote that "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." Since index funds do NOT promise SAFETY OF PRINCIPAL, they are therefore speculative! "Don't take my word for it" as the Intelligent Investor himself would clearly have favored the hedging and limited drawdowns from quality hedge funds versus the lack of capital preservation of index funds. The performance is unsatisfactory and inadequate compensation for the RISK of long only.
Bogle claims index funds are the "only way to guarantee stock market returns". Really? I think ABSOLUTE returns are what an investor needs, not guaranteeing their share of stock market crashes, deep drawdowns, high volatility and sometimes decades of losses. There is no need to take outright market risk when there are so many inefficiencies and mispricings to exploit in global markets. Skill does exist and CAN be identified ahead of time and in my experience alpha is actually more reliable than beta. Strategy diversification, risk management and hedging against disaster are surely more sensible than the unhedged gambling that Bogle favors.
Risk tolerance? I have little tolerance for risk which is why I invest in good hedge funds. "Passive" products are simply too volatile and unreliable for conservative investors. Staying below their high water mark for so long is unacceptable especially when there are superior alternatives. John Bogle's followers were "lucky" to get back to breakeven TEMPORARILY after just 7 years compared to the 17 year drawdown from 1965-1982 or the devastation of 1929-1954. And check out 1905-1942 for a 37 year zero growth nightmare. Should an investor have to endure even the possibility of waiting that long? 2005-2042?
I don't dispute that "passive" funds will likely outperform many, though not all, long only active managers over time. Skill is rare by definition. However that reflects the fact that UNHEDGED funds are too constrained and that talented fund managers are more likely to be at good hedge funds than long only funds. An AVERAGE hedge fund is not worth investing in but SKILLED hedge funds can be identified in advance IF you know what you are doing. Ben Graham and several Nebraska doctors backed Warren Buffett BEFORE his success as a hedge fund manager.
Hedge funds are not mentioned until "Funny Money" in a scathing, poorly researched, diatribe near the end of Bogle's book. "Too much hype"? Most hedge fund commentary is negative so what hype is Bogle referring to? Does he mean the REALITY of top hedge funds delivering absolute returns and preserving capital unlike the "cheap" products he pushes? Hedge funds don't just "invest in the very stocks and bonds that comprise the portfolio of the typical investor"; they use futures, options, derivatives, short selling, new kinds of assets and diverse holding periods to REDUCE risk.
Hedge funds offer "too many different strategies". That's a criticism? You need as many performing strategies as possible; it is a strength of the hedge fund industry not a weakness. Some hedge fund managers are successful and closed because their investors made far more. Index funds are the compensation strategy - you don't have to do much work but you still get paid that huge 18 bp for no work. And the extra layer of fees of a good fund of funds more than justifies itself in paying for evaluation, due diligence and monitoring of common sense investments like hedge funds.
The tyranny of fees fails to consider the product's value. Interesting how people get irate over hedge fund managers making a billion for doing a superb job while the firm Bogle founded levies exorbitant fees on $1.1 trillion and does NOTHING to hedge risk or avoid losses. For what you are getting in terms of risk-adjusted absolute returns the fees charged by proper hedge funds are CHEAPER than index funds.
The "low" fee charged for "managing" passive funds also obscures their enormous OPPORTUNITY COST for investors. While trillions have been languishing for almost a decade in index funds, vast money making opportunities have been missed. Such "common sense" is EXPENSIVE as investors await the assumed upward trend to reassert itself. Bogle also writes of the MIRACLE of compounding but fails to mention the MISERY of negative compounding that wrecked so many institutional and individual investors' portfolios.
Bogle argues for owning "all the nation's" publicly held companies. Which nation? All the companies? Just the biggest firms? Why just the public ones? Most companies are private. Good venture capital and focused (smaller!) private equity funds can offer excellent performance. By the time a company makes it to IPO a high percentage of its growth is often over so why shouldn't investors access private companies. A stock that makes it to the elite S&P 500 has already been a winner for years and there have been many instances of index trackers forced into buying the top but they NEVER have the opportunity to buy the bottom.
Although considered "passive" the S&P 500 is quite actively managed as companies go bankrupt or get acquired. If you had bought the ORIGINAL 500 components in 1957 and held on with no adjustment whatsoever you would have OUTPERFORMED the "real" S&P 500 at slightly LOWER risk even though only 86 names survived 50 years. That should be a very strong argument for TRUE buy and hold but John Bogle doesn't use it, instead pushing the frequently updated quasi-active index.
Innovation is always hated by salesman with a vested interest in the status quo. Predictably Bogle is also not a fan of the equally weighted and fundamental indices that have appeared in recent years or ETFs. Bogle even thinks Exxon XOM and General Electric GE have the best stock price appreciation prospects; a sad consequence of cap-weighted indices is the biggest stocks get the largest percent of your money, regardless of prospects or valuation. Surely common sense is for your cash to go to the BEST stocks not necessarily the BIGGEST stocks.
Why does the intellectual force behind passive capitalization-weighted indices urge a large active bet AGAINST global weightings? Bogle's "advice" to keep 80% of an equity portfolio in USA stocks is simply wrong, insufficiently diversified and logically inconsistent with his indexation argument. The world has moved on and such geographic constraints are not common sense. Investors need ALL of their equity portfolio allocated to the best opportunities wherever that may be. The USA is less than 45% of world market cap and the proportion drops each year. If an investor is a true Bogle diehard then their portfolio should surely be in line with global market cap. 40% of equity in US stocks in the correct "passive" amount.
Japanese stocks were the best performers last century. But that is in the PAST. The Nikkei has, over the long haul, vastly outperformed the S&P 500 though of course not over the short or medium term. Even though still far below its high and having trodden water for over 17 years, US investors would have done MUCH better holding Japanese index funds for 50 years than US index funds. John Bogle does not mention this either and is generally quite negative on "foreign" equities.
Japan outperformed because decades ago it was an emerging market and offered similar VALUE to certain OTHER opportunity-rich countries today. Based on Bogle's relentless rules of humble arithmetic the dollar return on the Nikkei was MUCH higher than the dollar return on the S&P 500 so, according to his performance chasing logic, should not he be urging Japan as the main common sense investment given his bizarre assumption that past is prologue?
Long term performance has little to do with long term investing. In fact some hedge fund managers with the best long term track records have the shortest holding periods. Steady capital growth does indeed the win the race but index funds are anything but steady. Good hedge funds are the reliable tortoise to the volatile and unpredictable index hare. Equity indices were designed to simply benchmark long only active managers; they are NOT a suitable product for conservative investors to actually put money in given the absence of risk management and high volatility.
You can read the John Bogle blog. Common sense is going with investment skill and the hedging of risk not this Boglehead nonsense. Investors need ABSOLUTE RETURNS, not EXPENSIVE "passive" products that are guaranteed to lose money in a bear market. Staying the course makes sense if you know the destination AND the route. There are safer vehicles for anyone's money than index funds.
Bogle considers EVERY stock to be worth investing YOUR money in. In the real world few equities are "buy and holds". Incredibly he says the largest stocks should get the biggest allocation! There are safer ways to invest than "passively" owning what someone else ACTIVELY decided to include in an index. Why endure massive losses and long periods before a manager makes new profits? An index fund is riskier and more expensive than a real hedge fund. Such a LOW return on HIGH volatility is unsuitable for conservative, long term investors like me. Passive "managers" levy outrageous fees for poor performance, zero skill and devastating drawdowns. Yes investors, you CAN diversify away systemic risk.
Index funds versus hedge funds is about PRICE versus VALUE and good hedge funds have proven their superior value proposition over many decades and after fees. It is time John Bogle looked at modern ways of managing money with an open mind rather than regurgitating misinformed views about strategies he knows nothing about. Why would an investor sign up for the often negative and unstable performance at ABOVE average risk of Bogle's folly when INNOVATION has progressed far beyond the stone age world of long only? Good hedge funds obliterate index funds in terms of risk adjusted returns in ALL market conditions. Index funds simply obliterate peoples' wealth in bear markets. Anyone that knows what they are doing avoids index funds like the plague.
Investing is NOT simple. Bogle cites Occam's Razor where the "easy" solution is supposedly optimal. William of Ockam has been misinterpreted and actually wrote "Entia non sunt multiplicanda praeter necessitatem". It is the simplest choice amongst VIABLE solutions that works. Index funds are too simple to be suitable for such ontological parsimony. The correct answer is multiple strategies within and across multiple asset classes and hedging and reducing risk as much as possible. William of Ockam would have seen quality absolute return funds as the answer not the risky trap of just holding assets. Things are also more complex today; when Sir William entered Oxford University 700 years ago, long only commodities and real estate were the only investment choices available.
Is it really common sense to claim investment skill does not exist and investors should not try to identify good fund managers? I guess not many people would want to ride in a car driven by John Bogle. Maybe he would just place a brick on the accelerator, remove the steering wheel, gaze at the rear view mirror and await the nice destination he anticipates. No need to worry about ongoing risks and economic obstacles in the path to riches when huge capital gains loom in the so-called long term.
Bogle says people should just ride out drawdowns no matter how much money his preposterous products lose. Is it "sensible" to suggest ignoring those 401(k)statements since they will supposedly be fine some day far into the future? John Maynard Keynes pointed out what happens in the long run so isn't it better to GROW and PRESERVE capital in the short run? Is it common sense to own every stock Standard and Poor's actively DECIDED to include in their S&P 500 index regardless of the underlying economic conditions and business environment for each company?
Is it sensible or prudent to passively hold onto value destroying corporations when you could be short selling or actively engaging them? Keynes said: "When somebody persuades me that I am wrong, I change my mind. What do you do?" but Bogle says to buy and hold the constituents of some arbitrary benchmark no matter what. Absurd "advice" that will cost investors dearly WHEN the recession begins.
Successful ACTIVE investors like Warren Buffett join the pro-index brigade despite avoiding index funds themselves. This "Do as I say not as I do" is weird. Why does Warren have a quote on the book's cover supporting index funds when he manages a foreign exchange and commodities trading, merger arbitrage, event driven, distressed securities, bid for Long-Term Capital Management, own a few core stocks, multistrategy hedge fund called Berkshire Hathaway and has outperformed the S&P 500 since the 1950s? In actions, not words, Buffett's performance is an argument AGAINST indexing and FOR actively managed absolute return strategies.
Buffett's mentor Benjamin Graham was also a successful hedge fund manager. Graham wrote that "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." Since index funds do NOT promise SAFETY OF PRINCIPAL, they are therefore speculative! "Don't take my word for it" as the Intelligent Investor himself would clearly have favored the hedging and limited drawdowns from quality hedge funds versus the lack of capital preservation of index funds. The performance is unsatisfactory and inadequate compensation for the RISK of long only.
Bogle claims index funds are the "only way to guarantee stock market returns". Really? I think ABSOLUTE returns are what an investor needs, not guaranteeing their share of stock market crashes, deep drawdowns, high volatility and sometimes decades of losses. There is no need to take outright market risk when there are so many inefficiencies and mispricings to exploit in global markets. Skill does exist and CAN be identified ahead of time and in my experience alpha is actually more reliable than beta. Strategy diversification, risk management and hedging against disaster are surely more sensible than the unhedged gambling that Bogle favors.
Risk tolerance? I have little tolerance for risk which is why I invest in good hedge funds. "Passive" products are simply too volatile and unreliable for conservative investors. Staying below their high water mark for so long is unacceptable especially when there are superior alternatives. John Bogle's followers were "lucky" to get back to breakeven TEMPORARILY after just 7 years compared to the 17 year drawdown from 1965-1982 or the devastation of 1929-1954. And check out 1905-1942 for a 37 year zero growth nightmare. Should an investor have to endure even the possibility of waiting that long? 2005-2042?
I don't dispute that "passive" funds will likely outperform many, though not all, long only active managers over time. Skill is rare by definition. However that reflects the fact that UNHEDGED funds are too constrained and that talented fund managers are more likely to be at good hedge funds than long only funds. An AVERAGE hedge fund is not worth investing in but SKILLED hedge funds can be identified in advance IF you know what you are doing. Ben Graham and several Nebraska doctors backed Warren Buffett BEFORE his success as a hedge fund manager.
Hedge funds are not mentioned until "Funny Money" in a scathing, poorly researched, diatribe near the end of Bogle's book. "Too much hype"? Most hedge fund commentary is negative so what hype is Bogle referring to? Does he mean the REALITY of top hedge funds delivering absolute returns and preserving capital unlike the "cheap" products he pushes? Hedge funds don't just "invest in the very stocks and bonds that comprise the portfolio of the typical investor"; they use futures, options, derivatives, short selling, new kinds of assets and diverse holding periods to REDUCE risk.
Hedge funds offer "too many different strategies". That's a criticism? You need as many performing strategies as possible; it is a strength of the hedge fund industry not a weakness. Some hedge fund managers are successful and closed because their investors made far more. Index funds are the compensation strategy - you don't have to do much work but you still get paid that huge 18 bp for no work. And the extra layer of fees of a good fund of funds more than justifies itself in paying for evaluation, due diligence and monitoring of common sense investments like hedge funds.
The tyranny of fees fails to consider the product's value. Interesting how people get irate over hedge fund managers making a billion for doing a superb job while the firm Bogle founded levies exorbitant fees on $1.1 trillion and does NOTHING to hedge risk or avoid losses. For what you are getting in terms of risk-adjusted absolute returns the fees charged by proper hedge funds are CHEAPER than index funds.
The "low" fee charged for "managing" passive funds also obscures their enormous OPPORTUNITY COST for investors. While trillions have been languishing for almost a decade in index funds, vast money making opportunities have been missed. Such "common sense" is EXPENSIVE as investors await the assumed upward trend to reassert itself. Bogle also writes of the MIRACLE of compounding but fails to mention the MISERY of negative compounding that wrecked so many institutional and individual investors' portfolios.
Bogle argues for owning "all the nation's" publicly held companies. Which nation? All the companies? Just the biggest firms? Why just the public ones? Most companies are private. Good venture capital and focused (smaller!) private equity funds can offer excellent performance. By the time a company makes it to IPO a high percentage of its growth is often over so why shouldn't investors access private companies. A stock that makes it to the elite S&P 500 has already been a winner for years and there have been many instances of index trackers forced into buying the top but they NEVER have the opportunity to buy the bottom.
Although considered "passive" the S&P 500 is quite actively managed as companies go bankrupt or get acquired. If you had bought the ORIGINAL 500 components in 1957 and held on with no adjustment whatsoever you would have OUTPERFORMED the "real" S&P 500 at slightly LOWER risk even though only 86 names survived 50 years. That should be a very strong argument for TRUE buy and hold but John Bogle doesn't use it, instead pushing the frequently updated quasi-active index.
Innovation is always hated by salesman with a vested interest in the status quo. Predictably Bogle is also not a fan of the equally weighted and fundamental indices that have appeared in recent years or ETFs. Bogle even thinks Exxon XOM and General Electric GE have the best stock price appreciation prospects; a sad consequence of cap-weighted indices is the biggest stocks get the largest percent of your money, regardless of prospects or valuation. Surely common sense is for your cash to go to the BEST stocks not necessarily the BIGGEST stocks.
Why does the intellectual force behind passive capitalization-weighted indices urge a large active bet AGAINST global weightings? Bogle's "advice" to keep 80% of an equity portfolio in USA stocks is simply wrong, insufficiently diversified and logically inconsistent with his indexation argument. The world has moved on and such geographic constraints are not common sense. Investors need ALL of their equity portfolio allocated to the best opportunities wherever that may be. The USA is less than 45% of world market cap and the proportion drops each year. If an investor is a true Bogle diehard then their portfolio should surely be in line with global market cap. 40% of equity in US stocks in the correct "passive" amount.
Japanese stocks were the best performers last century. But that is in the PAST. The Nikkei has, over the long haul, vastly outperformed the S&P 500 though of course not over the short or medium term. Even though still far below its high and having trodden water for over 17 years, US investors would have done MUCH better holding Japanese index funds for 50 years than US index funds. John Bogle does not mention this either and is generally quite negative on "foreign" equities.
Japan outperformed because decades ago it was an emerging market and offered similar VALUE to certain OTHER opportunity-rich countries today. Based on Bogle's relentless rules of humble arithmetic the dollar return on the Nikkei was MUCH higher than the dollar return on the S&P 500 so, according to his performance chasing logic, should not he be urging Japan as the main common sense investment given his bizarre assumption that past is prologue?
Long term performance has little to do with long term investing. In fact some hedge fund managers with the best long term track records have the shortest holding periods. Steady capital growth does indeed the win the race but index funds are anything but steady. Good hedge funds are the reliable tortoise to the volatile and unpredictable index hare. Equity indices were designed to simply benchmark long only active managers; they are NOT a suitable product for conservative investors to actually put money in given the absence of risk management and high volatility.
You can read the John Bogle blog. Common sense is going with investment skill and the hedging of risk not this Boglehead nonsense. Investors need ABSOLUTE RETURNS, not EXPENSIVE "passive" products that are guaranteed to lose money in a bear market. Staying the course makes sense if you know the destination AND the route. There are safer vehicles for anyone's money than index funds.
© posted by Veryan Allen on 16.6.07
by Veryan Allen 
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