An extract of a conversation between PAUL KAPLAN, Director of Research at Morningstar Canada and LARRY SIEGEL.
Larry served as the Director of Investment Research at The Ford Foundation and has been the Gary P. Brinson Director of Research for the CFA Institute Research Foundation. He co-authored an article in the Journal of Investing titled Debunking 7½ Myths of Investing. Paul brings up some of the myths discussed in this article and raises some related questions not addressed in it.
MYTH: There is so much passive indexing that the market must be getting more inefficient because there is not enough money actively managed by people analyzing individual securities.
I suspect the myth came from active managers. They're losing market share and revenue to index funds, and they have a motive to say that active management is necessary and possibly better. But there is some logic and theory behind the comment.
If you want to think about a difficult issue, it's helpful to start with a polar case, an extreme case. If no one analyzed securities at all, markets would be hopelessly inefficient, and the active management would be very fruitful.
Let's say now that only one person starts to analyze securities and that person only has $1 million. That doesn't change anything. So, there has to be a substantial amount of money at work in active management in order for the market to be efficient enough to function. I don't think there is any evidence that the market has become inefficient due to people dropping out of active management and using index funds because it's just as hard to make money as it ever was, and if the markets were really inefficient, that would not be the case.
MYTH: We are in a new era of technological change at breakneck speed, where growth outperforms value permanently. We have been discussing value and growth investing for years. While this myth says that growth will permanently outperform value, our opinion was that value should outperform growth over the long run. However, in the article you wrote that there cannot be a preferred return for one asset over another in the very long run other than as a compensation for risk.
Do you still believe that value investing works? Do you believe that the Popularity Asset Pricing Model (PAPM) explains why? Or have you changed your view? And if so, why?
I believe that if there is a preferred return to value over the long run because growth stocks provide a non-pecuniary benefit, the PAPM is then correct. But I don't think it can be very large. I just can't imagine a universe of more or less rational people where investors make large financial sacrifices year after year to hold stocks that feel good or that are fun to talk about at a cocktail party. They might make small sacrifices. And if they do, there could be a small premium for value over growth on average over the long run.
Now, I would like to point out the history of this. All of the historical excess return of value over growth using the Fama French indices was earned before the value effect was discovered by Marc Reinganum and Ralph Bonds around 40 years ago. After that, it became a zero premium with a lot of volatility. If you look at the chart drawn by Rajnish Mehra of growth versus value, you can see that value outperformed growth by a very large margin over the whole period of 1927 to 2020. But if you only look at the period – this is the panel on the right – when the value effect was known and people could invest using that information, the value effect basically went away and what you got was random variation in long cycles between growth periods and value periods. So, my concern about the assumption of a value premium is that it's been arbitraged away.
Now, I've jokingly called this Siegel's law that once an effect is discovered, it goes away, but obviously, it's not mine. I'm just joking. The caution, though, is that what appears to be a preferred return is likely to go away after it's been discovered and widely utilized.
MYTH: Big data and artificial intelligence, machine learning are the next big thing in active management. Why is this a myth?
Big data and artificial intelligence are controversial terms. Everybody uses them, but it turns out that machine learning – I'm going to drop artificial intelligence for a second and then come back to it – machine learning is statistics as interpreted by Thomas Bayes in the 1700s and improved on by William Gossett in the 1800s and then in the 20th century, statistics really came into its own as a science. What we call machine learning and to some extent AI looks qualitatively different from ordinary statistical inference because we have so much data, big data, because we have very fast computers, which we have not had until recently, and because we have very clever programmers who know how to make statistical inference look like the machine is doing something "intelligent".
People have always done this using various aids. And computers came into the investment business probably 40 to 50 years ago. And now, they are so fast and have so much data that it gives the illusion of intelligence. This is just the intelligence of the programmer and the analyst whose ideas the programmer is translating into machine language. And we call it AI because it gives that illusion so beautifully.
I wrote an article in Advisor Perspectives called "artificial intelligence is less than it seems and will not save or destroy us". The publisher used a simpler title, but I like my title because then you don't have to read the article. The title tells you the whole story. And it basically goes into some detail on what I just said.
MYTH: Investment returns are generous enough that if we all save aggressively and invest wisely, we can all become rich. What is the fallacy here? Why are we not all rich?
It's a fallacy of composition. A lot of people are confused by this. I had a conversation with Barton Waring who is one of the world's great thinkers on investment issues, and he was confused by it. Any one individual can get rich and buy lots of goods and services. But where is he getting them? He is getting them from other people. If everyone accumulates a lot of money, they will all be trying to buy goods and services from each other. But society, in the aggregate, can only consume what it produces. That's a hard limit. So, if everyone has a lot of "money", not real resources, but the currency that is used to buy those resources, used as a medium of exchange, prices will rise, making people with a lot of nominal dollars not rich until people start producing more.
So, we can all get rich, but only at the rate of increase in productivity. That is how we went from the economy of, say, 1500 with average incomes of $3 a day. It might have been $4 a day in Renaissance, Italy, because it was the richest country in the world. Some people say China was. But by 1800, the $3 a day was starting to creep up in northwestern Europe, and in England and the Netherlands, it may have been up to $5 a day. Today, the global average is about $50 a day. That's not personal income. It's GDP, which is a little higher. But let's just say it's $50 a day. If that doubles again, the whole world will be middle class except for pathological cases. And that's what I think will happen by 2100, because doubling global income per capita only requires growth per capita of 0.9% a year. We can do that. And the fact that our population growth is now under control is going to help because you don't have to have a massive increase in resource use and resource consumption and so forth in order to get 0.9% real per capita.
So, that's how to get rich, not everyone accumulating money, so they can all try to buy goods and services from each other and fail because the prices are so high.
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