Chance News 45

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Quotations

Science is not the arbiter of truth. All it can do is offer opinions about the answers to certain questions that we ask of nature. And it reserves the right to revise those opinions in the light of future discoveries.

Even mathematics loses touch with any notion of truth once it steps into the real world. Last May, the director of the Max Planck Institute for Mathematics in Germany, warned that financial systems were operating in dangerous territory because traders were transferring their naive notions of the truth of mathematics on to the "black box" models used to predict and control trading. A few months later, we all found out just how dangerous that territory was.


The Guardian
Saturday, 24 January, 2009

Michael Brooks


Submitted by Laurie Snell

Forsooths

College Kids and Monkeys About Equal on Math

Robert Preidt
MSN Health & Fitness headline


Submitted by Paul Alper

Is an intelligent mutual fund manager worth the cost

The Index Funds Win Again Mark Hulbert, The New York Times, February 21, 2009.

We pay mutual fund managers a substantial fee to invest our money intelligently. Hedge fund managers ask for even larger fees. Do we get value in return for this money? An alternative, index funds, simply try to match the return of the overall market and does not try to pick stocks that are expected to perform better than average. You could, for example, buy one share of every stock represented in the Standard and Poor's 500. Such a fund would never do better than average, but it would cost a lot less to administer because you would not be paying for a team of researchers to comb through the news reports to try to identify individual stocks or broad market sectors that are expected to perform better than average.

Most index funds do not purchase all 500 stocks in the Standard and Poors 500 (or all 3000 stocks in the Russell 3000) but rather select a representative sample.

The data seems to indicate that actively managed funds do not do much better than index funds, especially after expenses are accounted for. A new study by Mark Kritzman appears to confirm this belief.

Expenses associated with a mutual fund are surprisingly difficult to calculate.

"The bite taken out by taxes, for example, depends on the specific combination of positive years and losing ones, as well as the order in which they occur. That combination and order also affect the performance fees charged by hedge funds."

The average actively managed fund and the average hedge fund did outperform the index fund before expenses, but

"For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses."

Of course, no one expects to select an average fund. If you pick a very well managed fund, is it likely to pay off?

"Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year. The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds."

What makes it worse is that these 3% of the funds were only obvious in hindsight. Picking a fund that will perform well in the future is a very difficult task. Keep in mind the warning that appears in most investment literature "past performance is no guarantee of future results".

The first popular criticism of the expenses associated with actively managed funds was a book by Burton Malkiel, "A Random Walk Down Main Street." Dr. Malkiel argues for the efficient market hypothesis, which states that the current prices of a stock represents all that is currently known about a stock, and that any changes represent a random walk.

The Wikipedia article on index funds offers a historical perspective on index funds. John Bogle started the first index fund in 1975. It was widely derided at the time.

"At the time, it was heavily derided by competitors as being 'un-American' and the fund itself was seen as 'Bogle's folly'. Fidelity Investments Chairman Edward Johnson was quoted as saying that he '[couldn't] believe that the great mass of investors are going to be satisfied with receiving just average returns'."

The fund, now called the Vanguard 500 Index Fund is now the most popular mutual fund available to the general public.

Submitted by Steve Simon

Questions

1. How would you pick a representative sample from the Standard and Poor's 500 or any other stock index?

2. What statistical principle is behind the saying that past performance does not guarantee future results?

3. Is it possible for a "great mass of investors" to experience above average returns?