The smartest people don’t necessarily run the best funds.
Our Friend the Beaver
In one of the older Doonesbury strips, B.D. (wearing his football helmet, as always) asks Mike the subject of his biology paper. Mike responds, “Juxtabranchial organ secretions in the higher mollusks.” Mike reciprocates the question. B.D.’s answer: “Our friend the beaver.”
Mike will surely receive the higher of the two grades. In college biology courses, a paper that uses the word “juxtrabranchial” will almost always impress a professor more than a paper that can be readily understood by third graders. Would that B.D. were a mutual fund investor rather than a college student! In that case, he rather than Mike might be the victor.
The reason is explained by Jack Bogle, in a recent speech given to The Institute for Quantitative Finance (The “Q” Group). As evidenced by his title, “David and Goliath: Who Wins the Quantitative Battle?,” Bogle uses a different metaphor than I do. (SAT question: Jack Bogle is to the Old Testament as your author is to: A) Homer, B) Milton, C) Shakespeare, D) a comic strip.) In either case, though, the claim is simplicity.
Two Math Paths
As Bogle points out, there are two flavors of quantitative investors.
The organization before which Bogle spoke consists of “algorithmic quants.” They are “Goliaths of academia and quantitative investing,” who speak “the language of science and technology, of engineering and mathematics, developed with computers processing Big Data, and trading stocks at the speed of light.” Many have doctorates, and most invest through a “complex quantitative approach that ... dazzles even the vast corps of the financial engineers of our universities who emulate them.”
Opposing them are “arithmetic quants"--David with his slingshot, B.D. with his single-syllable vocabulary, and Bogle, who “would have been way over [his] head” had he attempted to follow his day’s leading academic theorists. However, he did not. Indeed, reports Bogle, when he founded the first index mutual fund, in 1975, not only was he unaware of future Nobel Laureate Eugene Fama’s existence but also had not heard of the term "Efficient Markets Hypothesis," or EMH.
What the arithmetic quant lacks in sophistication, he compensates for with simplicity. Bogle calls the arithmetic quant’s mathematics the “Cost Matters Hypothesis," or CMH. It is the simple yet unarguable fact that “investors as a group earn the stock market’s return less the frictional costs of investing.” From that comes the corollary that if a fund can earn the stock market’s return while keeping its frictional costs below most others’, that fund must be above average.
The Professors Prove Useful
Although Bogle’s CMH does not require the support of the EMH, it is greatly strengthened by it. The CMH guarantees that a cheap fund that emulates the overall market will beat the norm. What it does not speak to, however, is the possibility that an identifiable subgroup of active investors will also be able to manage that feat, and by a larger margin. If that is the case, why index? Buy the winning active funds instead.