Wise Money Decisions

The Wife points out a great way to save on rent:

Japanese Woman Caught Living in Man’s Closet

Tokyo - A homeless woman who sneaked into a man’s house and lived undetected in his closet for a year was arrested in Japan after he became suspicious when food mysteriously began disappearing.

Police found the 58-year-old woman Thursday hiding in the top compartment of the man’s closet and arrested her for trespassing, police spokesman Hiroki Itakura from southern Kasuya town said Friday.

If I’ve said it once I’ve said it a hundred times.  Don’t steal food from the guy whose closet you’re staying in.

There’s a well-written article in the New York Times on the growing debate over market-weighted vs. fundamental-weighted indexes.  The author Joe Nocera has done an exceptional job distilling a complicated topic into an easy-to-understand article.

If you have 5 minutes you should read the New York Times article.  If you only have 30 seconds here’s the 30-second version:

The world has been using market-cap weighted indexes.  The weight of each company in the index depends on its market capitalization.  Bigger companies have a greater weight in the index. 

Some believe that traditional market-cap weighted indexes overweight overpriced companies and therefore result in subpar returns.  Over the last few years there has been a growing movement that advocates the use of fundamental measurements (e.g. earnings, dividends, etc.) to determine each company’s weight in an index.  They have developed not only dozens of indexes, but also dozens of funds following such indexes.  They argue that the new funds generate superior returns over traditional market-cap weighted funds.

Robert Arnott, an advocate of fundamental-weight indexing: “It was very clear what was wrong with the index was that the weight was linked to the price.  If the price was wrong the weight was wrong.”

Opponents of the new movement complain that it’s not true indexing because it doesn’t seek to obtain the market return.  They claim it’s nothing more than a clever marketing scheme for what amount to actively managed funds. 

John Bogle: “The market return is the market return.” 

Bruce Greenwald, Columbia University finance professor: “It is a crime that they are marketing this as some kind of new theory they’ve come up with. All they are doing is dressing up a simple, well-understood practice.”

Supporters of the new movement (in no particular order):

• Robert D. Arnott
• Nobel laureate Harry Markowitz
• Charles Schwab
• Jeremy Siegel, well-known Wharton economist

Supporters of the traditional market-cap weighted indexes (in no particular order):

• André Perold, finance professor at Harvard Business School and a Vanguard director
• Vanguard founder John Bogle
• Burton Malkiel, author of “A Random Walk Down Wall Street”
• Clifford Asness, co-founder of AQR, a large quantitative hedge fund
• Bruce Greenwald, Columbia University finance professor

My Thoughts

I need to research the issue before I come to any firm conclusions.  But I’ll offer a few thoughts.

I sympathize with the view that traditional cap-weighted indexes can become skewed when stock prices are out of balance.  Also, I’ve long thought that a 500-company or a 3000-company market-weighted index is overkill when the top 20% of the index drives 90% of the index’s movement (that’s not a criticism of traditional cap-weighting, just a pet peeve). 

I like the idea of indexing based on something other than market capitalization.  However, fundamental indexing has the potential to introduce a great deal of subjectivity.  The whole point of index investing is to minimize the need for subjectivity. 

To the extent an index is based on subjective measurements, it seems like nothing more than a clever marketing strategy for active management (for now we’ll leave aside the fact that there is already some amount of subjectivity in many popular market-weighted indexes, including the S&P500.  Topic for another day). 

But if the index is based on something more objective, like earnings (and nothing else), I don’t have the same objection.  Note that one of the fund companies mentioned in the article uses earnings to weight their indexes, while the other uses a combination of earnings, dividends, and other fundamental variables.  There’s little or no subjectivity in the former, but a lot of subjectivity in the latter.

I love innovation and new financial products.  I don’t use most new products but I like that they’re available for research and for possible use if I decide it’s a good fit at some point.  I plan to watch the fundamental index funds for a while and see if they make sense for me. 

Bill Miller is a well-known stockpicker.  He is chairman of Legg Mason Capital Management and oversees some $35 billion.  Although not as famous as Warren Buffet, his reputation is on par with Mr. Buffet when it comes to picking stocks.  No less an authority than CNN Money proclaims him “the greatest money manager of our time.” 

Bill Miller is most famous for beating the S&P500 index 15 years in a row with his mutual fund Legg Mason Value Trust (LMVTX). 

During the streak there were several years that saw his fund underperforming the S&P500 leading into the final months or even the final weeks of the year.  But somehow he always ended the year with a miraculous finish to beat the S&P500 and grasp victory from the jaws of defeat. 

Nearing the end of 2006 he was in a familiar position: losing to the S&P500 with the year coming to a close.  There was a lot of media attention on whether this was the end of the streak. 

If memory serves me, he performed well at the end of the year.  But the deficit was too much to overcome and the streak ended in 2006.

What Does Bill Miller Prove About Active vs. Passive Management?

(Reader warning:  In the interest of space I’m about to make some generalizations.)

With the rise of index investing over the last 30 years there has been an ongoing debate about whether investors are better off choosing actively managed mutual funds or passively managed index funds. 

Supporters of passive management have compiled an impressive body of evidence indicating that passive management is likely to outperform active management over short periods of time, and even more importantly it is highly likely to outperform active management over long periods of time. 

Supporters of active management cite Bill Miller as proof that actively managed funds can outperform passive funds over long periods of time.  After all, Bill Miller did just that.  He beat the (mostly) passive S&P500 index for 15 years.

So who’s right?  Does Bill Miller prove that active management can beat passive management?

Evidence is Different than Proof

First, it’s important to remember the difference between proof and evidence.  Bill Miller might be evidence of some proposition, but not necessarily proof.  We have evidence of a Big Bang, but we haven’t proved it.  We have evidence of the Loch Ness Monster, but we haven’t proved it. 

If someone tells you that Bill Miller is proof that active management works, the proper response is that he might be evidence, but he’s not proof. 

Now that we all know the difference between evidence and proof, we can discuss whether Bill Miller is evidence that active management works. 

(For ease of use I’m going to use a shortcut.  When I say “does active management work” I’m really saying “can an active manager consistently outperform a passive approach over long periods of time.”   Similarly, when I say, “is active management better than passive management” I’m really saying, “can an active manager consistently outperform a passive approach over long periods of time.”)

Point

Supporters of active management see Bill Miller as evidence that active management is better than passive management. 

Counterpoint

However, supporters of passive management would rightfully argue that the existence of a single active manager that beats the S&P500 index for 15 straight years is a strong piece of evidence that active management doesn’t work. 

Passive management supporters recognize that there may be an occasional “lucky” fund manager that beats the index over a long period of time.  They would argue that with hundreds or thousands of fund managers in the world there ought to be more Bill Millers through simple random chance.  The index doesn’t have to beat all managers over a given time period, it simply has to beat the vast majority.  They would say the dearth of Bill Millers supports their argument that active management doesn’t work.

Point

Supporters of active management would argue that 15 years is simply too long for someone to beat the index by chance.  He must have special insight that allows him to do it year after year.

Counterpoint

Supporters of passive management would respond that 15 years may not be sufficient time for the index to prove its superiority over all other investing approaches.  (For some reason when I write the last sentence I picture Chris Farley saying, “All other tropical storms must bow before El Nino“). 

There may be a lucky active manager that beats the index for 15 years.  But continue for another few years and the lucky manager will eventually revert to the mean. 

I Got to Thinking…

There’s no question that Bill Miller has handily beaten the S&P500 index for 15 years.  But what has he been up to since the streak ended?  Unfortunately not much.  He has been beaten up the last couple years.  If this were a prize fight he’d be down for the count.

As a supporter of passive management I thought to myself, “If the last couple years have pulled down Bill Miller’s average return to that of the index, then passive management has once again proven its superiority, Bill Miller gets his comeuppance, and order reigns in the universe.”  After all, why should 15 years be the right testing period?  Why not 17-and-a-half?  Or twenty?  Or more? 

If the passive supporters are right, then the longer the testing period the more likely Mr. Miller should revert to the mean.

The Numbers

I gathered the numbers for SPY and for Bill Miller’s fund Legg Mason Value Trust.  I chose SPY because it’s the most well-known index fund that tracks the S&P500 and because it has data stretching back through most of Mr. Miller’s streak.   

SPY started trading in January 1993 so I started my comparison there.  By that point Bill Miller had already beaten the index for a couple years.

I’m not going to describe my methodology in detail since most of my readers want the bottom line without the details.  If you’re one of the chosen few that likes the details, post a comment and I can describe more in the comments.

From January 29, 1993 through the end of the streak in December 2005, Mr. Miller outperformed SPY quite spectacularly:

LMVTX:   13.7% annual return
SPY:        9.5% annual return

Miller’s numbers would look even better if I could include the first 2 years of the streak (SPY didn’t start until January 1993). 

Slightly more of Miller’s returns came through dividends.  Including the effect of taxes and taking into account the reinvestment risk would help close the gap a bit, but Miller still comes out far ahead. 

By the way, if you’re thinking, “Big deal, it’s just a few percent difference” then repent now.  A few percent is a big deal when compounded over several years.

Now let’s include the numbers for 2006, 2007, and 2008 through May 15 (from Jan 1993 through May 2008):

LMVTX:   10.74% annual return
SPY:          9.1% annual return

Including the last two-and-a-half years causes a slight decrease in SPY’s performance, but a staggering decrease in Miller’s performance.  Miller seems to be reverting to the mean.

Finally, I calculated the performance for an investor investing in LMVTX vs. SPY assuming a 25% tax on dividends.  SPY partially makes up the gap after-tax because a smaller share of its return comes from dividends.  The results (from Jan 1993 through May 2008):

LMVTX:   10.0% annual after-tax return
SPY:        8.8% annual after-tax return

If you’re like me, you appreciate the tax deferral opportunities of a fund with a low dividend yield.

(Although coming up with different numbers, Moneywise also concludes that SPY makes up ground on LMVTX once tax effects are thrown into the mix.)

Final Thoughts

Bill Miller earned his keep over the last 15 years as he thoroughly trounced the S&P500.  However, SPY is making up lost ground over the last 2.5 years.  It hasn’t caught up to Miller yet.  Only the future can tell if or when it will. 

In my view the existence of a single Bill Miller is strong evidence that active management can’t consistently beat passive indexing over long periods of time.  If active management worked (in other words, if active managers could consistently outperform the index) then there would be many Bill Millers that consistently beat the index year after year. 

Think about it.  The index has vanquished the vast majority of active managers over the years, but it doesn’t get any headline love from the media.  But when an active manager beats the index for 15 straight years it makes headline news in the financial section of the New York Times.  We’re still talking about it years later.

It ought to make you think twice before you pick an actively managed mutual fund.

Finally, if you believe that it’s just a matter of picking the right manager, you still face difficulty of identifying those managers ahead of time.  It’s once thing to marvel at Bill Miller’s outstanding returns over the years, but it’s quite another thing to identify the next Bill Miller without the benefit of hindsight.

Post Script

The New York Times (registration may be required) has this interesting graph showing Miller reverting to the mean after jumping out to an early lead in the late 1990’s and early 2000’s.

The presenter at last week’s seminar strongly recommended Made to Stick: Why Some Ideas Survive and Others Die. 

When I got home I looked up the book and found this review from a Heidi Dolamore of the San Mateo County Library in California:

While at first glance this volume might resemble the latest in a series of trendy business advice books, ultimately it is about storytelling, and it is a how-to for crafting a compelling narrative.

Employing a lighthearted tone, the Heaths apply those selfsame techniques to create an enjoyable read. They analyze such narratives as urban legends and advertisements to discover what makes them memorable.

The authors provide a simple mnemonic to remember their stickiness formula, and the basic principles may be applied in any situation where persuasiveness is an asset. The book is a fast read peppered with exercises to test the techniques proposed.

I had never heard of the book before, but based on what I’ve seen I’m leaning toward buying it.

If you are familiar with the book, let me know if you found it worth the read.

I’m not sure whether to laugh or cry:

“A California man who has defaulted on nine homes and expects banks to foreclose on all of them, forcing him into bankruptcy, says he now considers it a mistake to have invested in the real estate market.” 

It’s good that he now realizes it was a mistake.

The Story

The story goes that Shawn Forgaard was once a wealthy man.  He received $800,000 from stock options in his software company.  He began buying properties. 

He was putting anywhere from 10% to 40% down.  It wasn’t the down payment that caused him problems. 

What sunk him is the type of loan.  He was using negative amortization loans.  That’s the type of loan with a balance that can actually grow from month to month. 

A negative amortization loan doesn’t cause problems if the borrower pays the interest off each month.  But if the borrow fails to pay the interest, the deficit gets added to the balance.  The balance grows until the bank decides the loan is too risky and pulls the plug. 

As with any investment strategy, buying property in this way is not “risky” unless the borrower doesn’t have the ability to make the monthly payments. 

My guess is that Shawn had enough money in his bank account to pay the mortgages for a while.  He was counting on being able to refinance after the value of his properties went up.  He would be able to pull money out of each property and use it to continue to service the nine mortgages. 

The value never went up.  He wasn’t able to refinance, he ran out of money, he couldn’t make the payments, and kaboom!

If he had cash flow from another source, like his job or other investments, he may have been able to hold on long enough and make a killing when the market recovered.  His strategy was very risky because it required the market to behave in a certain way and he didn’t have the funds to hold on when the market didn’t cooperate.

Long Term Capital Management 

It reminds me of Long Term Capital Management (”LTCM”).  LTCM was a company started by brilliant people that figured out a way to arbitrage government bonds.  They borrowed incredible amounts of money and implemented their strategy.  For three or four years they made tremendous returns.  Then all hell broke loose.

The Asian financial crisis in 1997, along with other global financial events, led to tremendous losses for LTCM.  To make a long story short, the Fed organized a bailout of LTCM on behalf of various creditors. 

Bear Stearns declined to participate in the bailout.  They must not believe in bailouts.

The Moral of the Story 

Here’s the key point.  By the time they got around to liquidating LTCM’s positions, the global financial crises had abated.  Not only had LTCM’s positions recovered from their tremendous losses, they were actually liquidated at a profit!

As Jeremy Siegel indicates, if LTCM had not leveraged to the extent it did it may have had sufficient liquidity to weather the crisis and turn a profit despite the serious problems in the marketplace.

The Two Requirements for Successful Long-Term Investing

Here’s my short list of the requirements for successful long-term investing:

1) A winning long-term strategy

2) Sufficient liquidity to give your strategy time to weather any downturns.

Both Shawn Forgaard and LTCM obeyed the first rule but flunked the second. 

I recently went to a Stanford Engineering Alumni Association seminar held at Google.  It was my first time at the “Googleplex.” 

My first thought when I arrived, “I’m back on campus.”   Jeans, long hair, rows of colorful umbrellas outside the cafeteria, volleyball, marker boards covered with marker-graffiti (I assume what I saw was the famous idea board, or one of them), nearly everyone is under 40 — just like the good ol’ days of grad school.

When you live around here you hear stories about the Googleplex and what it’s like to work there.  So I was prepared for some of it.

There were, however, two things I wasn’t expecting:  whimsical architecture and tight security.  The architecture is more colorful and whimsical than the link suggests.  For example, there is a building designed to look like one of the stories has fallen over and is leaning into the floor below it.  It creates a bit of an optical illusion.  

I couldn’t find a picture of it on the web.  If anyone knows the building and has a picture, and you don’t mind sharing it with the world, I’d like to post it.

As far as the security, as soon as I walked through a door there was a guard telling me where to go, and then he watched to make sure I went there.  At every door. 

After the seminar I hung out at the bottom of the stairs reading the idea board.  I wasn’t interested in the board.  I just wanted to see how long the guard would let me loiter.  I was there for 5 minutes.  Then I decided I had better things to do with my time than bait Google security.  I left.

It was fun to see this place that is the subject of so many stories. 

Here’s an aerial shot of the Googleplex.

Here are a few more shots from the central hub of the campus taken by a Google employee.  The pictures are a couple years old but it looks the same today.

I couldn’t find the invoice for my wife’s engagement ring.  I called the store where I bought it a few years back.  They told me the amount.  I used the information to submit my claim form online.

If you have no idea what I’m talking about, you need to read about the De Beers diamond class action lawsuit.

To the right is a picture of a tension set.  It’s not my wife’s ring, but it’s similar.

I’m starting a new prediction tracker page dedicated to tracking financial predictions made by so-called “experts.” 

There are many so-called experts that make a very good living making predictions about where the market is going, how companies will perform, is oil going up or down, are we in a recession, is the housing market going to collapse, and anything else you can think of. 

They’re on cable TV, print, and the internet 24 hours/day.  It’s hard to miss them if you have functioning ears and eyes.  Even if you’re trying.

I haven’t seen any studies, but my sense is they get it wrong as often as they get it right. 

No matter how wrong they might be, no one ever bothers to check up (one exception is Jim Cramer, whose predictions are tracked rather thoroughly; see here and here). 

It must be nice to have a job where it doesn’t matter how often you’re wrong.

The gravy train stops here! 

I am going to unscientifically and haphazardly choose a non-random sample of expert predictions and track them to completion.  Hopefully I will learn something about determining which predictions have predictive value.

At long last the experts’ feet are held to the proverbial fire!

After United and US Airways announced that they would charge for a second piece of checked luggage, several airlines followed suit.  Every airline I reviewed has implemented the charge except Southwest and Hawaiian Air.

The extra charge may not apply if you purchased your ticket before a certain cut-off date.  For example, on Continental you can still check a second bag free if you purchased your ticket prior to April 5, 2008.

If you fly roundtrip and check the second bag on both legs, the fee applies twice.

Below is the updated table for domestic flights in coach/economy class according to each airline’s website.  Note that international and preferred/Medallion class passengers may fall under different rules.

By the way, the coveted award for “Jeff’s Favorite Background Image for an Airline Website” goes to Hawaiian Airlines.  It’s beautiful marketing.  When I see it I have urges to book a flight:

We had plenty of time to kill at the airport a couple weeks ago. 

My 2-year-old wanted to spend it doing escalators.  We couldn’t find a pair of up and down escalators next to each other.  Instead we found a down escalator next to a flight of stairs.  When I finally dragged her away an hour later I had done enough stairs to increase my actuarial lifespan by a few years. 

I had lots of time to get to know the other people on my flight.  One guy told me he had booked a ticket on ATA a few weeks ago.  Hours after he booked, ATA announced it was ceasing operations and filing for bankruptcy. 

My first thought was, “You book a flight and hours later the airline goes bankrupt.  You’re hexed.  Don’t stand close to me.”

My next thought was, “I hope you read my blog and know you should book airline flights with a credit card.”

He had indeed booked with a credit card.  He called the credit card company to ask how to get his money back.  They told him they had advance knowledge of ATA’s announcement and avoided charging it through.  His got his money back on the spot.

It’s nice to see that something I wrote about actually works in the real world!

A Lot of People Have Worthless Airline Tickets Right Now

There are a lot of people holding worthless tickets right now.  According to the Atlanta Journal-Constitution:

Five U.S. discount carriers have either declared bankruptcy or gone out of business in the last two months: Frontier, Aloha, Skybus, Champion and ATA, a unit of Peachtree City-based Global Aero Logistics.

If they didn’t book with a credit card, they will next time!