A Swiss chocolate surprise
The surprise move of the Swiss National Bank on 15 January to abandon its cap on the euro exchange range sent shock waves through global markets and exposed numerous instances of investment funds and trading operations that had made too-risky bets in the currency markets. Among the casualties are the following:
- Everest Capital’s Global Fund (the largest fund under Everest management) had to close its doors after losing virtually all of its money (nearly US$830 million). According to a Bloomberg report, the fund had recently bet that the Swiss franc would decline.
- Alpari, a London-based brokerage firm (which sponsors a popular professional soccer team) had to shut its doors. The firm reported that most of its clients sustained losses exceeding their account equity, which losses are then its responsibility; thus it has entered insolvency.
- FXCM, a currency broker in New York City, had to obtain an emergency loan after sustaining a US$225 million loss.
- According to a Financial Times report, Barclays, Deutsche Bank and Citigroup had each sustained losses in tens of millions of dollars, with Deutsche Bank and Citigroup losing close to US$150 million each.
- Global Brokers NZ, a New Zealand currency trading firm, suffered serious losses and was forced to announce that it could no longer meet minimum capital requirements.
These losses are certainly unfortunate, and we do not wish to minimize that pain for individual investors and others who may have been caught. Certainly the Swiss National Bank’s action was unexpected, and some have faulted the Bank for its failure to provide markets with some anticipation, or even to inform parties, such as the International Monetary Fund, which clearly had an important stake in the outcome.
Leveraged bets and the “black swan”
In at least some of these cases, “leveraged” bets were involved, which are in the category of “fourth quadrant” investments, in the terminology of mathematician Nassim Taleb, author of The Black Swan. Such investments are particularly risky because not only is the invested money itself at risk, but additional losses, in some cases almost unlimited losses, may result. This appears to be what happened in at least some of the cases mentioned above.
Such losses are reminiscent of traders who, in the first half of 2014, convinced that long-term interest rates were set to rise, purchased certain “leveraged ETFs,” such as one that features 2X the inverse of 20-year U.S. Treasury notes. Such investors were disappointed, of course, since long-term interest rates have actually declined since then, and many incurred steep losses.
Numerous other instances of how well-meaning investment strategies, particularly those that employ leveraged investments, can go wrong, see Nassim Taleb’s book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. See also our articles and online demo tool on backtest overfitting, which demonstrate how easy it is for impressive-looking strategies, based on backtests, to fail in real-world usage due to statistical overfitting.
“Bets” versus long-term indexed investments
But episodes such as this raise the following question, particularly for individual investors and firms that deal with individual investors: Why go through such highly convoluted contortions, including very risky “bets” on international currencies, stock or bond movements and interest rate trends, when it is so easy to achieve generally excellent performance just by investing in low-cost index funds and holding them over the long term? After all, numerous index funds (stock- or bond-based, conventional or exchange-traded) are available, not only for major market indices such as the U.S. S&P 500 index and the London FTSE 100 index, but also for other less-well-known indices, such as the Dow Jones Mid-Cap Total Stock Market Index, which some believe may yield even better long-term performance.
According to the 2014 edition of the Quantitative Analysis of Investor Behavior (QAIB) report, over the past 20 years, the average U.S. equity fund investor achieved an 5.02% annualized return. But this is woefully less than the 9.22% that he/she could have achieved by simply buying and holding an S&P 500 index-tracking fund over that time period. After 20 years, based on an initial investment of US$100,000, the “average” investor’s portfolio would have $266,000, whereas an S&P 500 index-tracked investment would be worth $583,000.
Index funds might not be for everyone, and it is certainly not our position or intent to offer investment advice to anyone. Some might not like the volatility inherent in index funds, while others may prefer to construct (with expert consultation) a diverse portfolio of direct stock and bond investments. But it seems clear from the QAIB data that the vast majority of investors would do better than they have done by simply investing their money in one or a handful of low-cost index funds, taking advantage of their superior long-term performance, and then not messing with it. As Jack Bogle, founder of Vanguard, suggests, “Confidence in the mathematics — the relentless rules of humble arithmetic — enables you to get through.”
One might expect such advice from the founder of Vanguard. It is more surprising to see essentially the same advice from Warren Buffett, arguably the world’s most successful stock picker. Buffett, who is now 83 years old, recommends that individual investors “put your money in index funds and move on.” His advice to the trustee of his estate is to place 10% of the proceeds in short-term government bonds, and the rest in a “very low-cost S&P 500 index fund.”
Along this line, the California Public Employees Retirement System (Calpers) announced that it is further increasing the fraction of its fund that is invested in passive (indexed) investments (it currently is 35% in passive investments).
Isn’t there a danger of too much money in index funds?
With regards to index funds, isn’t there a danger to national and global markets if most invested money is in passive investments such as index funds? In the extreme case, if almost all money is passively invested, then who is minding the store? How then will anyone, much less individual investors, know which stocks and bonds are overpriced or underpriced? And wouldn’t such a “blind leading the blind” market be highly subject to severe corrections and crashes?
Along this line, recently Lawrence G. Tint, colleague of Nobel laureate William Sharpe (of Sharpe ratio fame), argued that the U.S. stock market would remain “substantially efficient” even if 75% of equity assets were invested in index funds. The percentage of total U.S. equity assets in index funds has risen from roughly 10% in 2000 to 19.9% today, far short of Tint’s 75%. So it seems that the U.S. market, at least, has a long ways to go before the amount that is passively invested becomes a concern to the overall stability and efficiency of the market.
Conclusion
Even setting aside the issue of index funds versus non-index funds or even direct ownership of stocks or bonds or other investment vehicles, Warren Buffett’s general advice to investors is hard to beat:
Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.
As the Aesop fable goes, the hare may jump out ahead here and there, but over the long haul the unglamorous tortoise usually wins in the end.