First Principles

I have three great posts I would like to share. All deal with the subject of mental models and reasoning from first principles:

“Speculation In A Truth Chamber” (Philosophical Economics)

First, the idea behind the exercise is not for you to literally walk through it, in full detail, every time you are confronted with a question that you want to think more truthfully about. Rather, the idea is simply for you to use it to get a sense of what it feels like to be genuinely truthful about something, to genuinely try to describe something correctly, as it is, without pretenses or ulterior motivations. If you know what that state of mind feels like, if you are familiar with it, then you will be able to stop and return yourself to it as needed in your trading and investment deliberations and in your everyday life, without having to actually step through the details of the scenario.

Second, the exercise is intended to be used in situations where you actually want to get yourself to think more truthfully about a topic and where you would stand to actually benefit from doing so. Crucially, that situation does not describe all situations in life, or even most situations. There are many situations in life where extreme truthfulness can be counterproductive, creating unnecessary problems both for you and for others.

Third, all that the exercise can tell you is what you believe the most likely answer to a question is, along with your level of confidence in that belief. It cannot tell you whether you are actually correct in having that belief. You might believe that the answer to a question is X when it’s in fact Y; you might have a lot of confidence in your belief when you should only have a little. Your understanding of the subject matter could be mistaken. You could lack the needed familiarity or experience with it to have a reliable opinion. Your judgment could be distorted by cognitive biases. These are always possibilities, and the exercise cannot protect you from them. However, what it can do is make you more careful and humble as a thinker, more open to looking inward and assessing the strength and reliability of your evidence and your reasoning processes, more willing to update your priors in the face of new information–all of which will increase your odds of getting things right.

“Thinking From First Principles” (Safal Niveshak)

Practicing first principles thinking is not as easy as explaining it. As Musk said, it’s mentally taxing. Thinking from first principles is devilishly hard to practice.

The first part, i.e., deconstruction, demands asking intelligent questions and having a deep understanding of the fundamental principles from various fields. And that’s why building a latticework of mental models is so important. These mental models are the fundamental principles, the big ideas, from different fields of human knowledge.

The best way to achieve wisdom, said Charlie Munger, “is to learn the big ideas that underlie reality.”

The second step is the recombination of the pieces which were identified in the first step. This is again a skill which can only be developed by deliberate practice. Any idea as an isolated piece of information doesn’t stay in the human brain for long. To be sticky, it needs to be connected with other ideas. A latticework is essentially a grid of ideas connected to each other. These connections are the glue which holds those ideas together.

If the new knowledge doesn’t find any connection or relevance to the old knowledge, it will soon be forgotten. New ideas can’t just be “stored” like files in a cabinet. They have to connect with what’s already there like pieces of a jigsaw puzzle. As you become better in finding connections between seemingly disconnected ideas, your recombination-muscle becomes stronger. Someone with a strong recombination-muscle will find it easy to practice the second step of first principles thinking.

“Playing Socratic Solitaire” (Fundoo Professor)

I am going to play a game based on ideas derived from Socrates and Charlie Munger. We will start with “Socratic Questioning” which is described as

disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out logical implications of thought, or to control the discussion.

Socratic Questioning relates to “Socratic Method,” which is:

a form of inquiry and debate between individuals with opposing viewpoints based on asking and answering questions to stimulate critical thinking and to illuminate ideas.

Charlie Munger started using these two Socratic devices in a variation he called Socratic Solitaire, because, instead of a dialogue with someone else, his method involves solitary play.

Munger used to display Socratic Solitaire at shareholder meetings of Wesco Corporation. He would start by asking a series of questions. Then he would answer them himself. Back and forth. Question and Answer. He would do this for a while. And he would enthral the audience by displaying the breadth and the depth of his multidisciplinary mind.

I am going to play this game. Or at least, I am going to try. Watch me play.

If you are seriously interested in finance and investing, there is nothing more important to your development than accumulating a robust inventory of mental models. What mental models and reasoning from first principles allow you to do is see through to the true drivers of a situation, where it is often easy to get bogged down in unimportant details.

For example, if you are viewing a business through the lens of discounted cash flow valuation, here are the drivers of intrinsic value:

Operating margin
Asset turnover
Maintenance capex needs
Growth capex/reinvestment opportunities
Discount rate

Operating margin and asset turnover are quantitative measures reflecting the strength of your competitive advantage and, perhaps more importantly, the source of your competitive advantage.

Maintenance capex tells you how much cash the business needs to spend to keep running.

Growth capex/reinvestment opportunities give you an idea of growth potential over time.

When you combine operating margins and asset turnover (technically NOPAT x Sales/Invested Capital) you get a figure for return on capital. Return on capital is an excellent quantitative proxy for management’s skill allocating capital. Thus, it is also an excellent proxy for quality of management (though it is certainly not a be-all, end-all measure). When you combine return on capital with reinvestment opportunities you get an idea of what sustainable growth in operating income might look like.

There are lots of ways to handle the discount rate. Over time I have come to prefer an implied IRR method, where you simply “solve for” the discount rate that sets your cash flow model equal to the current stock price. You can then compare this to your hurdle rate for new investments.

DCF is one of the most important models in finance because it works with any investment that produces (or is expected to produce) cash flows in the future. At the end of the day, even an exercise as complicated as valuing a mortgage-backed security is just a variation on discounting cash flows.

All great mental models have two defining characteristics:

(1) They are robust. That is, they are applicable to a broad set of opportunities.

(2) They are parsimonious. That is, that is they demonstrate “economy of explanation.”

In my humble opinion, the most important mental models you need to understand in investing are:

Time Value of Money/Discounted Cash Flows
Capital Structure
Expected Value/Probabilistic Thinking
Optionality
Convexity/Linear Vs. Non-Linear Rates Of Change (e.g. compounding)
Investor Psychology

Conceptually that is really what it all boils down to (though the permutations are endless–for instance, a mortgage can be viewed as the combination of discounted cash flows and a call option). Now, you could of course write dozens of volumes on the nuances and applications of each of these models. That is part of what makes them robust. They are adaptable to an almost inconceivable range of circumstances.

This is something I don’t think most candidates in the CFA Program think about (they are too preoccupied with passing the exams!). The curriculum is designed to comprehensively introduce you to the most robust mental models in finance, and then to test your ability to apply those models to specific cases. Level I tests whether you understand the basic “tools” you have available to you; Level II tests more advanced uses of those tools (in exhausting detail, one might add); Level III tests your ability to apply all your tools to “real world” situations.

Maybe some day I will write up how I think about these super important mental models. In the meantime, enjoy the above linked posts!

I Would Like To Be Reincarnated As An Italian Mutual Fund Manager

I met with a UK-based portfolio manager yesterday and our conversation eventually led to a fascinating discussion of the differences in distribution and compensation structures in the US versus Europe.

In the US, for example, we have well-developed retail distribution channels for financial products (wirehouses, RIAs, broker-dealers, banks).

In continental Europe, distribution is dominated by the banks. For many reasons, there is simply not much of a retail investing culture in Europe. The end users of UCITS (European mutual funds) tend to be very wealthy families with multi-generational wealth management needs.

While here in the US we are preoccupied with what a fiduciary standard for investment advisor conduct and compensation should look like, the discussion in Europe is much different (to the extent there is any discussion at all).

Which leads me back to the title of this post, and why I want to be reincarnated as an Italian mutual fund manager…

In Italy, the standard compensation structure for an equity manager is apparently a 2% management fee with a performance fee assessed monthly, but with no high watermark or preferred return hurdle (!!!)

That is to say, if you are an Italian fund manager operating under this scheme, you get a cut of the profits every month you post a positive return. Even if your clients are underwater on their original investments. It is a hedge fund manager’s dream!

(I know, I know, #notallhedgefundmanagers…)

I will close with this chart from Deloitte:

Italian_Fund_Expenses — Source: Morningstar via Deloitte

The Netflix Delusion

(Usual disclaimer applies: this is not financial advice. I do not own any Netflix. Nor am I short Netflix at pixel time (though the thought has crossed my mind). Netflix is actually a super dangerous stock to short at this juncture as it appears to trade purely on momentum as of 3/7/18)

Netflix happens to be a stock market darling.

Netflix’s earnings numbers also happen to be garbage.

To those readers who own NFLX in any real size, I have a simple question for you: how does NFLX generate half a billion dollars of GAAP earnings while simultaneously burning $1.79bn of operating cash?

NFLX_FCF_Net_Income — Source: Morningstar

As I’m sure the NFLX bulls know, it has to do with the way NFLX accounts for the cost of content. NFLX spends real cash today to produce and license streaming content. However, on its income statement it amortizes that cost over a longer time period to (allegedly) better reflect the economics of that content. While the cash flow statement shows $1 of spend on content going out the door today, the income statement spreads that same $1 over about four years.

Who determines the amortization schedule? Why, management, of course.

Here is the relevant disclosure:

NFLX_Content_Amortization — Source: NFLX 10K

The table is a little hard to read so here is the text of the note again (emphasis mine):

On average, over 90% of a licensed or produced streaming content asset is expected to be amortized within four years after its month of first availability.

As of December 31, 2017, over 30% of the $14.7 billion unamortized cost is expected to be amortized within one year and 29%, 78% and over 80% of the $1.4 billion unamortized cost of the produced content that has been released is expected to be amortized within one year, three years and four years, respectively.

As it turns out, the NFLX of today is a massively capital intensive business. This wasn’t always the case. Back when NFLX distributed other people’s content it cash flowed quite nicely.

As a general rule I am suspicious of businesses that show growing GAAP income alongside large, negative operating cash flows (in NFLX’s case the cash burn actually gets larger over time–it is moving in the wrong direction). In these cases management’s judgement is driving the income statement. We have a special name for this in analyst land: “low earnings quality.”

So. Does the income statement or cash flow statement better reflect the economics of this business? This is hardly a trivial issue when you are buying a $138bn market cap company on 200x EV/EBIT. After all, it does you no good to add millions of subscribers if you have to burn up all your cash flow to retain them over time. Meanwhile you are funding that cash burn by taking on billions of dollars of debt:

NFLX_Liabilities — Source: Morningstar (columns are annual figures in USD’000 from 12/31/08 – 12/31/17)

The Red Queen’s comment to Alice is instructive here:

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

As a CFA Institute publication on earnings quality notes:

The benefit of accruals for smoothing irrelevant volatility comes at a cost. Accrual accounting opens the door to opportunistic short-run income smoothing that can lead to future restatements and write-downs (e.g., Enron). Earnings quality can be improved when accruals smooth out value-irrelevant changes in cash flows, but earnings quality is reduced when accruals are used to hide value-relevant changes in cash flows. Distinguishing between these two types of accrual adjustments is critical to financial analysis. As we discuss in Chapter 3, an astute analyst cannot focus on earnings alone. To assess earnings quality, the analyst must evaluate the company’s cash flow statement and balance sheet in conjunction with the income statement.

Hence I have this niggling contrarian idea about NFLX. My niggling contrarian idea about NFLX is that the business valued at 200x EV/EBIT is an accounting illusion, and what NFLX will really be in the long run is a massive incinerator of cash. A massively levered incinerator of cash. In extremis: a potential zero.

This is not without precedent. The movie business, for example, is notorious for creative accounting.

Now maybe NFLX is cut from a different cloth than the bankrupt movie studios of yore. Maybe it has developed super sophisticated ways of allocating production capital so as only to back projects with a high probability of success and very long cash flow streams. Management sure doesn’t account for content that way in the financials. But hey, maybe they are just that rare conservative management team of a highly touted momentum stock.

Anyway, here is a fun chart via recode:

recode_non_sports_content_spend — Source: recode

Has it occurred to anyone buying (or hawking) NFLX stock on 200x EV/EBIT that if you spend like FOX and Time Warner on content, maybe your stock should be priced similarly? (e.g. FOXA: 14x EV/EBIT BUT WITH $3.4BN OF FREE CASH FLOW)

I am not writing this up as a research note or an investment recommendation. This is simply an exercise in healthy skepticism.

What, you don’t believe me?

Ok. Fine.

This is simply an exercise in cynicism.

Warfighting

I want to share a reading recommendation with you all: Warfighting. This is not a manual but rather a philosophy for decision making under uncertainty.

h/t to Verdad Capital for the link in this excellent post (actually a newsletter piece), which opines:

I also learned at Quantico that complex linear planning fails in warfare because the profession involves “the shock of two hostile bodies in collision, not the action of a living power upon an inanimate mass,” as Clausewitz reminds us. In the military-industrial exuberance of the post–Cold War decades, we invested heavily in exotic platforms such as drones, cyber capabilities, and billion-dollar strike fighters. Our low-tech but moderately street-savvy opponents in this millennium decided to fight us precisely where and how these assets were near useless. With few exceptions, the most useful equipment for this environment came from the Vietnam era and the most enduring lessons from the time of the Spartans.

Financial markets, made up of people competing for an edge, are precisely the type of environment designed to bedevil static planning. The financial environment is one where valuation multiples persistently mean revert, where income statement growth is not persistent or predictable, where GDP growth does not correlate with equity returns, where market share and moats do not lead to competitive advantage or price return.

So what are we to do in such an environment where outcomes are determined not so much by the very little we can foresee but by what might unexpectedly happen relative to the expectations embedded in the price at which the security is bought? How would we affirmatively strategize and operate differently as investors if all of our most cherished and marketed crystal balls for forecasting price returns are shattered? How should we operate amidst the chaos without operating chaotically?

In Afghanistan, I found that the most consequential assets on our side were the most robust and persistent throughout the history of warfare. An asymmetric but intelligent adversary had refused to engage us on any terms but those where war devolved to a competition of wills, where discipline, resolve, adaptability, and habituated combat-arms tactics dictated the victor, not drones or robot pack mules. Our own persistent behavioral biases were our worst enemy.

This is precisely why I am so interested in things like tail hedging. And lest you be tempted to write this off as interdisciplinary silliness, consider for a moment that life itself can be viewed as an extended exercise in decision making under uncertainty.

UPDATE: After reading and reflecting on this, it seems clear to me it is essentially providing a mental model for what war is and how it is conducted.

At first glance, war seems a simple clash of interests. On closer examination, it reveals its complexity and takes shape as one of the most demanding and trying of human endeavors. War is an extreme test of will. Friction, uncertainty, fluidity, disorder, and danger are its essential features. War displays broad patterns that can be represented as probabilities, yet it remains fundamentally unpredictable. Each episode is the unique product of myriad moral, mental, and physical forces.

Individual causes and their effects can rarely be isolated. Minor actions and random incidents can have disproportionately large—even decisive—effects. While dependent on the laws of science and the intuition and creativity of art, war takes its fundamental character from the dynamic of human interaction.

Also this bit:

War is an extension of both policy and politics with the addition of military force. Policy and politics are related but not synonymous, and it is important to understand war in both contexts. Politics refers to the distribution of power through dynamic interaction, both cooperative and competitive, while policy refers to the conscious objectives established within the political process. The policy aims that are the motive for any group in war should also be the foremost determinants of its conduct. The single most important thought to understand about our theory is that war must serve policy.

Shenanigans! Pension Plan Return Assumptions Edition

From Reuters:

New Jersey’s treasurer said on Thursday she will increase the expected rate of return for the state’s struggling public pension system from 7 percent to 7.5 percent, then lower it again over time.

The switch to a higher assumed rate means that the state, and participating local governments in New Jersey, will for now escape the higher costs that arise when investment return assumptions are lowered.

The savings come at a fortuitous time for new New Jersey Governor Phil Murphy, who took office in January and is facing a shortfall ahead of his first budget proposal in mid-March.

The higher rate will save about $238 million for the state and more than $400 million for local governments in the near term, according to the office of Acting State Treasurer Elizabeth Maher Muoio.

Color me gobsmacked. Here is a translation into plain English:

We know that our current return assumption is unrealistic. But, if we lower it outright we are going to have to make large contributions we can’t really afford (we are only 49 percent funded as it is). So we are going to tell a teensy weensy little white lie, and pretend returns will be higher for a while. And eventually we will fix the numbers. It will all work out in the end. Trust us.

Where is one to begin with something like this?

With the fact that New Jersey’s treasurer is OPENLY FUDGING THE NUMBERS?

How about some healthy skepticism regarding whether a bunch of politicians will ever adjust the numbers back down to where they belong if it means a public outcry over unfunded liabilities or higher taxes?

Or maybe the troublesome fact that only 50% of projected liabilities are funded?

Puerto Rico should be instructive where these underfunded state and municipal pension plans are concerned, both in terms of the root causes of the problems and the difficulties inherent in closing massive budget holes. This is not likely to end well for New Jersey.

My Quixotic Obsession With Tail Hedging

We all have our weird niche interests and obsessions. For instance, my quixotic obsession with tail hedging. Conventionally, that means protecting portfolios against “rare” events (the VIX doubling in a single day, for instance). I am interested in tail hedging in a less conventional sense. I am interested in actually making money off “rare” events. I use “rare” in scare quotes here because contrary to the what you might hear from boilerplate financial advice, “rare” events are surprisingly common in financial markets.

If you are interested in the philosophical and mathematical underpinnings of tail risk, you should read Taleb’s Fooled By Randomness and Lo’s Adpative Markets (review forthcoming soon). But if you prefer practical applications, check out the below table:

SP_Returns_Following_Crisis — Source: *Alternative Investment Analyst Review*

This is taken directly from the paper “A Comparison of Tail Risk Strategies in the US Market.” The intuition is simple: markets offer the highest expected returns when they are bombed out, when valuations are deeply discounted, when (to borrow a Buffettism) everyone is feaurful. A tail hedge not only provides excess returns in times of crisis that mitigate drawdown, but also a source of liquidity that can be redeployed into equity and/or fixed income securities at firesale prices.

So, hypothetically, you make 2% at the portfolio level off a small-ish tail hedge and reinvest it into equities at firesale prices. Over the subsequent months and years maybe that amount doubles, triples or quadruples.

Sounds great, right? What’s the catch?

The catch is the cost of the hedge and the resulting drag on returns:

Tail_Hedge_Perf_Drag_ — Source: *Alternative Investment Analyst Review*

If you are interested in a detailed exploration of the strategies in the table, you will have to read the linked paper. However, at a high level the intuition is straightforward. When you are tail hedging you are essentially buying insurance. The person selling you the insurance wants to earn a premium for doing so.

The most common arguments against tail hedging are:

(1) there is no reason to hedge tail risk because in the long run equity markets always go up;

(2) the cost of the insurance is not offset by excess returns over time;

(3) there are better ways of mitigating tail risk.

I do not find Argument #1 compelling at all. All the data used to support this argument is subject to path dependency and survivorship bias. This is particularly true in the context of the US market, which is has been the best performing equity market in history. People tend not to respond well to my counterarguments because they imply an uncertain view of the future and they would rather extrapolate from the past (clients don’t like to face up to the uncertainty inherent in markets). People also have a difficult time with skewed payoffs–that is, understanding why a strategy with a 99% probability of a $1 loss and a 1% probability of a $100 gain is a good bet in the long run.

I do find Argument #3 compelling. AQR has a good paper on this that reaches similar conclusions to the Alternative Investment Analyst Review piece. However, AQR’s paper is focused on defensive applications of tail hedging strategies, whereas my interest is in playing offense. In full fairness, AQR addresses that in the paper:

We acknowledge that some investors might buy insurance for reasons other than reducing tail risk. For example, insurance can provide a cash buffer in times of market distress, potentially allowing investors to take advantage of fire-sales and other market dislocations. However, depending on the magnitude and frequency of the dislocations (and the manager’s ability to identify them), this opportunistic approach still might not make up for the negative expected returns from buying insurance. Other investors might occasionally have a tactical view that insurance is conditionally cheap. However, this is simply market timing in another form, and this decision should be made (and sized) in the context of other tactical views in the portfolio.

I have mixed views of Argument #2, mainly due to the issues of path dependency and survivorship bias noted above. If future equity returns look like the past 30 years or so, there is certainly no reason for long-term investors to tail hedge (assuming they have the wherewithal to stay invested in volatile markets). If the world becomes a more volatile and uncertain place over the next couple decades, investors may feel differently.

I have conducted some small experiments with real dollars over time. Most recently, I set up a long volatility trade using the VIXY ETF and ZIV ETN. It performed well during the February volatility spike, but was something of a blunt instrument (I have since closed out the position).

More recently I have been looking at Meb Faber’s TAIL ETF, which purchases a ladder of out-of-the-money put options on the S&P 500. Below is a rough scenario analysis I conducted to assess performance drag vs. crisis performance, as well as some historical monthly performance data for TAIL for context (the ETF has a short track record).

TAIL_Scenario_Analysis — Source: Demonetized calculations

TAIL_Monthly_Returns — Source: Morningstar

A couple takeaways:

This exposure has to be managed actively. When volatility spiked in early February 2018 the correct move would have been to trim the position on the back of the ~10% up move.
There is a consideration in play for me that is not in play for many retail investors, and that is that my compensation and career prospects are highly correlated to financial markets. For people with “bond-like” compensation (teachers, doctors) there is less benefit to spending portfolio dollars on a tail hedge from a pure risk management POV.
The real downside to putting on a position like this is not getting 18% annualized over a decade if the market returns 20% annualized. The real downside is getting an annualized 3% if the market returns 5%.

Billionaire Doomsday Prepping As Extreme Tail Hedging

I sometimes laugh when I read critical articles about billionaire hedge fund managers who are also doomsday preppers (this is enough of a “thing” that it has had a material impact on real estate prices in New Zealand). Of this behavior, The New Yorker commented:

Fear of disaster is healthy if it spurs action to prevent it. But élite survivalism is not a step toward prevention; it is an act of withdrawal. Philanthropy in America is still three times as large, as a share of G.D.P., as philanthropy in the next closest country, the United Kingdom. But it is now accompanied by a gesture of surrender, a quiet disinvestment by some of America’s most successful and powerful people. Faced with evidence of frailty in the American project, in the institutions and norms from which they have benefited, some are permitting themselves to imagine failure. It is a gilded despair.

I have a dramatically different reading: billionaire doomsday prepping is just an extreme form of tail hedging.

If you have a net worth of $1 billion, why not spend even $10 million of your net worth on a hedging strategy for the total collapse of civilization? This amounts to a 1% exposure. It’s a pretty good risk/reward tradeoff, if you ask me–especially if you are estimating your max downside as being drawn and quartered by some kind of Proletarian Justice Tribunal. Obviously, a financial hedge is not going to work here. You are going to need things like guns and butter. And some kind of bunker.

I am sure not all ultra-wealthy doomsday preppers look at it this way. But I am comfortable speaking for a majority. Even that New Yorker piece contains the following observation (they buried the lede, IMO):

Yishan Wong, an early Facebook employee, was the C.E.O. of Reddit from 2012 to 2014. He, too, had eye surgery for survival purposes, eliminating his dependence, as he put it, “on a nonsustainable external aid for perfect vision.” In an e-mail, Wong told me, “Most people just assume improbable events don’t happen, but technical people tend to view risk very mathematically.” He continued, “The tech preppers do not necessarily think a collapse is likely. They consider it a remote event, but one with a very severe downside, so, given how much money they have, spending a fraction of their net worth to hedge against this . . . is a logical thing to do.”

Trolling Warren Buffett

So the annual Berkshire letter is out and Buffett could not resist taking another swipe at Wall Street over his bet with Protégé Partners. I am not going to re-hash the letter or the bet here. (Incidentally, I highly recommend giving this annotated version a read) Rather, I want to draw your attention to one particular bit no one ever seems to talk about:

Berkshire_2017_Letter_Snip — Sources: Berkshire Hathaway; Safal Niveshak (highlight)

Am I the only person on the internet who believe this was a completely insane way to build a portfolio? Obviously, in the aggregate, the best investors can hope to do is match the market return, less fees (they can of course do considerably worse). It cannot be otherwise. There is nothing especially profound about the observation that it makes no sense to try and replicate the broad market with scores of active managers.

Fama and French demonstrated long ago that the aggregate portfolio of all investment managers more or less resembles the market cap weighted portfolio (read: an index fund, but with higher fees). Behold:

The high management fees and expenses of active funds lower their returns. If we measure fund returns before fees and expenses – in other words, if we add back each fund’s expense ratio – the α estimate for the aggregate fund portfolio rises to 0.13% per year, which is only 0.40 standard errors from zero. Thus, even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns. After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.

Adding insult to injury, the aggregate portfolio of active mutual funds looks a lot like the cap-weighted stock market portfolio. When we use the three-factor model to explain the monthly percent returns of the aggregate fund portfolio for 1984-2006, we get,

RPt – Rft = -0.07 + 0.96(RMt – Rft) + 0.07SMBt – 0.03HMLt + eit,where RPt is the return (net of costs) on the aggregate mutual fund portfolio for month t, Rft is the riskfree rate of interest (the one-month T-bill return for month t), RMt is the cap-weighted NYSE-Amex-Nasdaq market return, and SMBt and HMLtare the size and value/growth returns of the three-factor model.

The regression says that the aggregate mutual fund portfolio has almost full exposure to the market portfolio (a 0.96 dose, which is close to 1.0), but almost no exposure to the size and value/growth returns (0.07 and -0.03, which are close to zero). Moreover, the market alone captures 99% of the variance of month-by-month aggregate fund returns.

In short, the combined portfolio of all active mutual funds is close to the cap-weighted market portfolio, but with a return weighed down by the high fees and expenses of actively managed funds.

Therefore, in my view, Protégé’s failure was first and foremost a failure of portfolio construction. It’s totally fair to fault Protégé for this, just as it’s fair to fault many investors for buying into a collective delusion around hedge funds as magical assets* in the mid-2000s. To the extent Warren is underscoring that point, I wholeheartedly agree with him.

Beyond that, I don’t know the outcome of this best offers much insight into investment manager selection or the merits of investing actively. (See my Truth About Investing post for more on that subject) Warren Buffett did not get to be a billionaire buying index funds. Neither did Jim Simons. Or David Tepper. Or Seth Klarman.

Someone please sit down with Jim Simons or David Tepper or Seth Klarman or Howard Marks or any of the dozens of hedge fund managers who have trounced the S&P 500 over the past couple of decades and lecture them about the aggregate performance of active management. I would love to hear how it goes.

* When I write about magical asset classes I am referring to any asset class or strategy people believe is inherently superior to others. In the mid-2000s investors clearly believed they could generate outperformance just by “being in” hedge funds. There are lots of reasons why aggregate performance has declined since then. First and foremost, hedge funds became victims of their own success as the space attracted large amounts of investor capital and many hundreds of talented money managers. Now that hedge funds are out of favor, the magical asset classes of today are private equity and venture capital. Also, hedge funds are not an asset class. They are a type of fund structure, just like closed end funds and mutual funds are types of fund structures. Similarly, you can argue that private equity isn’t a unique asset class so much as a levered investment in illiquid small caps and micro caps.