Assets in ETFs exceed assets in hedge funds, Daniel Kahneman, and the value of good rules of thumb

1. Assets in Exchange Traded Funds now exceed assets in hedge funds. The Economist writes on the triumph of the humble ETF:


Yet the steady return claimed by hedge funds can be replicated, or indeed beaten, with ETFs. S&P, an index provider, calculated the return over the past five years from a portfolio comprising 50% American bonds and 50% global equities. This portfolio easily outperformed the average return from hedge funds. S&P then deducted hedge-fund-style fees from the model portfolio; the result tracks hedge-fund returns very closely. It looks, in other words, as if hedge funds are a very expensive way of buying widely available assets. Last year CalPERS, California’s public-sector pension fund, announced it was selling off its investments in hedge funds, citing both complexity and costs.
ETFs have also faced criticism. Jack Bogle, the founder of Vanguard, an index-tracking firm, has argued that the ease of dealing in the funds may cause retail investors to trade too much, switching in and out of asset classes in a vain attempt to time the markets. A more widespread concern relates to liquidity. All ETFs allow investors to redeem their holdings instantly, but some of the assets they own, such as corporate bonds, trade infrequently. They thus face a potential problem if prices fall sharply and a lot of investors want to sell at once. That might force them to delay or limit redemptions (imposing “gates”, in the jargon). Some see this as the trigger for the next market crisis.

2. Daniel Kahneman, one of SigFig’s heroes, shares stories with the Guardian.

What’s fascinating is that Kahneman’s work explicitly swims against the current of human thought. Not even he believes that the various flaws that bedevil decision-making can be successfully corrected. The most damaging of these is overconfidence: the kind of optimism that leads governments to believe that wars are quickly winnable and capital projects will come in on budget despite statistics predicting exactly the opposite. It is the bias he says he would most like to eliminate if he had a magic wand. But it “is built so deeply into the structure of the mind that you couldn’t change it without changing many other things”.

In general, Kahneman is downbeat about the capacity of his brand of psychology to effect change in the world. I imagine he would simply argue he’s a realist about human nature. And, indeed, studies showing that “skilled” analysts are hopeless at predicting the price of shares have yet to translate into mass sackings or even reduced bonuses on Wall Street or in the City. The same goes for evidence that the influence of a high-quality CEO on the performance of a company is barely greater than chance.
But there are more modest ways his insights can help us avoid making mistakes. He advises, for example, that meetings start with participants writing down their ideas about the issue at hand before anyone speaks. That way, the halo effect – whereby the concerns raised first and most assertively dominate the discussion – can be mitigated, and a range of views considered. Then there is the concept of adversarial collaboration, an attempt to do away with pointless academic feuding. Though he doesn’t like to think in terms of leaving a legacy, it’s one thing he says he hopes to be remembered for. In the early 2000s Kahneman sought out a leading opponent of his view that so-called expert judgments were frequently flawed. Gary Klein’s research focused on the ability of professionals such as firefighters to make intuitive but highly skilled judgments in difficult circumstances. “We spent five or six years trying to figure out the boundary, where he’s right, where I am right. And that was a very satisfying experience. We wrote a paper entitled ‘A Failure to Disagree’”.

3. Also on overconfidence, Morgan Housel of the Motley Fool writes on the perils of over-precision and how, often, good rules of thumb are good enough.

One of biggest investing lessons I’ve learned is that the more precise you try to calculate, the further from reality you’re likely to end up. Precise calculations creates a spell of overconfidence, which makes you double down on whatever you want to believe no matter how wrong it is. Some examples are staggering: Wall Street’s top market strategists predict each January how much the S&P 500 will go up over the following year. Their collective track records are worse than if you just assumed stocks go up by their long-term history average every year.
In a messy world of emotions and misinformation, broad rules of thumb can be an excellent strategy.

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