American Investment Services, Inc.

Disciplined, Diversified, & Cost Effective

Mar. 2010 – Active Managers versus Free Markets

The question of free markets versus socialism is in the news. We take this opportunity to remind investors that it is logically consistent for investors who accept the primacy of free markets to adopt passive, asset class management over the alternative of active management. In our discussion we draw upon a transcript of a presentation given by Rex Sinquefield, co-founder of Dimensional Fund Advisors and currently President of the ShowMe Institute.

Adam Smith, in The Wealth of Nations first pointed out that those nations that relied on free markets and voluntary exchange prospered relative to nations that did not. Friedrich Hayek refined this idea by explaining that no single entity can ever possess all the knowledge necessary to organize society’s resources to produce goods or services successfully.

Hayek demonstrated that prices determined freely through voluntary exchange will reflect relative scarcity and thereby convey all the information that is necessary to ensure the efficient employment of resources in the production of goods and services. Hayek’s insight was that no individual or group can measure effectively either the demand for a good or service or the various inputs required for its production. On the other hand, if prices are freely determined and their dissemination is unhindered, numerous individuals at various stages of production, acting in their self interest, will provide what is required to ensure consumer demand is ultimately met. Central coordination is not needed, nor can it be applied in a manner that will produce a more efficient outcome.

Put another way, the producer of fertilizer that is used to grow feed grain in Montana need not know the price of filet mignon in order for New Yorkers to enjoy fine dining. All he needs to know is the prevailing price of the fertilizer he is selling, the wages of his employees, and the prices of his raw materials and other inputs. He will organize his production to maximize his profits and in so doing ensure efficient employment of those resources. The same is true at every stage of production. Those who grow the grain, slaughter the cattle and transport the beef all operate efficiently, oblivious to the others’ constraints, and with no central coordination.

Beginning in the mid-19th century this insight gradually came to be overshadowed by a growing belief that man’s successful mastery of the physical sciences could be extended to the organization of economic activity. By 1917, centrally planned production and pricing had been formally established. Sophisticated mathematical modeling of inputs and production levels were employed with the aim of improving social welfare. Individual decision making was supplanted by central direction and coercion.

Eighty years later the socialist experiments in the Soviet Union and Eastern Europe ended in failure, during which time the largely unmanaged economies in the west yielded the greatest increase in living standards known to mankind. Hayek and Smith were vindicated. This dichotomy, free markets versus central planning, has striking parallels in the evolution of financial economics. Beginning in the 1950s Markowitz, Miller, Sharpe and others established the study of finance as a legitimate field of academic inquiry. Fama built on this foundation by establishing what is now widely recognized Efficient Market Hypothesis (EMH).

EMH asserts that current market prices are the best approximation of a security’s intrinsic value and that prices adjust rapidly to reflect the impact of unforeseen events. In other words, EMH is simply an extension of Hayek’s fundamental assertion: markets work. The central implication of EMH is that no money manager or investor, given publicly available information, can consistently provide risk-adjusted returns greater than those of the market.

Active managers (stock pickers and market timers) disagree. They assert implicitly, through their attempts to “buy low” and “sell high,” that market prices are often wrong, and that they, like central planners, possess the special ability to determine “correct” prices.

Stock pickers spend a great deal of time and resources visiting firms, pouring over financial statements and analyzing “intrinsic values” versus market prices to identify “undervalued” or “overvalued” assets. Similarly, market timers hope to devise methods that will determine when investors have failed to properly price the entire market in light of currently available information.

The efforts of passive managers, on the other hand, are directed largely toward defining empirically the parameters that establish an asset class. For example, they determine the market capitalization level that distinguishes small cap stocks from large caps in light of risk and return data that spans several decades. Then they simply maintain a portfolio that includes every security within the asset class so defined.

In short, passive managers trust markets to price risk appropriately; active managers do not. Not everyone can be a “price taker” of course; prices after all must be set by someone. But the riddle of “price discovery” is not confined to capital markets, it extends to microeconomics generally. No one denies that there are individuals whose marginal costs for discounting and interpreting information are lower than others. But their skills are not unique and even they must compete with others who hold a similar comparative advantage. The central point for individuals, however, is that evidence overwhelmingly supports our conclusion that these “price setters” are not to be found among the thousands of stock pickers managing mutual funds or expensive broker dealers with large marketing budgets.

Despite these parallels between central planners and active managers, there is also an important distinction: the costs of central planning are often imposed involuntarily, and fall on all of society. The cost of active management, on the other hand, falls only upon clients who choose to place their faith (and their wealth) in the hands of managers who claim to have a special talent.

Fundamental Differences

Passive investors are trusting by nature. Our acceptance of market returns is a vote of confidence in people who trade voluntarily in a free society. Passive investors are humble. Our goal is not to “beat the market”; instead we simply study and accept the nature of the markets’ long term risk and return and build a long term plan accordingly, in a careful and deliberate manner.

The passive investor is patient, and optimistic. We are willing to endure, rather than anticipate inevitable short term market fluctuations because we are confident that this volatility is the price we pay today for the reward we will ultimately reap. We have faith in the promise of long term economic prosperity. Perhaps most importantly, we are content. Our savings are invested in a manner that is structured, rational and consistent. We are not subject to the anxiety that comes with attending to market gyrations. This leaves us free to pursue happiness elsewhere.

Active investors pick stocks and move into and out of various asset classes. Their efforts to capture gains episodically expose a lack of faith in capital markets to reward investors for the capital they supply over the long-term. Their second-guessing of security prices is ego-driven. They distrust implicitly the mechanism by which millions of investors interact freely with firms to allocate capital and rely instead on their personal opinions and conjecture.

Rather than asserting control predicated on long term confidence, the active investor’s actions are driven alternatively by fear and euphoria. Since markets cannot be trusted, the active investor must monitor the market constantly or live with the fear that he might miss the next opportunity or pitfall. His portfolio’s allocation is not guided by the steady hand of statistical reasoning; instead it is subject to his vacillating emotions. This would appear to allow little peace of mind or time for life’s other pursuits.

Our Services

We hope that this newsletter is useful in helping you to maintain the self-discipline that is required as you apply our structured approach to your own portfolio. We also offer low-cost advisory services for investors who wish to adopt our approach. We manage over $370 million on behalf of individuals and institutions. Many of our clients simply wish to avoid any aspect of administering their portfolio, while others rely on us to apply the discipline they find so elusive in a world in which reason is so easily obscured by slick marketing.

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Also in This Issue:

Risk and Return: One Year Later
The Lost Decade?
The High-Yield Dow Investment Strategy
Beware the Boiler Room
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles