Wall Street\'s Shell Game

Wall St SignKeeping with the theme of survivorship bias, I stirred up some debate on a mailing list recently by claiming that managed mutual funds are a scam. Specifically, they are a variant of a particularly clever scam that goes like this:

Get a list of email addresses of people interested in sports betting. Say you have 32,000. Email 16,000 of them to say that the home team will win this week's big team, and 16,000 to say the home team will lose. Now, half of the people will have gotten the correct prediction, and the next week, you do the same thing with them. After 5 weeks, you'll have 1,000 email addresses of people who have seen you pick the winner five times in a row!. Now you pitch your 1-900 number or paid email list subscription to this amazed group.

Shell Game ConSuppose that managed mutual funds have two characteristics: substantial year-to-year variation (from market returns), and zero year-to-year correlation. The first is pretty clearly true, and the second has a fair amount of empirical and theoretical evidence. It's related to the Efficient Markets Hypothesis, and I don't have time to get into defending it now, and in fact it's probably slightly wrong. But its certainly not far off, so let's just take it as a given. Note that it was these same two characteristics that made the sports picking system a scam. The variation is high, since you are either completely right or wrong each week, and its random which is which.

So what happens is that someone (like Fidelity) creates a family of mutual funds, with different managers, styles, and sectors. After a few years, some will have done very well, and some will have done poorly. Funds that do well tend to attract lots of investment, because people irrationally believe that past results do predict future performance. So these funds will swell, and the others will be quietly closed.

Many industry participants may not even realize its a scam - after all, its perfectly natural to tout your winners and toss your losers. But if the conditions I stated hold, it is still a con game, even if the participants are conning themselves. And this happens year after year, and decade after decade, an endless cycle of pointless churning, of wasted money spent advertising and promoting these products, running these businesses. The scale is mind-boggling - its the biggest non-governmental scam I've ever heard of (although it pales in comparison to the fiat money con).

Now, I'm not saying that there should be nothing but index funds - that would be an inefficient market indeed. But the number of non-index traders required to keep the markets efficient is, I'm fairly sure, far smaller than the number we have today. But because because of our poor probability intuition, our desire to beat the crowd, and our belief in the power of talented individuals (like fund managers) many investment resources are misdirected in this direction. Another reason is that, unlike poker, investing is a positive-sum game, and so this sort of thing can continue forever. Its much easier to notice that you are losing than that you aren't making quite as much as you should be.

(There is an additional problem, which is that finding mispriced investments is essentially rent-seeking, and hence will lead to wasteful competition. But that's a much harder problem to solve.)

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I got my definition from

I got my definition from David Friedman's book Law's Order (chapter 3). He mentions that the term was originally coined to describe competition for government favours, but he uses it to describe a much more general class of activity: see, for example, his discussion of homesteading in chapter 10, and the section of "The Inefficiency of Monopoly: Part II" in chapter 16.

I think that the "arbitrage seeking", as described, is a pretty clear example of attempting to transfer wealth from someone else to yourself: if you don't take an opportunity, someone else will get there first, even if the wealth has still to be created. It's directly analogous to Friedman's examples of patents and homesteading.

However, I do think that it would be innappropriate to describe all efforts at arbitrage-seeking as rent-seeking, since arbitrage does correct misallocations of capital. The term rent-seeking would only apply to those efforts that are in excess of what would be expended in some hypothetical world in which property rights in the gains from arbitrage can be allocated securely.

Economically speaking, the

Economically speaking, the word "rent" has more than one definition. Thus, defining the term rent-seeking can also be difficult. I'm a pretty strong adherent to the Buchanan-Tullock school of public choice, so the definition I tend to use is basically theirs, It's summarized here:

http://www.magnolia.net/~leonf/politics/rentseek.html

That (and my) definition necessarily includes the granting of favors by government, and the process of competing for those favors (rent-seeking). In Patri's example, there is no governmental entity granting favors.

I also see rent-seeking as the transfer of some previously existing wealth, not the creation of new wealth by the market-exchange process.

It sounds to me like Patri is describing arbitrage-seeking, whereby the first person to discover such an opportunity is the only one to profit from it. But IMO this is actually the very mechanism that drives market efficiency - people seeking pricing anomalies (i.e., unresolved differentials between supply and demand.)

People seeking these anomalies is not some unfortunate side-effect, as Patri appears to put it, but it is in fact the central core practice that drives markets to proper equilibria.

I'm used to collectivists spouting on about "wasteful competition." I'm a little surprised to see a contributor here raise it. I can't even begin to talk about why "wasteful competion" in a basically free market is a misplaced notion. That's a whole other argumant entirely.

I can say that zero-sum competitions for government favors (or the compliance with governmental burdens) are indeed wasteful, in that they involve wealth-trasnfer, and not wealth-creation.

Going back to to Andy and Stephen's statements, I think we simply have differing definitions of what rent-seeking is. I think there is some conflating with the definition of capital or resource factor rent, which is a very different thing.

I was about to make a

I was about to make a similar objection to Grant, but I think Patri's answered the point well.

Calling it rent-seeking is misusing the term.

Is it? I'd understood that rent-seeking arises when there is an ill-defined or insecure property right, and that the term refers to the efforts people take to ensure that they, rather than someone else secured that property right.

This seems to apply to the case under discussion: the gains from an arbitrage opportunity can be claimed by anyone, so, as Patri describes, we can expect people to expend additional effort to claim them first. To describe that as rent-seeking seems quite appropriate to me.

Does the term have a narrower definition from what I was assuming?

Calling it rent-seeking is

Calling it rent-seeking is misusing the term.

Because I'm an economist, my colleagues assume that I know something about equities markets and are always asking me for stock tips. (I do know a bit about equities markets, but not because I'm an economist.)

I usually just tell them to take a buy-and-hold, index-based portfolio. On a straight asset-value basis, it will generally do better than at least half the managed funds out there, and when you figure in the absence of transaction and management costs, you're better off. People usually walk away feeling like I've disappointed them a bit - like I'm witholding some little bit of secret wisdom from them.

Of course, it is very difficult to get across to "regular" people the ideas that (a) the past is not a reliable indicator of the future, or (b) if some strategy works in the short run, it will be copied, thus invalidating its effectiveness over anything but the short-term.

the EMH has been well

the EMH has been well discredited by both empirical evidence and deductions made thereof. Certain fund companies DO perform better then others over both the long and short run. And this is not due to just plain luck and/or scamming the masses. If the EMH is correct or even largely correct then how could one take into account people like John Templeton, Phil Fisher, Jim Rogers, Benjiman Graham, and most blatantly of all, Warren Buffett. All of these are highly successful investors whose results have been consistently of good quality. This has not been due to luck, but due to a prudent analysis of the market and and exploitation of its undervalueings. Furthermore there are a good number of fund companies which have had a constant track record of good returns, such as the sequoia fund for example. For an even more complete debunking of the EMH, I implore those interested to read this: http://www.mises.org/fullstory.aspx?control=1599

Patri, ... We give the first

Patri,

... We give the first person to file a patent all the benefit from using it for the next X years. But society has only benefited by how much earlier this inventor had the idea than it would have come up otherwise....

Not necessarily true. At least in theory, the patent may create a monopoly for products that cannot otherwise be produced profitably, or at all. In this case any benefit to society will extend over the entire lifetime of profitable production, and not be limited to a time interval between first and second discovery.

Regards, Don

this is why I use TA instead

this is why I use TA instead of fundamentals. The TA shows the information LONG before anything is revealed by the company and its free! TA used to be an arcane ivory tower exercise but now the information is diseminated every 3 seconds via price. Everything i've read and my practical experience shows that the EMH is nice in theory but does not apply to short time frames.

Grant - this is a somewhat

Grant - this is a somewhat complex issue, and I stated my point quickly, hence the confusion. I agree with most of what you said. Here is a longer explanation, please let me know if you find it lacking. Really, I should make this into a post...

Anyway, there is an odd feature of market mispricings that leads to rent-seeking, which is that the first person to find them gets all the benefit. So its analagous to a similar problem in patents. We give the first person to file a patent all the benefit from using it for the next X years. But society has only benefited by how much earlier this inventor had the idea than it would have come up otherwise.

If I go search for a useful-shaped rock, the benefit to our village is not the value of that rock forever. If someone would have found it in their own wanderings, with no effort spent searching, then the village has only benefited by how much earlier we got it.

Returning to market speculation, presumably there is some curve with effort on one axis and how fast a mispricing is found on the other. Because the first person to trade based on the mispricing can (with enough capital) correct it, they reap all the benefit, even though someone else might have spent less effort and identified it a day later.

There is no reason to think that the result is optimal, in fact, like most rent-seeking, it is almost certainly not. There is an externality here - when I trade away a mispricing, I get the benefit, but I cost whoever would have found it next that same benefit. Sure, society has gained, but there is no mechanism tying the gain to the cost of achieving it (unlike in most areas of business).

Consider a mispricing that is worth a million bucks to correct, and I can spend $900,000 of analysis/computer power/manpower to find it in 5 minutes, whereas other traders would realize it in half an hour. I'm happy to pocket the $100,000 profit, but there is no reason to think that having this price change 25 minutes sooner is worth $900,000 of resources to the world. The normal weighing of cost against benefit that happens when A sells to B w/ no externalities has not occured.

So my argument is fairly general. I am talking about a fundamental issue w/ trading markets, that the first person to inject new information can receive most or all of the benefit. When there are ways to spend a lot of resources to find new information slightly faster, this results in waste.

It's tricky whether to call it rent-seeking, I see it that way, but I'm not positive that I'm right. The problem is that in normal rent-seeking, the value doesn't depend on who gets the rent. Here, by making the information come in faster, the speculators are adding some value to the system. It is not pure rent-seeking. Yet as they spend millions to shave off seconds or minutes, hopefully you can see the connection. They are spending money to capture a resource whose value varies only a little based on who gets it.

I find libertarians sometimes have great trouble understanding this particular issue, because we are so used to assuming that consensual interactions must be positive-sum. But of course with externalities this is not true. Because the externality here is so hidden, it is easy to miss the actual cost/benefit structure.

finding mispriced

finding mispriced investments is essentially rent-seeking

Umm, I was with you up to that point.

Finding mispriced investments isn't rent-seeking if you only find them. And if, after finding them, you transfer capital to or from them, you're injecting information into the system; unless your gains are out of proportion to the information you are injecting (and I'm not clear how they could be on average), you're reaping money for value -- no rent-seeking at all.

To put it another way -- imagine that we had a computer that could always and perfectly detect mispriced investments. And let us say that the computer played the stock market. In addition to becoming absurdly rich, the computer would reallocate capital so as to render the investments correctly priced. Its profit in doing so would obviously be bounded upward by the pricing errors corrected. So its profit would be bounded by the total misallocation of capital it corrected. In fact its profit would be less than that -- you can't sell all that stock instantly, after all, and information does migrate -- and all that difference would pay out to other investors or the companies clever enough to realize their own misvaluation.

While it's true that building two identical such perfect-trader computers would be wasteful competition, the argument that that alone made price-correcting trading rent-seeking would seem to prove too much: Determining and injecting into the market the correct solution to any problem, from crossword puzzles to astronomical distances, would constitute rent-seeking.

Enlighten us poor confused?

Sorry, that book is John

Sorry, that book is John Train's "Money Masters of Our Time".

I read this book

I read this book

http://www.amazon.com/exec/obidos/ASIN/0887309704/qid=1115850000/sr=2-1/ref=pd_bbs_b_2_1/002-6411478-8738421

for an investment management internship that I worked at last summer. It's hard to read about the investment greats and keep your faith in the EMH, other than as a long run theory.

The survivorship bias ruins

The survivorship bias ruins even the index funds concept , as losers or out of favor sectors get dumped for the flavor du jour. The DJIA is not even close to a true index. Look at the CRB, they're jacking with it now because its actually starting to reflect inflation. grrrrrr.

Anyhow, your argument is completely right, EMH or no EMH. i play junior mining stocks ALL DAY and believe me, there 'ain't no EMH round these parts'. insiders and the like are churning and selling etc etc. its like a 3 ring circus, and i like it.

Inflation is also so insidious that i cannot understand how people buy mutual funds based on those stupid linear projection graphs of returns they tout. as long as the graph goes up from left to right its good optics.
But thats outside of your original parameters of this discussion.

Only The Good (don't) Die

Only The Good (don't) Die Young: Survivorship Bias
Patri Friedman at Catallarchy has some great thoughts on survivorship bias. In the first post, Selection Bias and Risky Strategies, he writes about payoffs to players in poker tournaments. He writes:

But, there is value in funds

But, there is value in funds that focus on a certain investment style or sector. An investor may know that they want to put their money into small cap growth stocks but know that they don't have the time/skills to actually do the research. A fund allows an investor to do so.

A perfect example is health/biotech. This field will certainly grow in the future, probably faster than most other sectors, but each individual drug stock presents a huge variance. See Elan corp. If you like the sector as a whole, put your money in a biotech fund.

ETFs can do the same for less, since the expense ratios tend to be lower (although not always). And also, most brokers charge a stock trading fee to buy an ETF, but not so for no-load funds. You can keep adding to the fund for no charge. This savings adds up quick if you're putting in a monthly check and gives the value edge to a fund.

So if you're going to save a certain amount on regular intervals, you are better off in a no load fund than an ETF. If you're going to allocate a huge chunk as a one time only purchase, an ETF is better, if you can find one that fits your investment objective.

If you don't care about invesment style or sectors, then the index fund is almost certainly best.

nmg

Arbitrage seeking would be a

Arbitrage seeking would be a better term for use in this discussion.

Stephan - While it would be

Stephan - While it would be idiotic to believe in the strongest form of the EMH, ie that all markets are always efficient and you can never beat them, I think it is quite clear that a weaker form is true. That is, most markets are mostly efficient and in order to beat them you generally have to be in an unusual position of some sort. Whether its unusually lucky, unusually skillful, or unusually knowledgeable in a thin market.

The Mises article you posted has some good arguments, and some flawed arguments. To call it a complete debunking is an overstatement. For one think, supporters of the EMH actually crunch numbers, examine the success of proposed strategies, and look at correlations. I'll buy an argument that looks at empirical data over one that is all theory any day.

I’m used to collectivists

I’m used to collectivists spouting on about “wasteful competition.” I’m a little surprised to see a contributor here raise it. I can’t even begin to talk about why “wasteful competion” in a basically free market is a misplaced notion. That’s a whole other argumant entirely.

Yes, libertarians are often surprised when I raise this point, but perhaps you should consider the source as some evidence that it might be a valid one. And note that I originally encountered the argument in David Friedman's Law's Order, as Andy cites, so if you care about credentials it is being made by someone who is a staunch anarcho-capitalist and a libertarian economics professor.

If you go back and read my explanation, and really think about, I'd be curious to know if you still disagree with it. I am not making any general statements about competition being bad or wasteful, I am making a very *specific* argument, that in a *specific*, unusual type of economic activity (speculation), the normal parity between profit to an individual and profit to society is lost.

I can say that zero-sum competitions for government favors (or the compliance with governmental burdens) are indeed wasteful, in that they involve wealth-trasnfer, and not wealth-creation.

But why must wealth-transfer be limited to competition for governmental favors? We can easily construct situations w/o government where people compete for some fixed value. Suppose there is a mine, and the first one to find it gets to keep it. The mine is worth 100 million $ to society. I expend 99 million $ in resources to get there first. Society has profited by 1 million $. But it could have been found in a year for 10 million $, at a profit of $90 M. Competition has literally used up 89 million $ in value, in order to get the mine opened a year early. And this didn't happen because it was worthwhile, because it was a desirable tradeoff, but as a side-effect of the rule "first gets".

Patri, "... We can easily

Patri,

"... We can easily construct situations w/o government where people compete for some fixed value. Suppose there is a mine, and the first one to find it gets to keep it. The mine is worth 100 million $ to society. I expend 99 million $ in resources to get there first. Society has profited by 1 million $. But it could have been found in a year for 10 million $, at a profit of $90 M. Competition has literally used up 89 million $ in value, in order to get the mine opened a year early. And this didn’t happen because it was worthwhile, because it was a desirable tradeoff, but as a side-effect of the rule “first gets"...."

Your equating of dollars with value is entirely off base.
Society as a whole benefits greatly from the existence of the concept of money, but not at all from its total quantity. Society only benefits from the consumption of subjectively valued consumer goods by individuals. All exchange-valued goods including money merely serve to allocate that consumption over individuals over time.

The $89M is not used up, but merely represents a time- advanced and quantity-increased return to the owners of the resources employed. All money is owned by someone, and that person is responsible for using it to advance his own self interest, whether narrowly or broadly defined.

The results of free markets are never optimum, especially when compared with an unrealizeable paradise. It is the process of a free market that is the vital consideration, not its precise outcomes.

When competition is forced by government intervention, especially in terms of antitrust, but also often in patents, it is indeed often wasteful.

Regards, Don

The $89M is not used up, but

The $89M is not used up, but merely represents a time- advanced and quantity-increased return to the owners of the resources employed. All money is owned by someone, and that person is responsible for using it to advance his own self interest, whether narrowly or broadly defined.

The $89 million in question is not a quantity of money, but the market value of the resources expended in searching for the mine. The supply of money is unchanged, but the resources purchased with that money and consumed in searching for the mine have largely been wasted.

I suggest that before you

I suggest that before you lump ALL managed mutual funds together, you take a look at The American Funds family. 29 Funds with amazing long term track records, unique and effective management styles, and reasonable fees. They do not play that shell game that you nailed Fidelity with. Check it out! AmericanFunds.com

Brandon, "...The $89 million

Brandon,

"...The $89 million in question is not a quantity of money, but the market value of the resources expended in searching for the mine. The supply of money is unchanged, but the resources purchased with that money and consumed in searching for the mine have largely been wasted....

Nonsense. The money is no more wasted than in any other entrepreneurial enterprise that may produce a loss. Patri is free to invest HIS money in any investment that he chooses. In doing so, he produces a demand for resources and profits for the owners of those resources. If I buy something that Patri mines, all that is known is that I subjectively value that something more than the money price that I pay for it. The degree to which that is true is both unknowable and unlimited. If he opens his mine a year late, I may not still be alive to buy its output and realize its subjective value.

There is nothing that prevents Patri from forming a joint venture that includes all of the potential competitors and in that case a different decision on timing may be reached. If antitrust considerations intervene, then the original non-government premise of the example is violated.

If the output of the mine is merely a primarily exchange-valued good like gold, then the benefit to society results from only the part of the gold that increases the supply and reduces the price of consumption goods made from non-monetary gold. No increase in the quantity of any exchange-valued good results in a benefit to society.

Prices are NOT values. A price is an emergent temporary characteristic of a good that is the RESULT of a market attempting to balance supply and demand. Exchanges result from the INEQUALITY and REVERSE valuations of the parties involved.

Regards, Don

"the EMH is nice in theory

"the EMH is nice in theory but does not apply to short time frames."

No, it doesn't, and any reasonable model that incorporated costs of evaluation (and time needed to process information) wouldn't predict instant efficiency at all times.

"If the EMH is correct or even largely correct then how could one take into account people like John Templeton, Phil Fisher, Jim Rogers, Benjiman Graham, and most blatantly of all, Warren Buffett. All of these are highly successful investors whose results have been consistently of good quality."

None of these investors could have done well so consistently if the full EMH held. But at the same time, none of those investors could have done well so consistently if markets didn't adhere to some form of long term efficiency. If markets never reflect any sort of reality, then it's all luck. Virtually all active, as well as passive, investing indicates a belief in some form of eventual market efficiency. The only real debate is over how much, how quickly.

It takes time, effort and resources for a market to become more efficient. As Patri said, the market would be extremely inefficient if everyone tried to index. We need active managers, but the trick is spotting who's good and who isn't. A further complication is that an investment strategy that works well for a while may not work well later, particularly if more investors begin to use it.

What are TAs and ETFs?

Ann, What are TAs and ETFs?

Ann,

What are TAs and ETFs?

TA = Technical Analysis (Price Chart reading)

ETF = Exchange Traded Fund (a fund bought on the exchange like a stock instead of directly from a fund company)

Regards, Don

If the EMH is correct or

If the EMH is correct or even largely correct then how could one take into account people like John Templeton, Phil Fisher, Jim Rogers, Benjiman Graham, and most blatantly of all, Warren Buffett. All of these are highly successful investors whose results have been consistently of good quality.

This is a common and flawed argument against the EMH. If you have a penny-flipping contest, and you have enough participants, you are going to get some *amazing* track records. Without knowing how many speculators there have been, and what their variance is, we cannot know whether these good results are due to chance or skill. I would love to see an estimate of how good the luckiest investor should be, but I haven't. Without that information, the existence of successful individuals provides no evidence against the EMH.

Now, I am not saying that these individuals have no skill. I very much doubt that. But as with any field where success is a combination of luck and skill, the top are likely to be both skilled and lucky. It is human folly to tend to ignore the luck part.

Further, the existence of skilled individuals only disproves the strongest version of the EMH, which pretty much no one holds. I don't see how it contradicts my weaker view that markets are pretty efficient most of the time, and thus very difficult to beat, and its hard to predict in advance who will beat them.

I think a market where most

I think a market where most people are invested via index funds sounds pretty scary. It means someone buys a few shares of a stock, and then there is massive buying from index funds trying to rebalance their portfolios.

Sigma - that is a strawman.

Sigma - that is a strawman. Index funds have strategies to avoid frequent rebalancing, of course.

It's very easy to prove stupid systems wrong, but I don't see much point.

you obviously don't play

you obviously don't play junior mining stocks.

Corey - then I guess there

Corey - then I guess there aren't any good active managers.

We can hypothesize lots of ways that a "good active manager" could beat the market. But the vast majority of active managers do not, and no one can predict in advance who the tiny minority will be.

If you disagree, I'd be happy to cross-book a fund with you. You pick an active fund, I'll pick an index fund, and every quarter we'll pay each other the difference between their performance.

"this is why I use TA

"this is why I use TA instead of fundamentals. The TA shows the information LONG before anything is revealed by the company..."

Not always true, maybe not even 50% of the time. You've never seen a stock run up on earnings optimism only for the company to disappoint and the stock get hammered??? Some management teams don't leak material, non-public info.

There will always be inefficiencies in the market because of fear, greed, seasonality and neglect among other things. A good active manager will capitalize on these inefficiencies.

Arbitrage seeking would be a

Arbitrage seeking would be a better term for use in this discussion.

I don't think it is, if you want to refer to those efforts that you expend to ensure that you, rather than someone else, secure the gains from arbitrage.

A rent usually means revenue earned in excess of opportunity costs and we should expect rent-seeking to arise when there are rents to be earned and the rights to those rents are insecure. This certainly applies to the case under discussion.

"Arbitrage seeking" would include cases where the revenue from arbitrage is exactly balanced by the opportunity costs, but in those cases, we wouldn't expect any additional effort to prevent someone else claiming the revenue.

I agree that most active

I agree that most active fund managers are not that good and won't consistently beat their index.

The first handicap is expenses. Most active funds have fees around 1% whereas index funds are much lower and stock indexes alone don't have any expenses at all. Secondly, there is the cost of buying and selling securities (bid/ask spread and price impact) that chips away at performance. Thirdly, most managers don't have a process that consistenly exploits inefficiencies (they just aren't that good), especially in the large cap sector.

However, to say that there are no good managers is absurd. Look at Warren Buffett's record - he has dwarfed the index since the inception of Berkshire. Sure, there are years where Berkshire did poorly compared to the S&P 500 Index (especially late 90's during the tech bubble) but does this mean he's a bad manager? Of course not.....

Sure, its extremely difficult to predict which manager will outperform in any given year, but would you really want to bet against Buffett?

The best chance to predict which manager will outperform in a given year, IMO, is to accurately predict which style (growth, value, etc.) will outperform, and choose the manager with that style. How do you predict which style will outperform? Well, its not easy, but there are some pretty good indicators such as the yield curve. When the YC flattens, growth usually outperforms value and vice versa. I'd write more but I'm out of time for now.

Patri, i don't think he read

Patri, i don't think he read the prior articles, or does not believe them.

However, to say that there

However, to say that there are no good managers is absurd. Look at Warren Buffett’s record - he has dwarfed the index since the inception of Berkshire. Sure, there are years where Berkshire did poorly compared to the S&P 500 Index (especially late 90’s during the tech bubble) but does this mean he’s a bad manager? Of course not…..

Nor does it mean he is a good manager. The laws of chance suggest that even if outperforming the indexes is random, given enough funds and managers, some of them will do extremely well. In order to demonstrate that Buffet is good, you would have to model the number of funds and managers and their variance, and show that he has done better than we would expect the luckiest fund to do.

Now, from what I've read I suspect that Buffet does have skill, but without doing the analysis I suggested, I have no evidence - and neither do you. If we hold a coin-flipping contest and get enough entries, someone is going to seriously kick ass. It doesn't mean he is a good coin flipper.

And even if Buffet does have some skill, given that there is both skill and luck involved, success is correlated with both skill *and* luck. And if you can't predict the skilled managers ahead of time, how does the existence of skill matter to the investor?

The best chance to predict which manager will outperform in a given year, IMO, is to accurately predict which style (growth, value, etc.) will outperform, and choose the manager with that style. How do you predict which style will outperform? Well, its not easy, but there are some pretty good indicators such as the yield curve. When the YC flattens, growth usually outperforms value and vice versa. I’d write more but I’m out of time for now.

I don't believe you. If you could predict which sector would outperform, you could build a mutual fund on that basis, and the mutual fund would outperform. Given that there are a lot of very smart people trying to figure this out, and they seem unable to come up with market-beating mutual funds, it appears impossible to predict outperforming sectors - or at least, to do so at a cost less than the benefit provided.

Okay, meant to get back to

Okay, meant to get back to this sooner. Look, an index strategy is fine. I have a lot of personal money in the Vanguard Total Stock Market Index Fund. However, there are times when certain sectors of the market are extremely undervalued or overvalued, and a good manager or investor can take advantage of this. For example, tech (big part of growth indexes) was extremely overvalued in 1999 and 2000, and just about everything else was undervalued. Now, the opposite is true (although not nearly as extreme) and few people realize it. Tech is undervalued and energy and REITS are overvalued. To top it off, tech now has rising price momentum (10 month moving average) and energy has rolled over. Of course, its not certain that tech/growth will outperform value over the next 6 to 12 months, but I'd put the odds at about 80%. Active managers can overweight tech and underweight energy, and index investors can move some of their money to a growth index like IWF, the Russell 1000 Growth Index Fund to pick up some extra return.

Corey - care to bet? Let's

Corey - care to bet? Let's pick a couple indexes. Since you think the odds are 80%, you should be happy to give me 3:2 odds (since that would require only a 60% certainty). We can cross-book them, or just bet about which will have gained the most.