Wall Street\'s Shell Game
Keeping 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.
Suppose 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.)