I spoke with friend and Inside Investing contributor Lars Kroijer about a core premise he's developed: most investors should index. It's a good read, and it's worth remembering as you look through this that he still believes it's possible to beat the market...just that it's not likely for the bulk of investors.
As with all the stuff I do for work, I'll add this humble plea: if you like this sort of thing, you should subscribe to Inside Investing.
Conventional wisdom says that if you want to make money in the stock market, you need to exercise fanatical discipline and develop unique competence as an investment analyst.
Lars Kroijer thinks that’s all kind of a waste of time for most people. Can his mom really do that? Since she can’t, does it mean that she can’t ever make money investing?
The big question to him is reasonably straightforward. Do you really think that you are good enough to beat the market? If not, you can invest simply in low-cost alternatives. It’s easier, cheaper, and for many investors, likely to produce better results.
A lightly edited transcript of our interview follows. It’s long, but worth reading. We start by talking about his career (he used to run a hedge fund) and move to talk about how he came to the idea that most investors don’t have an edge.
CFA Institute: We’re in the London office of the CFA Institute with Lars Kroijer here who has just written Investing Demystified: How to Invest without Speculation and sleepless nights. An attractive premise!
Lars Kroijer: Well, thanks for having me!
Very, very pleased to do that. In your first book you outline the steps that you went through in setting up your own hedge fund where step one was hire a team, step two was get service providers…and sometime after step three you wind up rich, popular, and happy. Is that still how it works?
I’m not sure any of those three is still true, but I guess to some degree. The reason I wrote the first book was that I thought the hedge fund industry has been one where lots of things have been written and spoken, a lot of which were bad myths and misunderstandings.
It was generally described in very sensationalist terms where everyone became a multi‑billionaire or was a crook, whereas the industry that I had seen from the inside was really quite different from that.
I thought I was in a unique position to tell the story, from someone who, frankly, went into my first hedge fund interview without really knowing what a hedge fund was to joining the industry, working in it for years, and eventually launching my own fund.
The book was really more about that, trying to explain what the hedge fund industry is like from the perspective of someone who’s, lived a lot of facets of it. It wasn’t trying to be sensationalist. One of the reasons it ended up doing well was because a lot of people could relate to it.
Interestingly, the best feedback I probably got was from people in the industry. Just saying they recognized a lot of the stuff, even the stupid little stories of humiliations and losing money and being overlooked and all the stuff that we all live and that people could recognize. That was actually, perhaps, the most heartwarming part of the feedback.
Your question, does the same thing still hold? Well, it could, I don’t know. I don’t, every hedge fund start up story is perhaps different. But what do you need? I tell people that approach me about selling hedge funds, you need three things.
You need a good product, you need a good investment product and you need to make sure that you’re pretty convinced that that’s the case and you love being the provider of that product, i.e., that this is not a get rich quick scheme, which some people seem to think it is.
You need some money to invest, that seems pretty obvious and often forgotten by people who want to start hedge funds, because they think that comes naturally. But it’s pretty hard to raise money for a hedge fund. Always was, mind you, but that’s certainly true today.
The one reason for that is because the media will tend to talk about the success stories, someone running billions and billions and flying helicopters and living in big houses, whereas the mundane reality is very different for a lot of people in the industry.
Then the third thing you need is you need to be able to sustain the business. What does that mean? That means pay the bills and keep the lights on and get the right kind of computer equipment and the right team around you. Incur the costs of complying with the regulation and keeping your service providers happy.
That’s no small point, actually. Because if you don’t manage a lot of money early on, you’re not going to have a lot of fee income coming in. It’s pretty obvious stuff. But that still holds true today.
I’ve heard people say, there’s nobody who wakes up in the morning and says, “Gee, I really wish I had more hedge funds.”
Well, there was a time when that was the case. I think were a lot of pension funds who woke up and said, “Oh, I must buy some hedge funds.”
It seems to that there are fewer of those eureka moments in the pension fund industry today.
Why has that enthusiasm tapered off? How are hedge funds working, really, for the clients? Is part of that lack of enthusiasm driven by a lack of returns?
Well, first of all, I think, can’t neglect the fact that the industry has grown just a staggering amount over the last decade and a half. There probably was an unmet demand that to some extent has been met.
Then the second thing is that the industry’s now, I think, managing $2 trillion. That’s a lot of money. That almost is the market, right? If you slap a large amount of fees and expenses on that amount of capital, well, it’s got to be pretty hard to outperform as an aggregate.
I’m a huge skeptic of aggregate data in the industry because I think a lot of it has lots of biases and vested interests. I struggle to see that the high fee levels can be justified, particularly because so many funds are so correlated to markets.
You’ve got to keep in mind you can get market exposure for 15 basis points a year. If you’re charging 200 basis point management fees a and 2,000 basis point incentive fee, you’ve got to be providing something other than that. I’m not saying it doesn’t exist because in many cases it does.
On the other hand, if you can provide an investment product that doesn’t correlate to the markets, that’s incredibly valuable. Think of it: if you’re an insurance company you’ve got fixed liabilities, because people’s car crashes don’t depend on the market. If you’re a pension fund and people’s future retirement depends on the market you can be pretty unlucky if you don’t have enough, as you’ve witnessed in a lot of places in the US and elsewhere.
The premise of the product is brilliant. Uncorrelated returns are the Holy Grail of investing. If you can create that you ought to be a rock star, and a very well paid one. I just think the reality is perhaps sometimes a little bit more mundane.
For all the sex appeal, it’s just a bunch of guys in offices.
Don’t get me wrong, a lot of very, very smart guys, very well informed guys that sometimes provide a brilliant product for a very high price. That doesn’t mean they all do, but some people undoubtedly do.
To your point on aggregate data, one of our authors on Inside Investing, Ted Seides, has made that point pretty well. (Check out “Rethinking Hedge Fund Indices“)
There’s a lot of garbage. There is in a lot of places, though. Also keep in mind that it’s hard to buy the industry. There are hedge fund index trackers. I don’t know how well they all work.
But a big part of even what Ted does is to pick hedge fund managers. It’s a little bit like stock pickers except you’re a hedge fund picker. If you’re good at that, that’s a very valuable thing to be good at. It includes the analysis of data, but also a lot of softer things like management, and credibility, and the strategy that they undertake, and the future of that strategy, et cetera, et cetera.
Again, I wrote the first book for an even simpler reason than taking a view on the industry and whether it’s good or bad. I thought there was a story to tell.
Absolutely. It a great story. Some of the reaction to it that I saw was focused on the difference between what the audience expected and what they found. Can you talk about that a little bit?
First of all, it’s a little bit like if you had to write a story about football and the only thing you wrote about were the top teams, and assumed that anyone who played football, anyone in the world, would like to know who played for Arsenal or Chelsea. We ended up doing very well, but that’s not actually what’s interesting about the story.
It’s funny, whenever I give talks what I can see resonates most with people are our early failings.
The misery of trying to start a hedge fund with very little money is much more interesting to people than whether you made a billion, or a million, or a $100,000 because that’s the story they’ve read in “Forbes Magazine” ten times. Also, what does it actually take? Who do you go to? Who do you call?
I think something a lot people resonate with is, this presumption that if I were to start a hedge fund…the generic “I.” If one were to start a hedge fund I could call my 10 best friends and they’d turn up with some money.
I was certainly guilty of that myself. Very quickly i saw the error of my ways…Very little money actually turns up when the rubber hits the road.
If you shift to the average investor, hedge funds, obviously ‑‑ very complicated industry, lots of things going on there. But is this the thing that the average investor can even try to grok?
First of all, the average investor probably has hedge fund exposure, through their pension fund or even indirectly through their insurance company or their bank. So you have an exposure, but it’s very hard for you to understand what that exposure exactly is. And that’s probably an issue.
But taking a step back, frankly, for the retail investor, a lot of times they simply wouldn’t be allowed to invest in a hedge fund, just size constraints, qualified investor constraints, i.e. so many specific rules here in the UK regarding being approached, even, by hedge funds for the purpose of investing.
If you’re not an expert in hedge funds, I would strongly encourage you to look elsewhere to put your money, only because here’s a product and you know it might be interesting, but one thing you know for sure is that it’s expensive. And so you’re looking at a very expensive product where you’re not an expert. But you think, “Well, maybe I should let other people try to pick the best ones.”
I’m going to ask a stupid question. Are fees actually important?
No, I don’t think it’s a stupid question at all, actually. It’s a very good one because frankly, if you look at…I’m struggling to think of any other industry where high fees are not somehow correlated with better service or a better product, most places that’s the case.
Otherwise the higher‑fee end of the spectrum would self‑destruct. Frankly, other than perhaps government spending, where else can you be horribly inefficient with other people’s money and it not coming back to bite you?
Economic theory would suggest that if there is an expensive product that seems to thrive, so it must be valuable. Which, not to lead you into the second book, but that’s why I wrote the second book, because it actually starts with a very, very different premise, which is one of saying, “Well, who are you to ask?” Which is really saying, “Are you able to distinguish?”
So you know on the one hand, you’re paying a lot for something. On the other hand, there are very, very cheap alternatives, and you can’t convince me the very expensive ones in the aggregate make sense, if you’re blindly throwing darts. So you shouldn’t try at all.
You should index. This is the premise of the second book, is this whole idea of, do you have an ability or edge to beat the market? And I argue and I certainly think that the vast majority of people don’t. Well, in the aggregate, you can’t because in the aggregate, that is the market.
You are the market. But why don’t most people have that capacity?
First of all, if you think of someone who buys or sells stocks in the market, what is the market? It’s an aggregation of a ton of sometimes extraordinarily well‑informed investors with access to better information than you, better analysis, better access to management, to industry experts, to execution, to understanding data flow, statistical analysis, etc., etc. It’s just extremely hard for my mom to compete.
So the price…at the end of that whole sausage factory called the market of analysis and insight is a price that reflects the aggregate opinion of the market participants. No disrespect to my mom, but for my mom to essentially go in and say, “I know better,” that’s a pretty tall order. There’s every likelihood that she cannot.
Then add to that that she’s probably at a huge cost disadvantage. She is charged more to trade. She will probably trade frequently, which is a terrible idea. If she buys, she will buy on the offer and sell on the bid, even something as small as that, which for the the less liquid stocks actually matters.
There’s also every academic study backing the fact that even trying makes no sense for her, unless she is a rare, rare case of someone who is able to consistently beat the market.
When I say beat the market, there’s another thing there. I could go out and buy…pick a random stock. Say, Vodafone or since there are mainly American listeners, Microsoft. Let’s say I go and buy Microsoft and it skyrockets tomorrow. That doesn’t mean I had edge. It might mean I was lucky.
So eliminate that. Incidentally, Microsoft could decline massively in value tomorrow. That also doesn’t mean I didn’t have edge. You can’t turn around and say that either.
It’s not easy to prove or disprove edge. I hate to say it, this sounds awful, but you have to look inside yourself and say, “Well, what are the chances that I have it?” And when you’re at an analytical disadvantage, information disadvantage, and a huge cost disadvantage, the chances are very, very small.
So what I’m trying to do in this book is to say, “Well, on the basis of the premise that you probably don’t have edge, what should you do?”
This book, the subtitle, again, is “How to Invest Without Speculation.” We did another “Inside Investing” thing where we asked a bunch of guests, what are the differences between those two things? I wonder, your thoughts on that. (Editor’s note, Read responses from Howard Marks, Martin Fridson, Robert Hagstrom, Brad McMillan, and Malcolm Trevillian)
“Invest without speculation.” First of all, the subtitle partly came about because of the publisher….So you’re putting me a little bit on the spot here, and the sleepless nights bit also, but the whole point is, what do you do with your money in the long term when you don’t claim to be someone who can beat the market and speculate and outperform and gamble? I’m not saying those all associate, but what if you just want your money to grow slowly, boringly, in a way that makes sense for your risk level over the long term?
That’s what I associate with sensible, what I call rational investing. Because it’s rational if you accept that you can’t beat the market, and there’s very little speculative about that. In fact, you’re trying to take speculation out of it. You’re trying to say, “I know I don’t know a lot.”
Now, keep in mind, what I’m saying, lack of edge doesn’t mean you’re stupid. In fact most professors would be adhering to this strategy. So there’s this kind of investing. Some of the smartest minds will do this. They will simply say, “I don’t think I can beat the market. Or I don’t have the time, I have a day job,” or, “I hate being wrong.”
Or even, “I want to go walk on the beach sometimes. I just don’t want to do it anymore.”
Yeah, look at myself. I stopped running money in hedge‑fund world. I invest only in index funds. I don’t think you can…When I was doing it, I found a really great edge. But I also believe that it is bloody hard.
I don’t think you can do it half. The whole that you can come home from work at 5:00, look at some talk show about stocks, then pick which one ‑‑ where they’re right and where they’re wrong, and then go buy some stocks the next morning before you go to work. I just think it’s wrong. I just think there’s every chance you’re going to do a little bit worse.
So don’t. It’s hard‑earned money. It’s pretty boring, all right? Over time there’s every reason to think that you will do better and by cumulative, quite staggering amount. I think you should index, on the basic premise that you don’t have edge.
The trick then is index funds.
Yeah. If we can for a second, because it’s easier to understand, just think about stock markets. Obviously, you should not only think about stock markets. Say the S&P is an index to think about. So why do I think, if the world was only S&P that you should play the index?
It’s because you don’t think you can beat the markets, you don’t think you can reallocate capital within that index in such a way that you generate a superior return profile. The byproduct of that is that the investment product you’re trying to get is extremely simple.
A monkey couldn’t put it together, but a computer can very, very cheaply which is why they cost ten bps a year, or 0.1 percent, and trade very little, so there are those added advantages.
You are essentially buying securities in the proportion that the market has determined for you, so you are coming along in the market, if you will.
Why does that make sense? Well, because you don’t think you can do better. Why does that make sense? Well, because you don’t have edge.
That’s what you should do in the S&P 500. Now suppose you added an alternative, which is the Euro Stoxx 50 ‑‑ that’s the main European stock index ‑‑ and you had those two, S&P and Euro Stoxx 50. How should you allocate between those two?
Again, the market is allocating in terms of capital weighting, so you allocate them in proportion to their values. Why is that? That’s because you don’t know better than the market and that’s what the market has done. Now if there was added advantage from selling S&P 500 down 10 percent and buying the Euro Stoxx 10 percent, then the market would presumably do that.
Extend that logic to all equity markets and all currencies around the world. I argue that you can create an extraordinarily diversified product by simply buying the world equity index. You can do that through one index tracker, so you’re talking one security for all your equity holdings, and you get an extremely cheap, because it is that simple.
It’s a very simple index to buy, because you’re buying one stock and that represents sometimes thousands of underlying securities, across a range of capitalized sizes, and geographies and industries. You’re widely diversifying and you are getting the world equity exposure. Do that and it is very simple.
It happens to be theoretically ‑‑ like academic theory ‑‑ not far from what they were all ranting on about 30 years ago, before anyone could actually, properly do it.
Back then it was very easy. You had these great academic theorists and brilliant minds talk about the risk‑free rate, which sounds like an oxymoron.
Then you can buy and you’ve seen the capital market line and the correlations, and all that stuff, you smile faintly at them. Back then it really meant the US, because that was the only real market. Then eventually…Even when I went to college ‑‑ I’m 41 years old, I’m not that old ‑‑ we’re really talking the maybe Europe and Japan. That was pretty much it.
Now it’s 50 countries, right? Why is India any worse than the US? There’s no reason you would expect them to do any better or any worse, relative to its risk levels. But you can add that incredible diversification. That product was just very, very hard to buy 20 years ago.
Now you can. Those products exist. In 10 years there are going to be even more of them. It’s going to be even cheaper, I expect.
Isn’t it the kind of thing that as you get, let’s say my investment portfolio has $1, $10, $100 million…
Good for you. [laughs]
This is strictly a hypothetical. This is a non‑profit organization, but presumably at each of those different levels ‑‑ $1, $10, $100 million ‑‑ one percentage point of added performance is increasingly valuable in cash terms. You beat the market by one percent on a $1,000, it might not be that relevant, but on $100 million, it could probably buy something pretty nice. Is it the case that as your level of wealth rises, you should do something else? Or is that something that something that really works for everyone?
No, I think that’s an interesting observation. It think actually that pertains much more to your risk profile. Think of it this way. Let’s say you have $100 in your account and you needed $95 next year for heart surgery. You shouldn’t buy equities. That seems pretty obvious to everyone.
Now let’s say you have $100 in your account and you know you have some yet‑to‑be‑determined need in retirement 40 years from now. You should probably buy some equities, because there’s every reason to think that over the long term they out‑perform inflation. There will be huge dips, but you can afford to incur those dips.
The question of, “What will an extra one percent do for you?” is really, other than the simple math of it, it’s a very individual question of risk, and one I touch on a lot. How should you think about this? How should you think about draw downs and the inevitable “Oh, my God, I didn’t think it could be this bad”?
What a one percent draw‑down means for you is quite individual. When I say individual, I doesn’t mean to the individual person, but the individual as an institution. One way to think about risk is by‑an‑large, correctly, a lot of people have discredited standard risk matrices, like standard deviations.
Let’s take as an example and say you have $100, and you want $150 in 30 years, but you absolutely need $120. You can say, “If I put it all in equities…”
Let’s say you have an expected risk premium of four, five percent above inflation, which is what it’s been historically. You can say, “…in 30 years that’s going to accumulate to X.”
What is the risk you’re willing to accept that you don’t get to $120? Does that mean that you die ‑‑ you and everyone you’ve ever loved? Does that mean that you can’t be a member of a golf club, which you could live with?
What does that mean as an individual thing? That should partly drive your allocations and acceptance of risk. I try to touch on that in the book. If you come up with a hypothetical example of someone who puts aside some money every year between ages ‑‑ I’m not going to guess your age ‑‑ call it 30 to 70, or 65, and say therefore you should have X.
If you believe these numbers, the standard risk, standard return expectations as an expected outcome. Now let’s say you have a minimum you absolutely need. What is the probability you’re willing to accept that you don’t get it? Is it five? Is it 10, is it 20 percent?
What you can do is let’s say you have a choice between the world equity markets and something very, very safe. Assume for a second it’s government bonds. Let’s say that you then allocate more toward government bonds. Well, we’d all appreciate that your expected outcome many years hence will be lower, but the certainty of that outcome will be higher. There’s less risk.
You can therefore go along that continuum and say, if you say, “I accept no risk,” buy a 30‑year government bond. You know you’re going to have X, but you’re also going to have very little potential upside. That’s one way you can start thinking about risk. But it’s an interesting topic.
I also talk a lot about insurance as something that people should avoid if they can afford not to, and money in the bank, which I argue is not without its risks. Pensions, which I argue the vast majority of people get royally taken to the cleaners by various managers, certainly in aggregate, over many, many years.
It’s written to my mom, although she’s perhaps a little old to do the 40‑year time horizon, unfortunately.
Perhaps it is a little late for her.
She’ll probably actually live another 40 years.
The book is “Investing Demystified,” which you can buy on Amazon.
It’s just out, in fact, earlier this week.
Just out this week. It has got some very inspiring upward‑facing arrows on the front of it.
Yeah, there you go, and I didn’t have anything to do with those….
I encourage everyone to pick it up. Thank you so much Lars!