Why algorithmic trading will eventually replace fund managers

The traditional fund manager who uses his or her “expertise” to select stocks for their clients will gradually become an endangered species (and they know it). This is why you have been hearing a lot of negativity from these people about high frequency/algorithmic trading in recent times. These people know that their own returns are materially inferior to that of many high frequency/algorithmic traders.

As I’ve said previously here, most fund managers (and very especially Australian fund managers) have no discernable stock picking skills. Sure, you will have those who can point to index beating records over relatively short periods of time, but show me any fund manager in Australia who has returned a compound 15-20%+ over 20 or more years – they simply don’t exist. Most of them can’t even match a low cost index fund over time.

Many of these people have reached a station in life which is out of all proportion to their actual abilities. They have been able to so this by taking passive fees on assets under management which amount to billions of dollars across the industry.

How do they attract funds? Here’s how:

1. Firstly make sure you have a few years of good performance under your belt. This will have been obtained by simply getting lucky, playing popular (but temporary) trends, or with the assistance of a raging bull market (or all three);
2. If you can, appear in the media as an “expert” – the media classes anyone who is employed in the investment industry and who is breathing as an “expert”;
3. It always helps to have some charisma and to come across confidently;
4. Market your returns to investors who are too naïve to see through you and too lazy to care about the management of their own money;

 There you have it. Now you can sit back and charge 1-2% on assets for lousy performance. This can amount to millions of dollars and if you fail later on, don’t worry, you will get to keep all of your ill-gotten gains which were made when times were good.

Remember the full service stock brokers and also the old market makers? These guys use to rip us off – they literally stole our money for doing very little. Most of those guys are now out of business due to the internet and alternative market places and every day I’m thankful for that.

(Incidentally, I know many high frequency traders are involved in market making too, but their spreads are much lower than the old time market makers. The modern high frequency market makers simply cannot capture similar spreads to what the old market makers use to.)

The fund manager belongs in the same category as the old time stock brokers and market makers. Nearly all of them over-charge their clients. If you do not take responsibility for your own investments (including superannuation), you can be sure that someone is enjoying a very pleasant life style at your expense.

But why is algorithmic trading superior?

1. Algorithmic strategies can be accurately tested on vast amounts of data (often in seconds or minutes);
2. Algorithmic strategies can be executed by computers, removing human emotion from trading decisions;
3. Algorithmic strategies are consistent in what they do (unlike many humans);
4. Algorithms can detect patterns that are imperceptible to humans;
5. Algorithms can scan vast amounts of data, much more than a human ever could;
6. Algorithms can adapt to different environments, something many humans cannot do;
7. Properly conceived and successfully tested algorithms have predictive ability, something the vast majority of humans do not;
8. Advances in computing power are making algorithmic strategies cheaper and cheaper to implement as time goes by;
9. Because most algorithmic strategies are short-term, they are not as exposed to general market risk as buy and hold strategies, (e.g. regulatory risk is an all too common factor in Australia these days);
10. For all of the above reasons, algorithms have now advanced to the stage where they can trade stocks better than many humans.

This is why, over time, the traditional fund manager will go the way of the Dodo. As will the analysts at the investment banks and the economists (if you want to be rich, don’t listen to these people – they have mortgages). Algorithms can do all of their jobs much better than they can and in years to come they will.

The lazy, over-compensated fund managers will make a lot of noise and attempt to frighten people to maintain the status quo, but it will ultimately be futile.

Mohnish Pabrai’s comparative returns are misleading

The other day I was reading through the Pabrai Investment Funds Annual report for last year when it suddenly occurred to me that the comparative returns that Pabrai publishes there (i.e. his funds’ returns versus the various indexes) is misleading. Why you ask? Well, it all has to do with taxation.

Let’s have a look at the Pabrai investment funds:

Pabrai Investment Fund 2 (an Illinois Limited Partnership) – Commenced operation on 1^st October 2000 when units were issued at $10 each. As at 30 June 2012, the net asset value (NAV) of a unit was $43.36, an average annual compound return per annum of 13.3%.

Pabrai Investment Fund 3 Ltd (a British Virgin Islands corporation) – Commenced operation on 2^nd February 2002 when shares were issued at $10 each. As at 31^st December 2012, the NAV of these shares was $33.21, an average annual compound return per annum of 9.7%.

Pabrai Investment Fund 4 (a Delaware Limited Partnership) – Commenced operation on 1^st October 2003 when units were issues at $10 each (Pabrai must have a fondness for the figure of $10). As at 31^st December 2012, the NAV of these shares was $18.85, an average annual compound return per annum of 7.1%.

Now, the British Virgin Islands Corporation (Pabrai Investment Fund 3 Ltd) pays no income tax or capital gains tax in the British Virgin Islands and also pays no income tax in the United States. This is the reason that Pabrai domiciled this company in that jurisdiction. It’s also a fund for non-US investors. There is nothing wrong with this, it’s good tax planning. 

But when Pabrai compares the returns of Pabrai Investment Fund 3 to the returns of the Dow Jones Industrial Average (DJIA), the NASDAQ or the S&P500, he is comparing the returns of a fund which pays no tax with an index whose constituents must pay tax. 

For a moment, imagine that the US Federal and State Governments legislated to exempt all constituents of the DJIA from paying tax. What affect would that have? It would immediately increase the value of all the constituents of that index. Rationally, the percentage increase would be by approximately the tax rate divided by one less the tax rate multiplied by 100 or (TR% / (1-TR%) )*100. Of course, it’s not quite that simple, but you get the gist of it.

When Warren Buffett (or any other person running a US domiciled tax-paying investment corporation) compares their corporation’s returns to an index, it’s a fair comparison because like is being compared with like.

When an individual running a non-tax paying corporation compares their returns to an index which consists of tax-paying corporations, the comparison is not fair. A fair comparison would be to take the returns generated by the non-tax paying entity and then apply a notional tax rate based on the average tax rate paid by the constituents of the index being compared to and then compare the returns.

For example, if we applied a notional 25% “tax” to Pabrai Investment Fund 3, that 9.7% average return (mentioned above) might become about 7.3% - hardly returns to write home about. Incidentally, Pabrai Investment Fund 3 is the only vehicle currently open to new investors.

But what about Pabrai’s limited partnerships? They too pay no tax. All tax is paid by the individual unit holders.

So I would put it to you that any performance comparisons between any of the Pabrai funds and the various US indexes are misleading because any reported out-performance will always be skewed unfairly in Pabrai’s favour.

Pabrai has talked at some length in the annual letter about how he has compounded his own net worth at close to 26% per annum (since about 1995). That’s great for Pabrai, but the funds mentioned above haven’t achieved anywhere near this figure and as I’ve explained here, even those returns are misleading when compared to any index. So why mention your own much better individual performance?

My own net worth has increased at an average annual rate of 16.1% (post tax) from 1995 to 2012. On a pre-tax basis (if I had never had to pay income or capital gains taxes) it would have been roughly 23% per annum. That statistic alone demonstrates the difference between pre-tax and post-tax returns. 

So, finally, to have some fun, if I had issued shares at $10 each (Pabrai’s favourite number) on 31 December 1995 in “The Stock Scribe” (me), as at 31 December 2012, those $10 shares were worth $127.

Nathan Tinkler’s troubles are mounting

On 21 May, Blackwood Corporation (BWD.AX) announced that liquidators acting on behalf of the creditors of Mulsanne Resources had made an application in the Supreme Court of New South Wales to freeze the assets of Nathan Tinkler.

Nathan Tinkler’s story is an incredible one. I don’t really know of anyone who had made so much money as quickly as Tinkler did from scratch. But as they say: “Easy come, easy go.”

Tinkler was originally a coal mine electrician working in the Hunter Valley of New South Wales. He formed a company called Custom Mining which eventually purchased the Middlemount coal deposit in Queensland. Custom Mining paid $A30m for that deposit (although I believe Tinkler only used about $A1m of his own money and did a deal with a well known law firm to do all the legal work for an equity interest, most people would have been shown the door).

Now here is the unbelievable part, within one year of purchasing Middlemount, Macarthur Coal bought it for $A275m from Custom Mining delivering Tinkler an enormous profit.

Now, I’m a conservative character and if it was me, I would have realized how lucky I was and not put any of this new found wealth in jeopardy. But Tinkler didn’t make all that money by being conservative or risk averse and he was after even more. Deal-making on a grand scale has seen the demise of many an entrepreneur in this country.

Tinkler got more, a lot more. Tinkler made hundreds of millions more from seemingly miraculous  deals in the coal sector with the end result being that he was apparently worth $A1 billion by the time he was 35 years old (in 2011). But it wasn’t to last.

Tinkler indulged himself with his new found wealth, he bought race horses, interests in a rugby league team and a soccer team as well as plenty of flashy cars. The well trodden path of many a nouveau riche.

It all came unstuck when Tinkler made a deal with Blackwood Corporation (a coal mining minnow), to purchase approximately $A28m in equity at around 30 cents per share (via Mulsanne Resources). A very ill-timed agreement as Blackwood shares were set to start a steep descent shortly after the agreement was entered into, proving that not everything Tinkler touched turned to gold.

Now, $A28m for someone supposedly worth around $A1 billion shouldn’t have caused any concerns whatsoever. But after Mulsanne Resources missed a few payment deadlines, it started to become apparent that Mulsanne wasn’t going to pay up and the liquidators of Mulsanne allege that it was insolvent when it entered into the agreement.

Now, I’m not about to speculate on the reasons that this whole deal went sour, that will be discussed in court. But suffice to say, this episode has done enormous damage to Tinkler’s reputation – you simply shouldn’t enter into agreements that you can’t consummate.