MICHAEL EDESESS | Mathematician

Three basic rules for investing - simplify your options, don't look at past performance and screen out noise.

Administrators of large public pension funds in the United States still award the management of their funds to high-fee active investment managers, including heavy allocations to hedge funds, private equity funds and other alternatives to standard stock and bond funds. On average, each public fund hires 182 investment managers. In aggregate, these managers underperformed an equivalent mix of total market stock and bond index funds over the last 12 years by more than one and a half percentage points a year. For this failure, they have charged fees that have cost the average U.S. taxpayer $500 each year – a total of $68 billion annually. Had they invested in index funds instead, the fees would have been less than a hundredth as much. 

How Index Funds stole trillions from Wall Street by Michael Edesess.

You can read more from Michael Edesess at Advisor Perspectives.

MICHAEL EDESESS is an accomplished mathematician and economist with a PhD in pure mathematics in the field of stochastic processes and expertise in the finance, energy, and sustainable development fields. He is an adjunct associate professor in the Division of Environment and Sustainability at The Hong Kong University of Science and Technology, managing partner / special advisor at M1K LLC, and a research associate of the EDHEC-Risk Institute. He is author or coauthor of two books and numerous articles published in Advisor Perspectives, MarketWatch, The Wall Street Journal, Financial Times, South China Morning Post, Bloomberg, Nikkei Asian Review, Technology Review, and other publications, and was previously a co-founder and chief economist of a financial company that was sold to BNY-Mellon. He has chaired the boards of three major nonprofit organizations in the fields of energy, environment and international development.

M1K LLC Financial Modeling and Transaction Advisory Services | Specializing in the Renewable Energy Sector. Combined 60+ years experience in Wind (on and offshore), Solar (utility scale and distributed; combined with or without battery energy storage), Biomass, Energy Efficiencies, Stand alone Battery Energy Storage, Transmission Lines (above and under ground), Carbon Capture / Sequestration and infrastructure financial modeling and transaction services in the US, Canada, Europe, Middle East and Asia.

TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE

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EPISODE TRANSCRIPT

Phil (35s):

Hi and welcome back to Stocks for Beginners. I'm Phil Muscatello. Sauntering through the expensive glossy outputs of the professional investment field, you may glimpse arcane, sophisticated sounding articles, suggesting that discourses of an elite core of exquisitely knowledgeable experts. Yet professional investors don't do any better than the random investment picks of a gaggle of monkeys. That's a quote from my guest today, Michael Edesess. Hello, Michael.

Michael (1m 4s):

Hello. Good morning, Phil.

Phil (1m 6s):

Michael Edesess is an accomplished mathematician and economist, an adjunct associate professor in the division of environment and sustainability at the Hong Kong University of Science and Technology, managing partner special advisor at M1K LLC and an author and writer of numerous articles across a range of financial publications. And that's only a brief summation of his bio, which I will include in full in the episode blog post. Let's start by talking about that quote of yours, did that gaggle of monkeys run a managed fund and how can we invest in it?

Michael (1m 40s):

The gaggle of monkeys certainly do run lots of funds, I mean like tens of thousands of funds. In spite of all this sophistication, they do actually worse than a gaggle with monkeys would. This will be quite startling, among those tens of thousands of funds are university endowment funds such as Harvard, Yale, Princeton, Dartmouth, Cornell, MIT. And those endowment funds comprised billions of dollars. And they are run by dozens, in some cases, hundreds of professional investment managers who presumably have access to Nobel prize winners on campus.

Michael (2m 35s):

And they hire many professional investment managers. In fact, the average fund hires 180 outside investment managers. So, you would assume that they have the highest level of sophisticated financial knowledge: including the mathematics of investment and so forth and so on. And yet if you would've invested in a total market index fund, which you can get from Vanguard BlackRock for a fee of about a 20th of a percent a year, you would have done much better than all of those funds, all of them over the past 12 years.

Michael (3m 26s):

So that gives you an idea how well they do, or how poorly.

Phil (3m 31s):

Why do you think that is, Michael?

Michael (3m 35s):

Because they spend too much on fees, number one. On average, about a one and a half percent a year on fees for all of those outside managers they hire and that doesn't even include their own in-house investment managers' salaries. And the market is reasonably efficient. That is to say the prices of stocks move unpredictably and extra knowledge, particularly what is supposed to be sophisticated, quantitative knowledge helps not one bit.

Phil (4m 19s):

You just let the market do its thing. And it basically works in your favor.

Michael (4m 23s):

Yeah. I mean the idea of the stock market that was that you buy a stock when the company issues the stock. Used to be, you had a stock certificate, you put it in the drawer and then when you need the money, 30, 40, 50 years later, you take it out of the drawer and you sell it. And there's no reason why you would do any better buying and selling it in the interim. In fact, if you do it a lot, it will just cost you some fees, which will worsen your result.

Phil (5m 2s):

Michael you've, co-authored the book, "The 3 Simple Rules of Investing: Why Everything You've Heard about Investing Is Wrong — and What to Do Instead". What are those three simple rules? And I'm assuming that passive investing and putting the stock certificates in the drawer are part of it,

Michael (5m 19s):

Yeah, they're just very general rules. The first one is simplify your options because there are so many apparently different investment options. You should simplify them to really only three. Second one is look only forward. That is don't look at the past performance of an investment to help you decide whether to invest in it because prices change unpredictably in the past is no guide whatsoever. And the third rule is screen out noise, which is to say there's an awful lot of noise coming from people talking about finance and investments.

Michael (6m 12s):

And if you follow the first two options, then you don't need to listen to any of that.

Phil (6m 24s):

I think a lot of listeners come to my podcast because they've picked up on discussions on social media, on Twitter, the financial media, from advertising and the slick and glossy promotions of some of these financial companies. And they're very confused with it but you actually believe it's as simple as that, you can just tune out the noise and work out what you can safely ignore and invest wisely.

Michael (6m 51s):

It is as simple as that. There were three, let's say for virtually everybody, for almost everybody, now the trouble is if I say for almost everybody, people will think what I mean is for all but the most sophisticated investors. But I've already showed you that the most sophisticated investors don't do well. What I mean by saying for almost everybody is that say if you're Bill Gates, okay, and I would love to be Bill Gates, not for the money, not for the, you know, the problem of being recognized in public, I don't think it's worth it, but I would love to be him because of what he can invest in.

Michael (7m 33s):

You know, unfortunately that runs into problems too. So, for example, to try to solve the climate change problem, he has invested in a new nuclear technologies. Now that takes a very large lump sum of money to be able to do this. But he's not investing in, this is not in the stock market. This is investing in startup companies that need the money. And that's what a company does. First, it can get money from somebody like Bill Gates, somebody, you know, so-called angel investor, it can get money from venture capital, but then eventually it goes public.

Michael (8m 14s):

And almost all of the investing that social media is about, is about those stocks that are available in the marketplace after a company has gone public. Well, after that has happened, the company already has its money. What should be happening is that those people who bought the initial stock offering or bought it right after it came on the market, should be having their shares in the drawer, so to speak, and taking them out 30, 40, 50 years later when they need the money. But instead, they're trading them like crazy. But that doesn't do a thing for the company. It doesn't do a thing for the technology.

Michael (8m 54s):

It doesn't help in any way at all. And it doesn't help the environment. It doesn't help the, you know, social structure to trade stocks in the secondary market. So, what virtually everybody should do is just buy a well-diversified basket of stocks and keep them. Don't trade. Don't think about it. Don't watch the performance. Just sell it later when you need the money. Now, fortunately, you can buy a basket, very well diversified basket of stocks or bonds by buying an index fund.

Michael (9m 40s):

They're mutual funds and so-called ETFs, or exchange traded funds, which are essentially the same though. Also, mutual funds you can buy, there are three that, say, in the United States, which I know better of course, you can buy a so-called Total Market Index Fund, which is actually just all the US companies. You can buy a Total International Index Fund, which is all the non us companies, and you can buy a total market bond fund. So that's all you need to invest those three funds. And in fact, you can even buy a combination of the US and international, I think it's called the Total World Fund.

Michael (10m 24s):

So, you only need two or three investment vehicles. And this is thanks in effect to the advance of technology, although it's extremely simple technology, but it's something that became available only about 45 years ago to the general public.

Phil (10m 40s):

And also, it's something that's only become aware and top of mind for people maybe only over the last 10 or 15 years or so.

Michael (10m 49s):

Yeah, there's been a lot more awareness of late. The evidence that this is the only sane way to invest piled up for decades. But I think it only finally started to penetrate in the last 10, 15 years and now there's been a rush to buy those funds. But of course, the investment business, which is it wants to make as much money as it has become accustomed to, needs to find another way. And the public very conveniently provided them with another way, which they just leaped on, which is called ESG.

Michael (11m 32s):

And this makes you think that you're contributing to the environment by investing in funds that are about five times as expensive as index funds. And actually, it does no good for the environment at all. There are other ways you can do that. I mean, if it weren't for that five times higher fee those funds would probably do about the same on average as an index fund, except you have to pay five times as much to invest in them.

Phil (12m 4s):

ESG, that concept has become one of those buzzwords that's become a marketing tool for ETFs. That's what my belief is as well.

Michael (12m 13s):

Right. And sustainability. I mean, I have an interesting story about sustainability, but I won't go into that. I mean, I know the whole history and I know who came up with the word and I'm sure he never would have expected it to suddenly become such a widespread buzzword.

Phil (12m 32s):

Oh, you can speak to that point?

Michael (12m 36s):

Okay. The problem is how to do it briefly because there's a whole backstory.

Phil (12m 41s):

Yep

Michael (12m 42s):

Long ago in the sense of like 50, 60 years ago, the environmental movement really just liked wilderness. And that's the way I felt since I was like 10 years old. And I felt that people were the problem and the population was growing rapidly. So, there was a lot of concern about population growth starting in about 1968 or earlier.

Phil (13m 9s):

That was the Club of Rome period, wasn't it?

Michael (13m 13s):

Well, the Club of Rome thing was the SOC called Limits to Growth, that was 1973. Paul Ehrlich's book, he's still around, "The Population Bomb" was 1968. That got a great deal of tension because he predicted famines that in which hundreds of millions of people would die in the seventies.

Phil (13m 33s):

He was spectacularly wrong as well.

Michael (13m 34s):

He was spectacularly wrong, but for a specific reason, I mean, you know, some people would say, "But, you know, people like that will always be wrong for this reason." He was wrong for the reason that Norman Borlaug and others developed crops that yielded three or more times as much from the same area of land.

Phil (13m 54s):

That's right. It was the green revolution, wasn't it?

Michael (14m 1s):

Right. And that basically solved the food problem. And also, people started this, something called, the demographic transition when children started not dying so much. I mean, it's improvement in health. People started having less children. So, the, the population started to level off and didn't explode like a bomb as Ehrlich foresaw. However, at that time, when there was all this concern about population, there were solutions proposed and actually put into practice. Like at that time, the iPhone of the day was the transistor radio.

Michael (14m 44s):

And so, the idea was you'd give Indian men a transistor radio in exchange for becoming sterilized. So, if they became sterilized, so they couldn't have children, they would be rewarded with a transistor radio. And after a while, people started to think this is not very humane. And so, there was a problem about, you know, how can we put together preserving the environment and allowing people the world over to pursue economic development, which they all want. And so, this commission was formed called the Brundtland Commission and it produced a report in 1987 called "Our Common Future".

Michael (15m 39s):

And it coined the term sustainable development, which meant economic developments that uses resources sustainably, that is to say, without reducing the ability of future generations to use resources. And I happened to be at a conference one time and I was sitting with two or three people and what one of them said, "You know, I came up with that term 'sustainable development'. That was an understaff to the commission and people would think, 'Okay, what can we call this? We need, we need a good, a good phrase.'" He proposed that term. His name was and still is Lloyd Timberlake.

Phil (16m 13s):

That's amazing to hear the backstory about that and where the term came from and the history that's now being shoehorned into the ESG basket.

Michael (16m 23s):

Oh yeah. Yeah. It's become, I mean, everything becomes a buzz word. I also taught a course on cryptocurrency and I think it was the first course on cryptocurrency almost five years ago now in Hong Kong. And I mean, it was starting to happen then, but things just get buzzword-ified and blockchain became buzzword-ified. So now if you've got a database, you want to call it a blockchain because then people get excited. Database doesn't excite anybody.

Phil (16m 56s):

Hasn't excited, anyone for about 20 or 30 years, since it first appeared in windows 95 or 3.1. So, with sustainability, I recall a recent article that you wrote that mentioned nuclear energy as being part of the energy transition. Do you think this is possible considering the resistance to it and the cost of nuclear power?

Michael (17m 19s):

Well, it certainly is possible in China and Russia and many countries that they are engaged in commerce with. So, Russia is providing nuclear power plants to other countries so it's certainly possible. In the United States it's a tough go because as this book that I read recently shows, the regulation, which is the reason why it has increased so much in cost, is going to be very hard to get rid of. And the deeply entrenched belief that it's dangerous is going to be hard to get off.

Michael (17m 59s):

In fact, it is less dangerous than other forms of energy, probably even than solar and wind. And that's going to be very difficult to overcome that because the fear of nuclear energy was set in place by the same forces that believed in nuclear energy, but they also wanted to ban the bomb. And so, they wanted to make sure people were scared about nuclear weapons testing. And so, if they were scared about fallout from nuclear weapons testing, that served their purposes and that meant that even very widespread radiation at the same levels, that you get radiated just being, you know, next to a stone wall or something like that, had to become fearful.

Michael (18m 54s):

And that's going to be very hard to get out of the US population. I don't think the Chinese have the same feeling

Phil (19m 4s):

And any form of energy production is going to have tradeoffs, really. There's no perfect energy for,

Michael (19m 15s):

Right, right. There is no benign energy source. They all have side effects and coal is probably, it's the worst. And nuclear power, the rising cost is just a result of this regulatory cycle. Well-intentioned

Phil (19m 32s):

Making something that's already pretty safe, just a few nths of a degree, even safer, I'm assuming.

Michael (19m 39s):

Right. Exactly. Exactly. I met a nuclear energy consultant one time strangely. Strangely, it happened to be while I was walking on a Croatian island and sitting at a tiny cafe. And this guy was at table next to me and I struck up a conversation with him and he said, "You know, over the past 40 years, there was a relentless effort to reduce the cost of solar energy and wind energy. And for nuclear energy, there was only a relentless effort to increase the safety, even to the point where it made it not more safe. And no effort to reduce the costs."

Phil (20m 16s):

Let's get back to investing then. And you're a mathematician. That's your, your background and your expertise. And a lot of people come into the investment markets thinking that you have to be good at maths. Is that something that you believe to be true?

Michael (20m 31s):

No. I mean, as I said, to do the best job of investing your own money or somebody else's money, you just invest in those three index funds and this obviously needs no math at all. I mean, those people that those endowment funds and pension funds and so on, these professional people, they were a wash in mathematics or,

Phil (20m 55s):

And modeling and as well. Yeah. Yeah.

Michael (20m 57s):

So, I have a PhD in mathematics and then I happened to get into the finance business by, you know, I didn't really know what it was, but I joined a brokerage firm and it was supposed to be a firm that was one of the most sophisticated. And they sent me to conferences of things called Institute for Quantitative Research in Finance. And I have to tell you, I was appalled at the level of mathematics. They don't really understand mathematics. They use the wrong tools for the wrong purposes. So, the math in that field is not good. I would constantly write articles critiquing the math in what's called the top financial journals.

Michael (21m 37s):

Some of them the math is okay but they draw conclusions from the map that simply aren't in the math. They leap to the conclusions that they wanted to leap to in the first place, they write a bunch of mathematics and then they say, "this shows that". Every time they say "this shows that" I want to say "Like hell it does it. Doesn't show that at all. It's just some math."

Phil (21m 59s):

And you reside in Hong Kong. Do you have any, any experience of the local stock market there? The Hang Seng?

Michael (22m 10s):

Not particularly, but I mean, Hong Kong is the world's third largest stock market. But this is embedded in the, for example, the Vanguard Total International Index Fund. So, it will have some of those same stocks, just like the Hang Seng index one. But if, for some reason, you specifically wanted to invest in stocks in this region, the Hang Seng index fund would be a good way to do it. And that would basically include all, all the stocks on the Hong Kong Stock Exchange.

Phil (22m 43s):

Any big differences? I mean, I believe, I may be wrong about this, but they only have numbers rather than ticker codes for companies on the Hang Seng, is that correct?

Michael (22m 52s):

Yeah. Yeah. I mean, I have to tell you, I haven't really gotten involved with this, but yes, they have numbers.

Phil (22m 59s):

Yeah. That must reduce the emotional a little bit because there's so much emotion involved in investing and even the name sometimes is there to market something.

Michael (23m 13s):

Yeah. I don't know whether that's true. There are different versions of the same company's stock available in the mainland and to external investors. Well, China has, you know, it just so happens, they have a much less developed stock and bond markets than the United States. The United States has the largest stock market, but China's is not very well developed yet.

Phil (23m 41s):

Let's talk a little bit about your work with M1K. And again, we're talking about ESG here.

Michael (23m 51s):

Not really. No, no, no. Well, the principal partner in M1K, a guy named Pascal Schoenberg, he used to work for JP Morgan Chase and others. And his expertise is in something that truly is a useful financing and you could put it in the ESG category but, like, nobody knows about it except a whole bunch of insiders. And that is providing the financial capital for solar and wind farms, solar PV farms and wind farms. And that gets quite complicated to like so many other things because of the tax rules.

Michael (24m 37s):

So, he's particularly an expert on something called tax equity, which is a long story I won't get into, but it provides the ability to build solar energy installations and wind farms. And some of it gets quite interesting and explains how some of these companies like Apple and Microsoft and so forth can resolve to reach net zero emissions is because they, with something called the virtual power purchase agreement. They can buy the so-called environmental attributes of a project. And that means they're buying the renewable energy credits of a project.

Michael (25m 22s):

They do this in large part, of course, to say, they invest in renewable energy. And they're not exactly investing it because there's also other investors needed to build the project, but they do help to enable the project to go ahead. And part of the deal in a VPA is that they guarantee a constant flow of income to the project, which it can't be sure of because electricity prices fluctuate, but where the guarantee of a constant flow of revenue, they can go to a bank and get the additional financing they need.

Michael (26m 3s):

So, it's a very useful thing. I mean, it's so far from what most people understand is ESG investing, which is just all about investing in the secondary market, which doesn't do anything to fund solar and wind. It's just people trading among themselves stocks in companies that have already gotten their money.

Phil (26m 28s):

Oh, that's interesting. So, are you saying then that the ESG market is enabled by companies like this who by becoming customers and by providing the cashflow to other companies that are providing renewable energy, that there's like this market that exists that most people are unaware of?

Michael (26m 47s):

Yeah. I think most people are unaware of this direct financing of solar and wind energy projects. I mean, I don't anybody in that area particularly calls it ESG because they don't need to, they're not marketing to the general public. But of course, it contributes to a reduction of the carbon dioxide emissions.

Phil (27m 6s):

So, if listeners want to find out more about you, Michael, and your work, how can they find you?

Michael (27m 14s):

Well, I write a lot of articles, more of my articles appear in an online journal called the Advisor Perspectives than anywhere else. And they cover the various topics that I've talked about here. More of them are about finance than about anything else. Some of them get quite technical and mathematical in finance, but the ones that are the most technical tend to be the ones that show how wrong the articles in the financial journals are. So, they're kind of like counter mathematical finance articles.

Phil (27m 57s):

So, you're kind of a mathsbuster.

Michael (27m 60s):

Yeah. You know, who's that magician who liked it, he liked to debunk other magicians? I forget his name. Oh yeah, Randi, the magnificent Randi.

Phil (28m 8s):

Yeah, James Randi, that's right. And he was famous for busting Uri Geller and his spoon bending.

Michael (28m 13s):

Right. Yeah.

Phil (28m 13s):

Michael Edesess, thank you very much for joining me today. It's been a great pleasure chatting with you.

Michael (28m 19s):

Thank you. My pleasure.

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