By LARRY SWEDROE
In our 2015 book The Incredible Shrinking Alpha, Andrew Berkin and I discussed why it was getting persistently harder for active managers to generate alpha. We provided four explanations: (1) academics were converting what was once alpha into beta (exposure to a numerical characteristic, or set of characteristics, common across a broad set of securities); (2) the supply of victims that can be exploited has been persistently shrinking; (3) the skill level of the competition is persistently increasing; and (4) the supply of dollars chasing the shrinking supply of alpha has persistently increased.
We presented the evidence demonstrating that active management was what Charles Ellis called a “loser’s game” — a game that’s possible to win but whose odds are so poor it’s not prudent to try. Like roulette in Las Vegas, and in all loser’s games, the winning strategy is to choose to not play. In investing, that means using passively managed funds such as index funds, unless perhaps you are Warren Buffett or some other superstar investors.
In a speech entitled The Superinvestors of Graham-and-Doddsville, which Buffett gave in 1984 in honor of the 50th anniversary of the publication of Benjamin Graham and David Dodd’s book Security Analysis, he identified several funds that had produced outstanding track records.
As it is now the fifth anniversary of the publication of our book, I thought it worthwhile to look back and see how the two funds that Buffett identified in his speech that have public records for at least the last 15 years, Sequoia (SEQUX) and Tweedy Browne Value (TWEBX), have performed. In other words, we can determine if the incredible shrinking alpha was impacting the ability of these two superstar funds to outperform. We’ll begin by looking at the returns of the legendary Sequoia Fund, which Morningstar considers a large growth fund.
Using the backtest tool at Portfolio Visualizer, for the most recent 15-year period 2005-19, Sequoia returned 7.9 percent per year, underperforming the 9.1 percent per year return of Vanguard’s Total Stock Market Fund (VTSAX) by 1.2 percentage points. It also underperformed Vanguard’s Growth Fund (VIGAX), which returned 10.1 percent, by an even greater 2.2 percentage points per year.
Using Portfolio Visualizer’s regression tool, we can also examine Sequoia’s results by taking into account their factor exposures — in other words, examine their risk-adjusted returns. Interestingly, accounting for the fund’s exposure to the factors of market beta, size, value (using AQR Capital Management’s metric), momentum and quality, we find that despite underperforming VTSAX by 1.2 percentage points per year, the fund’s five-factor alpha was 1.5 percent. The explanation for the fund’s underperformance relative to the market was that its exposure to market beta was just 0.69 percent. Importantly, we can see that the low beta exposure was not the result of loading on the “betting against beta” (or low volatility) factor because, when adding this sixth factor, we see that the fund’s exposure to it was -0.13. Instead, it seems likely (because if we include fixed income factors, we see that the fund had a small negative exposure [-0.09] to the term premium) that, in an attempt to time the market, the fund was sitting in cash or equivalents. This is a good demonstration of why generating risk-adjusted alpha is not a sufficient metric. You need to consider how the returns were earned as well. In this case, the fund’s alpha was more than offset by its low exposure to the market factor.
We now turn to analysing the performance of Tweedy Browne Value (TWEBX), which Morningstar classifies as a large value fund. Again using the analytical tools of Portfolio Visualizer, for the most recent 15-year period, TWEBX returned 5.8 percent per year, underperforming the 9.1 percent return of VTSAX by 3.3 percentage points per year. Examining TWEBX’s returns when taking into account its factor exposures, we find that the fund’s five-factor alpha was -0.9 percent per year, explaining less than one-third of the fund’s underperformance. As was the case with SEQUX, the fund’s performance was hurt by its exposure to the market beta factor of just 0.7. And like SEQUX, it too had a slightly negative exposure to the betting-against-beta factor. It also had a very slightly negative exposure of -0.02 to the term premium. TWEBX also underperformed the comparable Vanguard Value Fund (VVIAX), which returned 8.2 percent, by 2.4 percentage points per year.
Perhaps, like Warren Buffett, these “superinvestors” have been burdened by the huge amount of assets they have under management. Or perhaps over time, alpha has become harder to generate. In terms of capturing the incredible shrinking alpha, “The Superinvestors of Graham and Doddsville” have been less than super for at least the past 15 years. This evidence serves to highlight the benefits of passive investment strategies.
We can also see that even if you have Warren Buffett-like skill (and can use your power and reputation to negotiate great deals as well as the cheap leverage obtained from Berkshire’s insurance operations, as he did in 2008 when he helped Goldman Sachs with a $5 billion investment), it’s getting harder and harder to generate alpha. Using Portfolio Visualizer, over the last 15 calendar years ending 2019, Berkshire Hathaway returned 9.4 percent, managing to slightly outperform Vanguard’s Total Stock Market Fund (VTSAX), which returned 9.1 percent, by just 0.3 percentage point per annum. While Berkshire outperformed the market, that’s not the stuff of which his well-deserved legend was made.
S&P Active Versus Passive Scorecard results
Just how hard it is to beat the market on a risk-adjusted basis can be seen in the results from SPIVA’s December 2019 Persistence Scorecard for the United States, with data through September. Here are some of the highlights:
- Irrespective of asset class or style focus, few fund managers consistently outperformed their peers.
- An inverse relationship exists between the time horizon length and the ability of top-performing funds to maintain their success. Less than 1 percent of equity funds maintained their top quartile status at the end of the five-year measurement period. And no large-cap fund was able to consistently deliver top quartile performance by the end of the fifth year.
- Over longer horizons, most fixed income categories showed no persistence: Of the 13 fixed income categories, seven showed no managers remaining in the top quartile over the five-year horizon.
- Of 545 domestic equity funds that were in the top quartile as of September 2017, 8.1 percent managed to stay in the top quartile through September 2018 and again through September 2019, slightly more than the 6.3 percent we would randomly expect to do so.
- Over the two non-overlapping five-year periods, it was almost as likely for a bottom quartile large-cap fund to rise to a top quartile performer (9.6 percent) as it was for a top quartile performer to remain a top quartile performer (10.6 percent). The results were similar for small-cap funds, with 18.8 percent of top quartile performers becoming bottom quartile performers while 16.1 percent of bottom quartile performers became top quartile performers. The results were better for mid-cap and multi-cap funds.
- Over the five-year horizon, the results show a lack of persistence among nearly all the top quartile fixed income categories, with a few exceptions.
In 1998, when Charles Ellis wrote his famous book Winning the Loser’s Game, about 20 percent of actively managed funds were outperforming the market on a statistically significant risk-adjusted basis (generating alpha). Due to the incredible shrinking alpha, studies such as Luck versus Skill in the Cross-Section of Mutual Fund Returns and Conviction in Equity Investing have found that today that figure is about 2 percent. And that is even before considering taxes, which for taxable investors is typically the largest cost of active management.
In other words, active management has persistently become even more of a loser’s game.
To me, that means the greatest anomaly in finance is neither momentum, the performance of small growth stocks with low profitability and high investment, or the performance of stocks with high bankruptcy risk.
Instead, the greatest anomaly is that about half of all dollars are still invested in actively managed strategies.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
If you’re interested in reading more of his work, here are his other most recent articles for TEBI: