The Quest for Alpha is The Holy Grail of Investing. It is the quest for money managers who will deliver alpha- returns above the proper risk-adjusted benchmark.
The journey on this quest is that tale of two competing theories about how investment markets work and which investment strategy is most likely to allow you to reach your financial goals.
Theory 1: Markets are inefficient. Therefore you can select stocks which are undervalued and sell them when they reach fair value or are overvalued. This is the art of stock selection. You can also predict when the stock market is going to rise and when it will fall and rearrange your equity allocations so. This is the art of market timing. If you can find managers who have done this well in the past, you can hire them and outperform the market.
Theory 2: Markets are highly efficient. The market price of a security is the best estimate of its right price. Therefore efforts to outperform it are unlikely to be productive after the expenses of the efforts. Therefore you should focus on asset allocation, fund construction, costs, tax efficiency and building globally diversified portfolios.
To prove theory 1 we need to find evidence of persistent out-performance beyond the randomly expected.. Otherwise we cannot differentiate skill from luck.
Evidence from mutual funds
- Active mutual funds underperform passive benchmarks
- Past performance of active managers is a poor predictor of their future performance
- Expenses, turnover and taxes reduce returns
- Morning star ratings do not help to find outperforming mutual funds.
- Focus funds do not outperform diversified funds or the market
- Actively managed bond funds do not outperform the market.
- Most of the annual variation in performance is due to luck and not skill
- The argument that active management wins in inefficient asset classes like small caps or emerging markets is simply a myth.
- There is no benefit of active management during periods of market stress. The belief that bear markets favour active management is a myth.
- Even a long record of persistent out-performance has little value. The 44 Wall Street fund, Lindler large-cap fund, Legg Mason Value Trust Fund and the Tiger Fund are all examples of funds that outperformed the market for a long period only to underperform the market after.
- Professional investors and academics say that indexing is better than active management.
Warren Buffet says-“By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals”
Evidence from pension plans
Pension plans have the highest chance of outperforming the market because they have access to the best managers, consultants, large amounts of money and lower fees. However they are not able to outperform their benchmarks. They outperform mutual funds because they have lesser costs than mutual funds. Hiring top investment managers, consultants. Similarly 401(k) plans do not outperform benchmark indices.
Goldman Sachs, one of the world’s largest active managers says: Few managers consistently outperform the S&P 500. Thus, in the eyes of the plan sponsor, its plan is paying an excessive amount of the upside to the manager while still bearing substantial risk that its investments will achieve sub par returns. Slowly, over time, many large pension funds have shared our experience and have moved towards indexing more domestic equity assets.
Evidence from hedge funds
Hedge funds underperform the market. The problems with hedge funds are lack of liquidity, lack of transparency, non normal distribution of returns, risk of dying of the fund, riskiness of the assets, tax inefficiencies, a lot of agency risk(compensation structure, high water-mark, fraud, closing the fund), biases in the data and liquidation bias( funds that become defunct do not report their last returns). Hedge funds make money for the managers, not for individual investors.
Evidence from private equity/venture capital
Private equity outperforms the S&P 500 between 1985-2005 but does not outperform small cap value(13.8% versus 16%). Venture capital(early stage) gives 20.2% return but is highly risky. In other periods they underperform similar risky asset classes like micro-cap and small cap value stocks. Private equity/venture capital is not liquid/transparent/diversified and has long lockout periods, extreme positive skewness in returns, high standard deviation of returns. Individual investors cannot access this asset class easily as well.
Evidence from individual investors
Individual investors and investment clubs earn less returns because of greater trading activity. Investor return(dollar weighted return)is lower than investment return(time weighted return). Investors are better off with index funds and not trying to pick stocks. The idea that any single person without extra information or extra market power can beat the market is extraordinarily unlikely. But we think we can do it and almost all of us who think so ultimately fail.
Evidence from behavioural finance
Behavioural finance says that human behaviour leads to mispricing of assets. These pricing anomalies present a problem for those who believe in the efficient market hypothesis. The main question is not whether the market persistently makes pricing errors but whether the anomalies are exploitable taking into account real-world costs. Funds that try to exploit behavioural errors of investing have outperformed the S&P 500 sometimes but they have not outperformed the value indices. Richard Thaler, a behavioural finance expert concedes that it is not easy to beat the market, and most people don’t.
Richard Roll says with great insight:I have personally tried to invest money…in every single anomaly and predictive result that academics have dreamed up. And I have yet to make a nickel on any of these supposed market inefficiencies…Real money investment strategies don’t produce the results that academic papers say they should.
The conclusions so far are:
- The markets are highly efficient.
- The costs of exploiting any inefficiencies are sufficiently great to make it difficult to generate persistent alpha enough to overcome the costs of the efforts.
- If there are inefficiencies, the competition to exploit them causes them to disappear rapidly.
Why persistent out-performance is hard to find
Above average skill produces above average results in almost all endeavours. However this is not true in investing. The reason is that an investor does not compete with another investor but competes with the collective wisdom of the entire market. It is really difficult to beat the collective wisdom of the entire market for a long period especially when you have transaction costs, taxes and slippage costs. Another problem is that as you have more money, you end up buying more stocks(you begin to look like an index fund), you buy more of the same(transaction costs goes up), you change your style by buying larger stocks(you start performing like the index) or you have to close the fund( most do not want to do that). No one knows where the economy and the market are headed, so you cannot really outperform the market. Although we think that by security analysis we can buy undervalued stocks and sell overvalued stocks, most of us cannot do it and if we think we can do it then we will usually fail and get below average returns. Further, we have almost instant access to information, low trading costs and very high institutional ownership and trading and these things make the market more efficient and less easy to exploit. No one can forecast what the market and the economy are going to do. Hence it is very difficult to outperform the market.
The Prudent Investor Rule
There is an old story about a financial economist and passionate defender of the efficient markets hypothesis (EMH) who was walking down the street with a friend.
The friend stops and says, “Look, there is a $20 bill on the ground!”
The economist turns and coolly replies, “Can’t be. If there was a $20 bill on the ground, somebody would have already picked it up.”
This “joke,” told by those that believe that the markets are inefficient and that investors can thus outperform the market by exploiting mispricings, is actually a very misleading analogy to the EMH. The following is a better analogy:
A financial economist and passionate defender of the efficient markets hypothesis (EMH) was walking down the street with a friend. The friend stops and says, “Look, there’s a $20 bill on the ground.”
The economist turns and says, “Boy, this must be our lucky day! Better pick that up quick because the market is so efficient it won’t be there for very long. Finding a $20 bill lying around happens so infrequently that it would be foolish to spend our time searching for more of them. Certainly, after assigning a value to the time spent in the effort, an ‘investment’ in trying to find money lying on the street just waiting to be picked up would be a poor one. I am also certainly not aware of lots of people, if any, getting rich mining beaches with metal detectors.”
When he had finished they both look down and the $20 bill was gone!
What those who tell the first version of the story fail to understand is that an efficient market does not mean that there cannot be a $20 bill lying around. Instead, it is so unlikely to find one that it does not pay to go looking for them-the costs of the effort are highly likely to exceed the benefits. Also note that if it became known that there were lots of $20 bills to be found in a certain area, then everyone would be there to compete to find them, reducing the likelihood of achieving an appropriate “return on investment.”
The analogy to the EMH is that it’s not impossible to uncover an anomaly (that $20 bill lying on the floor) that can be exploited. Instead, one of the fundamental tenets of the EMH is that in a competitive financial environment, successful trading strategies self-destruct because they are self-limiting. When they are discovered they are eliminated by the very act of exploiting the strategy. Economics professors Dwight Lee and James Verbrugge of the University of Georgia explain the power of the efficient markets theory in the following way:
‘The efficient markets theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns. (For example) If stock prices are found to follow predictable seasonal patterns this knowledge will elicit responses that have the effect of eliminating the very patterns that they were designed exploit. The implication is striking. The more empirical flaws that are discovered in the efficient markets theory the more robust the theory becomes. (In effect) Those who do the most to make sure that the efficient market theory remains fundamental to our understanding of financial economics are not its intellectual defenders, but those mounting the most serious empirical assault against it.”
In summary, while the markets may not be perfectly efficient (it is possible to find a $20 bill waiting to be picked up), the prudent investment strategy is to behave as if they were. Investors that accept the EMH as fundamental to their investment strategy don’t have to spend their time searching for the very few $20 bills lying on the ground. Instead they earn market returns, less very low costs, based on the amount of risk (their asset allocation) they are willing to accept. They also get to spend their time on much more productive and important things like their family, community service, reading a good book, or whatever other “big rocks” in their lives.
This is a good enough reason to invest in index funds.
Whose interests do they have at heart?
An out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of the guides indicated some handsome ships riding at anchor. He said, “Look, those are the bankers’ and brokers’ yachts.” The naïve customer asked: “Where are the customers’ yachts?”-Fred Schwed. Jr., Where Are the Customers’ Yachts?
Wall Street makes money out of us and not for us because that is how they earn their salary. They will say or do anything to defend their business because their salary depends on us buying their services. But buying their services means you have higher trading costs, higher taxes and the cost of cash.
Active management is a negative-sum game, also known as a loser’s game.
Peter Lynch says:
“[Investors] think of the so-called professionals, with all their computers and all their power, as having all the advantages. That is total crap. … They’d be better off in an index fund.”
Warren Buffet says:
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
Buying an index fund over a long period of time makes the most sense.
Over the [past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.
Michael Lewis says:
A vast industry of stockbrokers, financial planners, and investment advisers skims a fortune for themselves off the top in exchange for passing their clients’ money on to people who, as a group, cannot possibly outperform the market.
How to play the winner’s game
An asset allocation that Larry Swedroe advises:
US large value:7%
US small cap:7%
US small value: 7%
MSCI EAFE value:14%
S&P/GSCI Commodities: 4%
Intermidate Govt/Credit Bond:40%
Between 1975 and 2009 this portfolio gave an annualised return of 11.6%. This is not an average return. It is a market return. You got this cheaply if you persisted with it no matter what.
The other important thing in life is to know whether you have enough or not:
Most wealthy people have become wealthy by taking risk, especially in a business. The strategy to get rich is to take risks, especially in one’s own business. But the strategy to stay rich is to lower risk, diversify risk and avoid spending too much. When deciding on an investment policy you should consider three criteria:
- Ability to take risk
- Willingness to take risk
- Need to take risk.
If you already have enough, you should question the need to take risk. Very often we increase our need to take risk by converting what were once desires into needs. We should remember that once you have enough money to meet basic needs like food, shelter and safety, incremental increases have little effect on your happiness. Once you have these, the good things in life, the really important things are either free or cheap.
Know when you have enough and differentiate needs from desires. This is one of the keys to play the winner’s game in both life and investing.
The Holy Grail of Investing is available to each and every investor. There are only two requirements:
- Give up the quest for alpha and accept market returns. By doing so you are almost guaranteed to outperform the majority of individual and institutional investors, assuming you have the discipline to stay the course.
- Stop paying attention to the noise of the market. Noise causes investors to make decisions that are likely to be unproductive. Don’t look at your holdings. Choose a sensible diversified portfolio and stop reading the financial pages. You will continue to make more money when snoring than when active.
Passive investing can be easily done. You can spend time on things that are more important, like your family, doing community service, reading a good book or pursuing your favourite hobby. This is what Warren Buffet says:
Our stay-put behaviour reflects our view that the stock market serves as a relocation center at which money is moved from the active to the passive.
Hence, passive investing in low-cost globally diversified asset classes is the Holy Grail of Investing and this is available to all of us.