In this episode of The Acquirers Podcast Tobias chats with Larry Swedroe. He’s the author of a brand new book called The Incredible Shrinking Alpha. He’s also the Chief Research Officer at Buckingham Wealth Partners. During the interview Larry provided some great insights into:
- Alpha Becoming Beta
- The Pool Of Victims Is Shrinking
- Is This The End Of Active?
- New Book – The Incredible Shrinking Alpha
- Active Versus Passive Investing
- The Paradox Of Skill
- Passive Increases Market Efficiency
- What Should Individual Investors Do?
- The Biggest Mistake Investors Make
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Larry Swedroe. He’s the author of a brand new book called The Incredible Shrinking Alpha. Larry is the Chief Research Officer at Buckingham Wealth Partners. We’re going to talk to him about his long history of fascinating research on finance right after this.
Tobias: Larry, you must be the most prolific writer on factor investing out there. Is there anybody who publishes more frequently than you do?
Larry: I don’t think so.[laughter] Larry: I think it’s over 4,000 pieces over the year so, on almost any subject–
Tobias: Oh my God.
Larry: –of course, it’s not just factor investing, but I’m working on a piece this morning on– there’s a new paper on ESG and bonds. The first one I’ve seen. Now, the logic is very clear if you have a good ESG score, and people screen out bad stocks, then the good high ESG companies will have in the short-term capital gains. As cash flows in, you’re raising valuations, you have lower costs, the capital, those companies gain a competitive advantage can be more profitable. So, they have incentive to do that, but the end game is lower returns because you have higher valuations. That’s pretty clear in the literature.
So, this is the first paper out. I just started to read it, but it looks like the same effect, which doesn’t shock me but it surprised me a bit. You’re seeing the same effect in the bond market, that people must be screening out even bonds now, because companies with higher ESG ratings have higher credit ratings and therefore, lower cost of capital, gain competitive advantage. And so, they have incentive to do that. So, ESG investing is actually serving the purposes, causing companies to behave better to get the lower cost of capital. So, that’s sort of a good nice story, I think to tell. In fact, there’s a friend of mine named Sam Adams, you happen to know him?
Tobias: I don’t know Sam, no.
Larry: Sam used to work at Dimensional and he left to form a real estate company based on ESG principles, by investing in real estate that has more efficient use of energy and those kinds of things. He’s now taken on himself to become sort of master in the whole socially responsible–he does lots of lectures and webinars, seminar. I’ve been sharing my articles that I write up on the research on that. And then, I said to Sam, “Well, Sam, why don’t we write a book? I’ll do all of the academic research findings. And you tell the history and stuff.” So, we just signed the contract with Harriman House and got the whole outline done. Mine is done already, as you might imagine, in a couple of months– because I’d written 25 papers, and I just took a month or so to consolidate them. And I’ll just keep it up to date as new things come out.
Now, I’ve got to teach Sam how to write. I helped him. We got the introduction done and combined my two chapter as that was enough plus an outline for Harriman to do the book. But now I said, “Alright, Sam, now you’ve got to write one chapter a month.” [laughs]
Tobias: Oh, that’s tough.
Larry: We’ll have an ESG book out next year by this time, I hope.
New Book – Larry Swedroe – The Incredible Shrinking Alpha
Tobias: That’s amazing. Given how much you’ve written on factors, the new book that you’ve got out, The Incredible Shrinking Alpha: How to be a successful investor without picking winners. What is there left to say? What did you say in this book that you haven’t said before?
Larry: Most of the book here is not about factors, though we do talk– one of the things in the first edition of the book was the criticisms, if you will or request from readers, “Larry, this is great information. It tells us why we should be or avoid active investing. But it doesn’t tell us what to do with the information. How do we build the portfolio?” So, we wanted to add whole series of chapters on asset allocation, implementation. A bunch of other issues that we get lots of questions about is a dividend strategy. A good one, for example.
Tobias: Is it a good one?
Larry: [chuckles] One of my favorite topics. And then, of course, we updated the data on the research over the last five years since the book was published. So, this book is really mostly about why active management is getting harder. While the world of active management has always professed to try to tell the story that as this trend towards passive increase, it would become easier because there would be fewer people doing price discovery. My, and Andy’s, hypothesis is exactly the opposite is happening and we see the evidence of that.
We know certainly in the last 20 plus years since I wrote my first book, the market’s gone from about 10% passive to about 50%. And yet, the odds show that 22 years ago in ’98 when I wrote The Only Guide You’ll Ever Need to Have a Winning Investment Strategy. And that came out about the same time as Charles Ellis’ much more famous, Winning the Loser’s Game. Ellis pointed out that about 20% of active managers, pre-tax anyway, were generating statistically significant alpha.
Today, the research is showing it’s down to about 2%. So, you’ve got this trend. And I think we can probably both agree 22 years ago, if you told any active manager that half the market, it’ll be easy to outperform because there’s so much less price discovery and yet the exact opposite has happened, and we discuss the reasons why in the book.
Active Versus Passive Investing
Tobias: Well, let’s talk about that. Let’s talk about first, how are you defining active versus passive?
Larry: Yeah, that’s a great question because outside of– Well, there’s no such thing as a purely passive strategy because if you are purely passive, you have to own every asset in the market cap weighting that it’s owned by the rest of the world. And that would include things that are incredibly illiquid like art or rubber plantations, and then Indonesia and all kinds of stuff. Even if you own an S&P 500 Index fund, which I think 99.99% of people would agree or believe is a passive fund, you and I know, it’s not passive at all. It’s not the top 500 stocks by market cap.
Tobias: And they have some discretion, right? We know that they recently excluded Tesla.
Larry: Yeah, do you include Tesla or not? And in fact, there was an interesting study done back, I think, it was in the late 90s. The original 500 stocks in 1957, if my memory– outperformed, even though some of them disappeared and totally bankrupt. The original five, you were better off holding that than the selection, which shows how difficult it is, that outperform. So, that’s an interesting question.
So, how do I define active and passive? I think you have to break it down into all good management involves some active decisions. How much equity versus debt? How much US versus international? We know there are some definite negatives of pure indexing, just the horse-trading when smart, high-frequency traders know you have to trade if you only care about matching the benchmark, you’re going to get front run. And the best example of that was the Russell 2000 underperformed a very similar CRSP 610 by 2% a year or more for decades before even Vanguard woke up and said, “No, this is dumb. Why are we matching this index?”
And they switched– I can’t remember where they went first, to CRSP or the MSCI 1750. And many firms adopted DFA strategy of creating buy and hold ranges to minimize that damage. We know all intelligent design involves some active management. And even you can have three great examples, three passive small value funds– in my writings, I wrote an example of and this is a little bit dated with the data, but it’ll give a good picture. You take Vanguard small value fund, DFA small value, and Bridgeway. Now if you ask most investors, hey, they’re all passive, they buy all the stocks that are in those. They’re going to have very similar returns, and if one beat the other, well, they must be a better fund, they’re better designed.
Well, the Vanguard fund had an average market cap of about $4 billion, it’s somewhat less now. DFA’s was 2 billion and Bridgeway was $1 billion. Well, they’re all passive, but they each define their universe differently. Bridgeway wanted to be much smaller. DFA used to be smaller but was may be concerned about not– all these cash flows are coming in, so they change the buy and hold ranges. Vanguard was much bigger because they’re dealing with a big retail base. And the P/Es were very different because of that. Vanguard’s P/E might have been say, 16, DFA 14, and Bridgeway 12. They’re all probably somewhat lower today, but they were roughly in that ballpark.
The key is, to me, passive management means that, first, you have active fund construction rules. Those rules have to be totally transparent and implemented in a systematic, replicable way. And that doesn’t mean– or let me say it this way. It means you have to accept tracking error because you’re not going to automatically sell when something leads your index. You’ll have a buy and hold range and even then, you may even screen for momentum and the computer is going to drive your trading. Because of the front running by high-frequency traders, Dimensional today virtually all the trades are 100 share locks, so they can’t be taken advantage of any longer. So, that makes a big difference.
You want to have a fund that’s intelligent design. But I define it as you’re active in your fund construction rules. But once you have that set, it’s implemented in a totally transparent, systematic, and replicable way. And I then consider you’re passive investing. But every asset allocation decision whether you include gold or whatever in your portfolio, that in itself is active, but how you implement it is either active or passive. So, you can invest in gold and time it using momentum, for example, or you can invest in a gold fund and just sit with it and you’re not– one is active, one is passive.
Tobias: So, it doesn’t necessarily imply market capitalization weighting, which is– I think if most people think about a passive index, they probably think of the S&P 500 or the Dow, which is not market cap weighted, but they would think of– Let’s say, the S&P 500, that might be the most popular index, which is market capitalization weighted. Do you think that a lot of the issue with outperforming for active is just that market capitalization weighting has been unusually strong for a decade and everything compared to that has just been struggle straight?
Larry: Well, I think that’s easy to address in this way. First of all, we have to make sure we’re looking at risk-adjusted benchmarks. So, if you’re a small-cap manager, you shouldn’t be judging your performance against the S&P 500. Of course, that’s going to leave you underperforming during periods when large stocks outperform, but your benchmark should be something more like the MSCI 1750. And if you’re a small value manager, it should be that. But then, you also have to look at, well if you believe in small and value, then I want to be smaller than the index and I’ll look like a genius when I outperform. Now, it’s just your fund construction rules. You took more of those risks. And we know that factors do a great job of explaining differences in returns.
I wrote a paper that looked at those three small value funds, so Dimensional, Vanguard, and Bridgeway, with Vanguard being the least exposed to the small and value factors, DFA in the middle, and Bridgeway being the smallest market cap and the lowest P/Es or price to book or price to cash flow. And I looked at their returns over a 10-year period, and we have 30 data points, 10 years, three funds. And any year where small beat large and value beat growth, I guarantee you will predict with 100% accuracy virtually which fund did the best. You get a chance to show off here. [crosstalk] –small value and wins, give me the order of which will fund had the best returns. Vanguard, DFA, or Bridgeway.
Tobias: It’s the smaller, more value-focused fund of those three, I don’t know off the top of my head, but it just follows the factor.
Larry: Yes. So, Bridgeway [crosstalk] was in the middle and Vanguard was at the bottom. It doesn’t mean Vanguard was a bad fund and had poor performance. And if you look at Morningstar ratings, if we have three or four years where small value outperforms, Vanguard’s going to look like a lousy fund and it’s going to get poor ratings. Well, the last three years, exactly the reverse is true. Vanguard’s fund has the highest return and DFA in the middle and Bridgeway at the bottom. Out of 30 data points, 29 of them lined up exactly the same. And the other was a tiny difference, which was, of course, [unintelligible [00:16:25] and there’s a little bit of a difference also. Vanguard includes real estate in their fund, whereas DFA and Bridgeway think real estate really should be treated more as a different asset class. And since it has lower returns historically than small value, you might want to exclude it anyway. But lots of people own real estate separately, so they made the decision, right or wrong, to not include real estate. If real estate has a really bad year, like in say 2013 relative to the market, then Vanguard’s is going to look poor. And other years when real estate does really well, then Vanguard will look great. Again, it’s all three funds are doing exactly what they were expected to do. But you have to decide which fund you want the exposure to because if you want more deeper exposure, I’m willing to pay more to get it.
Let me give one simple example. Let’s just say, you think that the size premium is 2% a year and a value premium is 3%. And the Bridgeway fund has a 0.2 higher loading on those factors. Well, 0.2 on size, that’s worth 40 basis points for the 2% premium and it’s worth 60 for the 3%. That’s 100 basis points. Would I be willing to pay 90 to get 100? No, because one’s guaranteed and one’s not. But would I be willing to pay 20 or 30 to get a likely 100? Probably yes.
So, that’s what people have to look at. They shouldn’t be focused so much only on the expense ratio, but the expense ratio relative to what they believe the expected value the fund is delivering. And we talk about that in the book as well.
Alpha Becoming Beta
Tobias: One of the interesting things early on that I saw, you talk about alpha becoming beta, what do you mean by that and how does that happen?
Larry: Yeah, so let’s define alpha for your listeners. Some may not really understand that term.
Tobias: Feel free to explain it to me too.
Larry: [chuckles] Yeah. Alpha, of course, is the return against the appropriate risk-adjusted benchmark. So, if you buy Indonesian bonds and you outperform one-month T-Bills, that’s not alpha. Or, if you buy small value stocks and you beat the S&P 500, that’s not alpha. If you load up on value more than a value benchmark, that’s not alpha. That’s having more exposure to a common trait or characteristic.
Now, if you deliver alpha or beat your benchmark because in years when value outperforms, you load more on it and then in periods when value underperforms, you loaded less, so you shifted and bought more growth stocks as an active manager. So, your average exposure to value was the same as the index, but you had the right exposures, that’s truly alpha. The key issue is this. We want to look at alpha as outperformance against an appropriate risk-adjusted benchmark. Beta is nothing more than a common trait or characteristic of a stock or a portfolio.
The original asset pricing model was the CAPM or Capital Asset Pricing Model. It was a working model for about 25, 30 years from the early mid 60s until Fama and French came along and that was a single-factor market beta. And right away, problems came along with the single-factor market beta.
Now, the CAPM was important. I don’t want to dismiss it even though it was wrong because models we know are not meant to be like cameras. They don’t take a perfect picture. They’re more like engines that help advance our understanding. In other words, if it was a law– it was a perfect picture like a camera, we would call it a law, like we have in physics. This is a hypothesis, a theory about how markets work. So, right away people, practitioners, and academics went to see if they could find if there were flaws in the model. And they found out that the model market beta was only able to explain two-thirds of the differences in returns of diversified portfolios.
So, for your audience to keep it simple, Toby’s got a portfolio of 100 stocks, he gets 13% returns. I build a portfolio of 100 stocks, I get 10%. Now, that difference of 3% could be attributed to Toby being a much better stock picker than me, it could be luck. Maybe we both threw darts, and his stocks happen to get better than mine, or no. We don’t know. Now, beta was able to explain two -thirds of that difference or 2%. So, most of Toby’s outperformance was explained by he just bought higher beta stocks. However, there are other one-third could have been luck, it could have been skill, or it could have been some unexplained factor.
Well, just walking quickly through, one, we now know that market beta has a real problem because the asset pricing line is not flat. It’s really humped. The lowest beta stocks have lower returns than the stocks that are in the middle of that hump. So, it’s fairly flat, but slightly upward sloping, and then when you get to the fifth quintile, the highest beta stocks, the returns collapse. They’re a disaster. You want to avoid them except in stock market reversals like in March of 2009. If you can predict them, you want to load up on high beta stocks.
But at any rate, so that created a problem, they became known as the black hole of investing, lottery stocks. Typically, they were small growth companies with high investment and low profitability. People trying to find the next Microsoft, overpay for those stocks and limits to arbitrage and the cost of shorting them and the risks just prevent sophisticated investors correctly. So, that was the first problem there.
But academics also were trying to find whether there’s some common traits that active investors were using to identify stocks that could outperform the CAPM. And so, in effect, they reverse engineer things. You might think of say Toby’s PhD in finance. He says, “I want to see if I can replicate Warren Buffett’s performance. So, I’m going to see what are the common traits? Are there common traits of the stocks Buffett buys? And if there are, I can replicate his performance, or at least maybe come close to doing that. So, Toby does his work and he finds Warren Buffett likes to buy low P/E stocks. Well, research show that low P/E stocks outperform, and they explained a good amount but not anywhere near all of Buffett’s outperformance and the research showed small stocks outperform large stocks.
Eventually, we then saw that momentum stocks. Stocks with recent outperformance, outperform those that did poorly. And then later, academics learned the real secret sauce from Buffett, which he had been telling everybody all along, but it took until about 2006, Fama wrote a paper on profitability. Robert Novy-Marx built on that. I think his was 2012 called Gross Profitability. If you combine profitability with value, so Buffett’s real secret sauce was buying cheap companies that were also more profitable. Turned out that you virtually eliminate certainly from a statistical significance standpoint, Buffett’s alpha was gone.
In other words, his secret sauce was not individual stock-picking skills, but in figuring out 50 years before all the academics that if you bought stocks with these traits, you would outperform. And that research was published in two papers by teams at AQR in Buffett’s Alpha and Betting Against Beta, that combined. You don’t want to own those high beta stocks, and you want to own cheap stocks that are also profitable, or they expanded profitability to a broader quality.
And now, every single fund that my firm uses, whether it’s Dimensional or Bridgeway or AQR or BlackRock and others, they’re all using these same now well-known factors, so every investor today, literally being passive can buy the exact same types of stocks that Warren Buffett bought. The only difference is, they don’t get to buy Goldman Sachs at their debt with convertible options or whatever at a big discount because Goldman desperately needed both Buffett’s $10 billion overnight and they wanted his imprimatur name and reputation, so he could cut a special deal. But if you look at the stocks that Berkshire owns publicly, there’s no statistically significant alpha any longer once we account for the leverage that he’s able to apply from his insurance.
So, that’s what we mean by alpha getting converted to beta. Academics call it reverse engineering, are able to figure out what this really smart active managers were doing to generate alpha and then make it systematic, transparent, and replicable. So, all these sauces of what were once alpha have disappeared. 20 years ago or 30 years ago, you could claim alpha by buying small value profitable companies. You can’t do that anymore because I can replicate them in an index fund or a similar systematic passively managed fund, whatever the words you want to use. So, that’s the biggest problem. Most of these sauces of alpha have disappeared. They’ve been converted into– that was only one of the four factors though that are influencing this trend and going to continue, I think, to make active management even more difficult.
The Pool Of Victims Is Shrinking
Tobias: Well, let’s talk about those other ones. You say, “The pool of victims is shrinking.”
Larry: Yeah, this is important. Think about a poker game. If you’re playing among friends, it’s a zero-sum game. But investing isn’t like that. It’s more like playing at a poker game in Las Vegas where the house is taking some of the chips. You have trading costs involved. So, think about the poker game with your friends. It’s zero-sum. So, if you’re going to win, there has to be a sucker at the poker table you’re going to exploit. In the investment world, if you’re going to outperform a zero-sum game even before expenses, you have to find suckers to exploit insufficient number to overcome the burden of those extra expenses, your expense ratio and your trading costs, which are not only bid offer spreads, but for big investors active, of course, market impact costs, trying to move that.
So, here’s the bad news for the active investors. Coming out of World War II, 90% of all stocks were owned individually by individuals in their brokerage accounts. So, Warren Buffett picking up the phone, calling his broker and say, “I want to buy this stock.” The seller, 90% odds, were some dumb retail investor was selling, and Buffett was buying. Buffett had a big pool of victims to fish at that pond with. Whenever active managers were trading, 90% odds, they were exploiting some dumb retail money.
And we know the research shows that retail money on average is dumb money. Lots of studies show, for example, that on average the stocks individuals buy go on to underperform after they buy them. And on average, the stocks they sell go on to outperform after they sell them. Well, if it’s a zero-sum game, somebody is winning, turns out it’s actively managed mutual funds, hedge funds. The first big study on that was Russ Wermers. He found that active managers, their stocks outperformed by about 70 basis points. Sadly, the total costs exceeded 2%. So, the only winners were the fund sponsors. If all there was gross alpha, the net alpha was negative. So, that was a problem there. But the institutions are the winners. What’s happened since then?
Today, those figures have pretty much reversed. 90% plus of all trading is done by institutions. So, you get some Robinhood investor who’s buying Tesla, let’s say, the latest hot stock. He never stops to ask himself this question. Who’s on the other side of the trade? There’s got to be a sucker at this poker table. Who is likely? Is it me? Or is it Warren Buffett, some Renaissance Technology trader, SAIC Capital, D. E. Shaw, Goldman Sachs? Which one of us likely knows more about this stock? Is it me or them? They never stop to ask the question, who’s on the other side? And one of us must be wrong because the seller can’t outperform the market if the buyer does. One of the two will underperform. Someone’s underweighting or overweighting the stock.
Today, 90% of the trading or more is done by big institutions. When the Robinhood investor is buying a stock, the odds are 90% it’s Goldman or somebody on the side, and there, Robinhood is the likely sucker. Now the problem for the active managers are, if Warren Buffett’s trading, it’s probably SAIC Capital on the other side, or Morgan Stanley or somebody else. So, now who is the sucker at the table?
A great way to think about this is that you have to think about Roger Federer in a tennis tournament. So, he is one of, clearly, if not the greatest tennis player in the world. He gets into a Grand Slam match. He’s playing one of the top 128 players in the world. And to my knowledge, he has never lost ever a single first-round match. Now, he’s playing against 128 best players, never loses. Now, you’re an individual investor. Are you one of the 128 best players? Probably not.
There are all these hedge funds and mutual funds. But Federer has great skill, he’s almost certain to win that first match. As he advances, the odds of him losing go up. By the time, he got to the quarterfinals, maybe he lost 25% of the time. I don’t know the numbers. Semifinals, maybe he lost 30%, and the finals, maybe 40%. So, even the number two or three player in the world that Federer was playing against couldn’t win, likely when they were down. I think that’s the way the active world has become because there are few and fewer victims at the table, even if you’re a highly skilled, the competition is no longer dumb retail Joe investor. It’s someone who looks just like you when you look in the mirror. They have the same skill sets.
The Paradox Of Skill
Tobias: It’s the paradox of skill. Can you elaborate a little bit on the paradox of skill?
Larry: [crosstalk] — wrote about that. He wrote a terrific paper. It’s why there are no 400 hitters in baseball anymore when we know today’s athletes are so much better. They’re bigger, stronger, faster, better training routines, better pharmaceuticals, some would argue. But yet, we haven’t had a 400 hitter in now 80 years since Ted Williams did it in ’41, despite the fact that the average batting average is unchanged, it’s about 250 to 260. The difference is that the standard deviation of that batting average has collapsed. So, what that means is, when Ted Williams hit 400, the average batter hit 250. But there were 180 and 200 hitters, and lots of 350. Today, the standard deviation is collapsed. The average batter hits 250. You don’t see many even over 300 and you don’t see many below say 220. The standard deviation has collapsed from over 40 to probably today under 25. So, to hit 400, you’re a five or maybe even today a six standard deviation event. Not likely to happen.
Well, the same thing is true, and that’s the third of these factors. The competition level of skill is getting tougher and tougher because 50 years ago, when I was getting out of school, the typical active manager might have been a liberal arts major who went to work at Goldman Sachs and got trained to analyze stocks. There wasn’t even a finance theory until the mid-60s when the CAPM was there. And if you took a course in investing, it might have been either in an accounting class program or in an economics program, though I was one of the first people to ever graduate with a finance degree because there was no finance [crosstalk]
Today, who’s managing money? It’s everybody’s got a PhD in nuclear physics, rocket scientists, math. You think about my coauthor, Andy Berkin, who’s the Chief Research Officer of Bridgeway. He’s a PhD in physics from Caltech and a winner of the NASA award for the Best Software of the Year. Eduardo Repetto, the Chief Head of Avantis now also prior to that ran DFA. Rocket scientists literally. And Renaissance Technology, that’s all they hire. Our world-class mathematicians. So, who is the sucker at the table you’re trying to exploit? The competition is so much harder, it’s amazing to me how these people on Robinhood, they’re making exactly the same mistake that Day Trader in the TV commercials or Scottrade made in the late 90s.
When they’re trading, do they really think they’re going to outsmart all of these most sophisticated investors in the world who have got not only brilliant minds, but all these resources, computer programs, faster connections? They’re getting exploited on every trade, they don’t even realize that somebody has sold their order flow to a high-frequency trader who’s ripping them off on every trade a little bit.
Is This The End Of Active?
Tobias: Given that is the case and that the paradox of skill seems to indicate that everybody is standing on their tiptoes to see the parade a little bit better, which means that nobody’s seeing the parade any better, is this the end of active?
Larry: Well, let me say it this way. But before we do, there is a fourth theme I just want to touch on real briefly, because this one, I think, is probably adding in. If you go back to ’98 when I wrote my first book, the amount of money in hedge funds was only $300 billion. There’s an interesting paper done by a fellow named David [unintelligible [00:38:45]. He estimated and I have no idea how he did this– he estimated there was about $30 billion of alpha, true alpha that could be captured. So, $30 billion, $300 billion of assets, hedge funds can generate 10% alpha’s gross. Well, and in the five years, they generated 5% alphas, outperformed by 5%. Pretty consistent with that number.
Money, of course, float in. Everyone, “Oh, we want to capture those great returns.” Well, today there’s $3 trillion. Well, take $30 billion and assume that there’s even that amount alpha– as we already discussed, a lot of alpha got converted to beta. But let’s even use that. Well, now you’re down to 1%, you got a hedge fund charge you 2 in 20. You’re already in the hole. And by the way, while the first five years, they outperformed a lot from ’98 to ’02, the next five years, they about broke even, and the next five years, they significantly underperformed, and the last 10, they barely beat one-year treasuries, and underperformed dramatically every major equity asset class, which may not be a fair benchmark, because they may be in bonds and long-short strategy.
When you barely outperform one-year treasuries, obviously, somebody is making money at your expense because you could outperform one-year treasuries by buying one-year CDs and probably get 30, 40 basis points more. It didn’t cost you anything and you took no risks. But I think that trend is over, I think people have seen, now 15 years of horrible performance out of hedge funds. So, that money may stop and may even start to shrink. BNN is at least one of those fads].
To come back to your active question, I think that alpha gets converted into beta. We’re almost at the end of that, but probably never– somebody will figure out something that we missed. But if we’re able to explain 97%, 98% of the variation in returns between diversified portfolios, there’s not much room left, but someone will discover an opportunity. It’ll get exploited, it’ll get published, and it too will then get converted to beta. I don’t see that trend in any way disappearing, but much of it is already over. But the sucker at table, that’s almost inevitably going to continue to shrink, because you have to think about it this way. People are looking at the evidence and seeing active underperforming and it’s getting more difficult, so more people will drop out.
Now, the third is the interesting part. All right, so you have to ask who are these people abandoning active management? Well, I think as human beings, we know it’s not people who’ve been winning the game have recognized, “Gee, this was just lucky. And I’m getting out.” Our egos are too big. There may be a few of those people but we can probably count them on one hand. If you’re outperforming, I’m sure you’re attributing it to your brilliant analysis. So, now who are the people who are dropping out? It could be people who are lucky and then got unlucky. They were lucky and outperformed, got unlucky, figured it out, woke up, they abandon the game. Or people who are unskillful and saw they were losing, they drop out. If it was luck, it will eventually run out, those people leave the game. So, who’s left?
It’s now the first round of a Grand Slam tournament. All the other bad players are dropped out. You’re the 128th round. Now, you’ve got 128 people competing. What happens? You were once able to generate alpha because you were 129th best in the world out of 10,000 managers and millions of investors. But now, you are the worst player left in the game, you’re gone. And so now another 64 drop out, half of them disappear. And then, 32 until you have Warren Buffett competing against Peter Lynch. That would be the ultimate end game, and even there, it’s a zero-sum game.
Now, obviously, we’re not going to get down to those two people. As the number of people leaving, eventually you would see less price discovery and there’d be more opportunity then, but if you have less activity, then trading costs are going to go up. So, it still has to be– Sharpe’s arithmetic has to hold, no matter how many people are there. So, you still need victims to exploit. I don’t think it’s going to matter too much. As long as we have a significant number of researchers, the odds that we outperform are not good.
Let me close with this bit, which is important. 1950s, how many mutual funds do you think they were? And they were all active, there were no passive funds. Today, there are about 10,000 in the US alone, and over 10,000 hedge funds. How many mutual funds do you think there were in the 1950s, Toby?
Tobias: 1000? 500?
Larry: Yeah, it shows you’re obviously sophisticated, one of the most knowledgeable people I know, and you will off by a factor of 10. Less than 100, or about a 100.
Larry: That’s it. And the market was pretty efficient. The first studies done showed that the average investors underperform, even with all those victims. And by ’98, with only 10% of the market passive, 20% were delivered. So, you keep shrinking this pool– I think 90% of the active world based on that could disappear if you had 100 of the smartest people in the world trying to keep markets efficient through price discovery. That would be plenty. Since we have tens of thousands today, I think we’re at least many decades away from anybody worrying about that happening.
The Amount Of Money That’s Active Is Shrinking
Now, I do want to say this. The amount of money that’s active is shrinking, and that has changed the liquidity in the markets. And the advent of the decimal trading and high-frequency traders has virtually eliminated the market maker world. Market makers provided liquidity, and today as I said, DFA is trading everything in 100-share lots. What happens when there’s that little liquidity and you get news or anything unusual? You see unbelievable moves, like we’ve seen in these flash crashes, or anything comes out and prices just– Tesla, 17% moves in one day. We never used to see moves like that. I think that’s something that investors are going to have to learn to live with and accept that we’re going to see more liquidity shocks as more people become passive.
Passive Increases Market Efficiency
Tobias: You say that passive increases market efficiency. How do you figure that?
Larry: Well, there is a research paper that looks at an interesting question about shorting stocks. But let’s talk about this. If you have lots of people who are noise traders and they have limits to arbitrage, then those noise traders influence prices and the markets are less efficient. If those noise traders disappear, by definition, the market becomes more efficient. You have only the smarter, more effective, more knowledgeable players setting prices. You don’t have noise traders. So that number one, I think is the main point. But there’s an interesting point, we know that there are limits to arbitrage and the cost of shorting can be high. And there are lots of institutions that are unable, even by their charters, to go short.
There are cases. I think it was Qualcomm that had a stub that was trading for more than the combined companies, but people couldn’t short it. There was no stock available to borrow. So, what happens is, this research looked at who actually lends securities. And it turns out, it’s the passive index funds who are more aggressive trying to lend because they expect to hold the stock and that they don’t need to call it back in. And if you increase the supply of stock available to borrow, that’s going to lower the cost to shorting because there’s more supply available, and if you lower the cost to shorting, that allows an arbitrageur to come in because it reduces the limits to arbitrage, and make the market more efficient. And that’s what the paper found. I think that both two arguments favor the story that the markets are becoming more efficient and explaining why the percentage of active managers outperforming continues to collapse.
Tobias: What do you think about the thesis that the increasing flows to passive, which tend to benefit the bigger companies, which tend to be more expensive, that will push the prices further away from fundamentals and that’s a self-reinforcing cycle that continues from here until it collapses?
Larry: I don’t buy that at all because it doesn’t do that. If you’re Vanguard’s total stock market fund, and you get a billion dollars in cash flow, how do you deploy it? You deploy it in a market cap fashion, it shouldn’t impact relative prices at all. And what you have to remember, the very simple point is this, passive investors are price acceptors. They accept whatever the market prices. It’s the actions of the active investors who are driving prices, not the passive investors. So, it’s these high-tech stocks are running way up and driving the S&P up, who is it? It can’t be the passive investors because they’re buying Tesla and Microsoft and everything else in a market cap fashion. It’s the active investors, whether they’re the Robinhood investors or whoever they are, acting poor driving the prices.
This whole story is, in my mind, the totally concocted story by active world to try to spin something to say passive is making the world dangerous. It doesn’t make– and by the way, money goes into passive, it may be going into, for example, just a bit, what if all the money went into small value stocks?
Tobias: That’d be great. [laughs]
Larry: Well, you and I would love that right now. Why would that all money going passive mean that high flying tech stocks go up? No, it would mean the small value stocks would go up. So, passive doesn’t just mean the stocks in the S&P 500. It means emerging markets and international. How come we don’t see the same phenomenon? It’s total nonsense, Toby. Why aren’t we seeing the same phenomenon with the EFI and the emerging markets? If that money is just become much more passive also, but those markets aren’t running up? It’s a bunch of garbage concocted by Wall Street to get you to believe that they have a better story to tell. There’s no logic to it.
What Should Individual Investors Do?
Tobias: We’re coming up on time, Larry. What do individual investors do given what you’ve set out so far besides buying your book?
Larry: Buy the book, read it, learn, and implement. What investors make the big mistake is they try to focus on beating the market. What they should focus totally on is managing risks. So, you want to define your life in financial goals. Once you do that, you can then say, “All right, here are my assets, here is my earning power. What rate of return do I need to give me the best chance to reach those goals?” And then, you construct a portfolio around that, but without taking more risk than you have the ability, willingness, or need to take. And then, once you identify which asset classes or factors you want to invest in, you should invest in them in a passive or systematic transparent way.
Now, I’ll give you my three big themes here, Toby, that I think every investor should live by, unless you want to set aside a little entertainment account. Lots of people go to the racetrack, I think that’s perfectly fine, but you can have just as much fun betting $2 or $5 on a horse, you’ll cheer just as hard as if you bid $1000. And no one would take their IRA account to the racetrack or Vegas casino, and you shouldn’t take it to the brokerage office or Robinhood either. So, here are my three principles.
The evidence is overwhelming that the markets are highly but not perfectly efficient. Can you beat the market with skill? Yes, but you’re not likely to do it. If anyone’s likely to do it, it’s people like Renaissance Technology, SAIC Capital, and other people like that, and you’re not going to be able to invest with them in all likelihood. So, if the markets are highly efficient, which is what the evidence shows, then it must follow that all risky assets should have similar risk-adjusted returns. And by risk, I don’t just mean volatility, I mean tail risk, I mean illiquidity risk. If you invest in a rubber plantation in Indonesia, you may not get your money out for 10 years, that better require a maybe 3% risk premium to compensate you for that. So, you have to look at all of these risks.
The third principle follows from the first two. If markets are highly efficient, you must believe that all risk assets should have similar risk-adjusted returns, then you should want to diversify across as many unique sources of risk and return that meet the criteria that Andy Berkin and I laid out and I’m really proud of, it seems to be adopted now, you hear it all the time, that there’s a premium that has evidence of persistence across very long periods of time, pervasive across industry sectors, countries, regions, even asset classes to a bust of various definitions, meaning value works for P/E or EBITDA, to enterprise value, momentum works, whatever the holding period is, and formation period has to be implementable.
So, it doesn’t do any good if there’s a 3% microcap premium and it costs you 5% to trade it. And it has to have intuitive reasons why you think it’ll persist. I prefer risk-based explanations because you can’t arbitrage that away, but I’ll accept behavioral ones if you can show me limits to arbitrage which exists mostly in the smaller stocks, much less so in large stocks.
So, if you have a premium that’s identifiable, and it meets this criteria, why would you want to have all your money in an S&P 500 fund, which has only one risk factor, market beta? I want to diversify that into value, momentum, profitability, quality, and you do that by lowering your exposure to beta and raising it to these other factors. And then, I want to find other asset classes or factors, things like reinsurance or the variants risk premium, real estate, whatever it might be, infrastructure, whatever. If you can identify premiums, then you should diversify.
There’s nothing new here. Ray Dalio, All Weather Portfolio, risk-parity, these are all terms people use, and it’s the way the Harvards or the Yale have been investing for decades. They don’t have 60/40. They’re more like 20% to 30% in equities, and then broadly diversify in, of course, these other asset classes, so they dampen the volatility of their portfolio, which is really important, especially for retirees. So, I think the 60/40 S&P 500, 40% treasuries is dead, if you will, and you should want to diversify.
But I’m not a huge fan of risk parity except directionally, and here’s why. It’s my last point. You need to have faith in what you’re investing in. So, if you don’t understand or are not comfortable with the– call it reinsurance. Global warming is going to destroy the business and etc. Okay, well, then don’t invest in reinsurance because every single risk asset class goes through long periods of underperformance and you will be tempted to bail out. “Oh, I knew it. I’m getting out.” I’m a big believer in values. So, I have a big tilt in my portfolio.
I have as much exposure to value as I do to market beta. Not more, because I think they’re pretty equal. I have confidence in both. But if you have less confidence than me, then tilt less. You have no confidence, then you have to accept that you have a much more concentrated portfolio. And just as a reminder, the S&P 500 has underperformed totally riskless treasury bills to three periods of at least 13 years. ’29 to ’43 at 15, ’66 to ’82 at 17, and 2000 to ’12, at 13. That’s 45 of the last 91 years, you were not rewarded for taking risk. That to me is a great example of why you should believe in a risk parity type of portfolio but make sure you’re invested in the things that you’re comfortable with. and just accept that at some point… of your portfolio isn’t doing miserable, then you’re probably not diversified enough. Don’t complain about it. That’s what we’re doing. We’re diversifying as insurance against having all our eggs in the one wrong basket called market beta.
Tobias: That’s great. That’s really helpful. Thanks very much. Larry Swedroe, author of The Incredible Shrinking Alpha, best title and best cover I’ve seen on a finance book in a long time.[laughter] Larry: Thanks, Toby. That whole strategy that we just walked through is explained in the 2018 edition of Reducing the Risk of Black Swans, for those investors who are interested in learning more. That book goes into great detail. But then you have to accept, for example, while value dramatically outperformed from 2000 through ’16, now you’re getting value underperforming, but your market beta is doing well and other parts of your portfolio may be doing well. You have to be willing to live with fairly long periods of time. And I’ll conclude with this last warning.
The Biggest Mistake Investors Make
I think the biggest mistake investors make is when it comes to judging performance, and whether it’s a manager or a risk asset, they think 3 years is a long time, 5 years is a very long time, and 10 years is like infinity. You and I and all finance professionals know 10 years is likely noise. Trend following has been a great strategy over the very long term. The last 10 years, it was miserable. You go back one year to include ’08, and it looks great again.
That shows you that you need discipline and patience. Value’s going through its bad period, it went through a similar one in the late 90s, it went through two similar ones in the 30s. It will happen again, but it’s also happened to the S&P 500 market beta, emerging markets, international growth, real estate, gold, doesn’t matter, it happens to them all, which is why we don’t run away from risk. We diversify it.
Tobias: Well said. Thanks very much, Larry Swedroe. Thank you, sir.
Larry: My pleasure.
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