Is This The End Of Active?

During his recent interview with Tobias, Larry Swedroe, author of The Incredible Shrinking Alpha discussed Is This The End Of Active?. Here’s an excerpt from the interview:

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.

Tobias: Really?

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.

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.