Chief Research Officer at Buckingham Strategic Wealth
“What I’ve learned in 25 years of working with both individual and institutional investors is that when it comes to judging the performance of a strategy, they think three years is a long time, five years is a very long time and 10 years is an eternity. We know that's true, not just based on anecdotal evidence, but also on investment flow patterns and studies on pension plans and endowments.”
“I’ve sat on the boards of public companies and their investment policy committees for their pension plans. And they typically have a three-year cycle to evaluate a fund. And I've even seen them hire and fire passively managed funds after three years, when the whole purpose was just to match the benchmark.”
“Financial economists, on the other hand, take a very different view. They would view even 10 years as likely nothing more than noise, when gathering the necessary evidence to be able to consider a factor premium – using the language I use in my book on factor investing – persistent, pervasive, robust, implementable, and intuitive.”
“The best example I can cite is that you can ‘data-mine’ and find a 40-year period, from 1969 to 2008, during which small and large cap growth stocks underperformed long-term US Treasuries. That's 40 years you'll look back on, and you had much higher volatility and lower returns. So, are you now going to abandon your belief in investing and market beta? I would hope not.”
“We know that all factor-based investment strategies go through long periods of poor performance, and should be expected to, just by the simple math of looking at the premium and the standard deviation of that premium. The odds are always there, over a 20-year period for the equity premium. Japan is a perfect example: we're now 30 years out with no market premium.”
It should be absolutely no surprise that people are saying value is dead
“So, it should be absolutely no surprise that people are saying value is dead. We already heard this in the 1990s, when people were making fun of Warren Buffett and saying: ‘You know, he's just an old fuddy duddy’. Then, of course, in 2000 we began one of the largest runs for value ever.”
“I wouldn't say no risk. But I would say it this way: some factors, like momentum and quality, are basically behavioral stories. You can't make a solid argument to me – at least, I haven't heard one – that these are risk factors. But then you have other factors, like small and value, that tend to have at least some risk-based explanations, and you can't arbitrage risk away. Now cash flows coming in after discovery and publication in academic journals can lead premiums to shrink, but you can never arbitrage the risk away.”
“Some years ago, I co-authored a book titled The Incredible Shrinking Alpha. In that book, we laid out the case that active managers’ ability to deliver alpha is rapidly deteriorating and will continue to deteriorate.”
“When Charles Ellis wrote his book, Winning the Loser's Game, 20 years ago, around 20% of active managers were generating statistically significant alpha. In recent years, that number has come down to 2%, or less. And all the trends we see lead us to believe things are only going to get tougher for traditional active managers. I think their problems really come from three big issues.”
The first issue is that the academic world has been converting what was once alpha into beta. Things such as value, size, quality or low volatility investing were once considered hedge fund-type of active strategies. As an active manager, you used to be able to claim alpha if you were exposed to low volatility, value, momentum or quality. And now you can't. We know it's just factors.”
“The second issue is that, for example, when I got out of school after my MBA program, trained to be a security analyst, there were only very few of us. I was one of the first people in the late ‘60s, early ‘70s to take a corporate finance program. Before that, you had to turn to accounting or economics, because there was almost no field of finance until basically the mid to late ‘60s, when the CAPM was made available.”
“The third issue is that 70 years ago, 90% of trading was done by dummy retail investors. Now it's 10% at best. So, who's left to exploit? You’ve got to exploit a dummy. Now, when Goldman Sachs trades, they are probably trading against Robeco. Well. I don’t know who’s smarter. If somebody is trading with you, both of you can’t be right even though you're both smart.”
Significant benefits can still be added through intelligent design
“Of course, I believe some significant benefits can still be added through intelligent design, which can provide higher loadings on factors. Also, I think all public indices, except total market indices, are certainly dumb. So you shouldn’t index because you trade off a goal of tracking error, minimizing it for a higher trading cost, for example, or being set up to be exploited by arbitrageurs. So here’s where intelligent design can add some value on the margins, I believe.”
“I mostly use the SSRN website, to see if there's anything I'm interested in reading. I check it pretty much every day unless I'm travelling. Then I'll read research and determine if there's anything that others would be interested in reading. And the skill that I bring to the table is the ability to take a 70-page dense academic paper and turn it into something that's much more readable, that explains the research and its implications for investors.”
This article is an excerpt of a longer interview.
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