“Evidence Based Portfolios”
You don’t know what you don’t know. It’s the part of the iceberg under the water. Continuing with our series on the Science of Smart Investing [excerpted from ThinkAdvisor]
Part 3: Evidence-Based Portfolios
In the recent book “The Incredible Shrinking Alpha”, Larry Swedroe, director of research for Buckingham Strategic Wealth, and his co-author Andrew Berkin, director of research at Bridgeway Capital Management, lay out the convincing argument that the investment industry spends far too much time chasing any hint of Jensen’s alpha (a measure of performance on a risk-adjusted basis above a fund’s benchmark) and not enough time paying attention to science.
This point has also been made by Eugene Fama’s frequent co-author Ken French, professor of finance at Dartmouth. In a 2008 presidential address to the American Finance Association, French estimated that over $100 billion is spent chasing elusive returns that cannot be explained by beta.
Swedroe and others point out that the actual alpha that can be captured by skilled investors is just a fraction of this amount. French estimates that 0.67% of the total stock market value is lost each year by investors who can’t let go of the active management story.
It appears that the ability to instantly make low-cost trades coupled with the remarkable flow of new information have further driven down opportunities for exploiting market mispricing. If it costs less than 10 basis points to fully capture beta, then fund managers needs to earn their keep if they are charging an additional 50 or 100 basis points to manage assets. [This is referring to actively managed mutual funds in the retail fund space.]
In other words, you could pay a fund manager $1,000 on a $1 million portfolio to capture beta. If you pay an additional $9,000 for something extra, is that a good investment? You’ve made a $9,000 bet on the story of managerial skill and you’re hoping for a good return on that bet. The science says that this is a sucker’s bet. A manager may have had a few lucky years where they’ve been able to justify their extra costs, but there is no evidence that even the star fund managers are able to consistently earn their keep.
Evidence (or research) does say that fund managers should follow the research and identify factors that provide return above beta. This was the philosophy of David Booth, also a student of Eugene Fama, who created an investment management company that hoped to exploit some of the newly identified factors, or dimensions, of stocks that provide a higher-than-average return. His fund company, Dimensional Fund Advisors, ended 2016 with $460 billion in assets by following the evidence-based investing philosophy. [There are now several portfolio managers that are using this research to benefit their clients.]
How then do evidence-based investment portfolio managers earn their keep? First, they need to be aware of the evidence. Dimensional recently added a new factor — profitability — to capture a firm characteristic that has historically predicted higher returns. Profitability is found on the income sheets of companies. [I hear you accountants out there… like ‘Duh! Where else would you find that?’ It just took a while to build it into the algorithms.]
Research is constantly unearthing potential new factors. Being skeptics, scientists test (and often reject) these factors using data from various time periods and countries outside the United States. Evidence-based investing requires that advisors pay attention to the current state of knowledge in financial economics. Recent studies have unearthed the potential value of investing in funds that invest in low volatility securities, low-beta stocks, or even leveraged bonds.
In many cases, once a factor has been identified, its ability to predict higher performance appears to go away. The small stock effect has largely disappeared since it was identified by scientists as more traders over-weighted small cap within their portfolios. [However, as my first email in this series would indicate, small is still big when it comes to returns, as a class of assets.]
For us advisors who are interested in exploring the newest investing research coming out of academics, there aren’t a lot of resources. Of course, there are academic journals and conferences, if you’re open to being a serious student of the research and its applications. And if it’s challenging for us, do you think you can keep up with and implement it on your own? The evidence, as demonstrated by DALBAR’s research on equity investor returns over the years, says no.
Next week: The Benchmark Problem.
Looking forward to seeing many of you at the event on Friday, May 12th at Manor Hill!