(Last Updated On: 12/05/2017)

We want to start this post by understanding Alpha.

Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole.

That ‘investment’ could be an actively-managed fund or stock picking or trading using the principles of value investing, with or without technical analysis.

The excess returns of an actively managed fund or stocks picking strategy relative to the return of a benchmark index is the fund’s alpha.

The “conventional wisdom” has always been that Warren Buffett’s success can be explained by his skill in picking stocks which are below its intrinsic value, his contrarian approach and his ability to keep his head while others are becoming emotional.

However, the 2013 study” Buffett’s Alpha,” authored by Andrea Frazzini, David Kabiller and Lasse H. Pedersen, revealed a differing perspective. The authors found that, in addition to benefiting from the use of cheap leverage provided by Berkshire’s insurance operations, Warren Buffett bought large cap, high-quality stocks when they cheap (undervalued). The most interesting finding in the study was that stocks with these characteristics tend to perform well in the long term, not just the stocks with these characteristics that Buffett buys.

High-quality companies have the following traits: low earnings volatility, high margins, high asset turnover (indicating efficiency), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk) and low specific stock risk  (volatility unexplained by macroeconomic activity). Companies with these traits have historically provided higher returns, especially in market slump.

In other words, it is Warren Buffett’s strategy, or exposure to these factors, that explains his success, not his stock-picking skills. Andrea Frazzini and Lasse H. Pedersen, the authors of the 2014 study “Betting Against Beta,” found that once all the factors—market beta, size, value, momentum, betting against beta, quality and leverage are accounted for, a large part of Buffett’s performance is explained, and his alpha is statistically insignificant.  

Again, it is crucial to understand that this finding doesn’t detract in any way from Warren Buffett’s performance. After all, it took decades for modern financial theory to catch up with him and discover his “secret sauce.” And being the first, or among the first, to discover a strategy that beats the market is what will make you rich, not copying the strategy after it is already a mass knowledge.

With that said, the findings do provide insight into why Warren Buffett was so successful

His genius appears to be in recognizing long ago that these factors work. He applied leverage without ever resorting to a panic selling and stuck to his investing principles.

Buffett himself stated in Berkshire’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”

The case of Peter Lynch

Secondly, it is worth considering the case of Peter Lynch, generally considered the greatest mutual fund manager of them all. Lynch joined Fidelity in 1966. However, it was not until 1977 that he was given responsibility for the Magellan Fund, which was not even available to the public until mid-1981. Prior to that time, it operated as the private investment vehicle of the Johnson family, Fidelity’s founders.

From mid-1981 through mid-1990, Lynch outperformed the S&P 500 Index by 6 percentage points per year (22.5 percent versus 16.5 percent). Lynch started with about $100 million under management, but ended up running $16 billion.

The original small-cap fund not only had become a large- cap fund, but it also eventually owned 1,700 stocks. While Lynch did generate alpha, even over the latter part of his career, the margin of his outperformance narrowed, just as we should expect. Over the last four years, Magellan managed to beat the S&P 500 Index by about 2 percent per year.

Still a good performance, although not quite as legendary and one that might be explained by random good luck. Perhaps Lynch purposely retired from managing the fund in 1990 before the game was up and market forces caught up with him. He may have realized that—because of the market’s efficiency and hurdles to outperformance made higher by closet indexing, market
impact costs and the other burdens of active management, the odds of his continuing success were not very good.

Why not go out on top? While we will never know how Lynch would have done if he had continued to run Magellan, his carefully handpicked successors all failed to deliver alpha.

The case of John Bogle

Let’s also talk about John Bogle founded The Vanguard Group, now the largest mutual fund company in the United States. He started the First Index Investment Trust, later renamed the Vanguard 500 Index Fund, in December 1975.

The following June, a very prescient story appeared in Fortune: “Index Funds: An Idea Whose Time is Coming.” It concluded: “Index funds now threaten to reshape the entire world of money management.”

Philosopher Arthur Schopenhauer said that all great ideas go through three stages.

In the 1st stage, they are ridiculed.

In the 2nd stage, they are strongly opposed.

In the 3rd stage, they are considered to be self-evident.

This was certainly the case for Bogle’s experiment.

When it was launched, his index fund was ‘crucified’ by the mutual fund industry.  Fidelity’s then chairman, Edward Johnson, assured the world that the company had no intention of following Bogle into index funds when he stated: “I can’t believe that the great mass of investors are going to be satisfied with receiving just average returns.” Another fund manager, National Securities and Research Corp., categorically rejected the idea of settling for average. “Who wants to be operated on by an average surgeon?” they asked.

And that refrain that indexing and passive investments in general will get you only average returns became one of the big lies told by Wall Street.

 

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What Ray Dalio said

And lastly, let’s talk about Ray Dalio, an American investor, hedge fund manager and philanthropist. Dalio is the founder of investment firm Bridgewater Associates, one of the world’s largest hedge funds with over $ 150 bil asset under management.

The screenshots below from Business Insider articles are self-explanatory

Ray Dalio on beating the market

 

 

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Footnotes:
The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches by Andrew L. Berkin and Larry E. Swedroe

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