The Incredible Shrinking Alpha 2nd edition

How to be a successful investor without picking winners

Larry E. Swedroe, Andrew L. Berkin

• Publisher: Harriman House
• Year: 2020
• eBook ISBN: 9780857198259
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Active managers persistently lag the returns of benchmarks and index funds that track them, with the excuses for underperformance recycled every year. This comprehensive book is the antidote for the active managers' siren song. If you understand the benefits of indexing, or systematic investing, it will reinforce your commitment while increasing your knowledge. If you don't yet believe, Swedroe and Berkin provide a compelling case that you're playing the loser's game of active management. Alpha, or outperformance against appropriate risk-adjusted benchmarks, is shrinking as it gets converted into beta, or factor exposures. They demonstrate that even for the most talented managers, their ability to add value is waning because: the amount of alpha available is declining; it must be split among an increasing amount of investment dollars; and the competition is getting tougher. In this greatly expanded second edition, Swedroe and Berkin show you how to develop an investment plan that focuses on what risks to take, and how much of them, as well as how to build a diversified portfolio. They present a list of vehicles to consider when implementing your plan and provide guidance on the care and maintenance of your portfolio. As a bonus they add appendices that will make you a more informed and, therefore, better investor. This makes The Incredible Shrinking Alpha a complete guide to successful investment strategy.

Chapter 1: The Quest For The Holy Grail: What Was Once Alpha Becomes Beta

According to legend, the Holy Grail was the dish, plate or cup used by Jesus at the Last Supper. It was believed to possess miraculous powers. Legend has it that the Grail was sent to somewhere in what is now Great Britain, where several guardians keep it safe. The search for the Grail is an important part of the legend of King Arthur and his court.

The financial equivalent of the quest for the Holy Grail is the quest for money managers who will deliver alpha, defined as returns above the appropriate risk-adjusted benchmark. For the vast majority of investors, the quest for alpha has been a frustrating one, marked by far more failures than successes. Larry’s 2011 book, The Quest for Alpha: The Holy Grail of Investing, presented the evidence on the failures of most individual investors, mutual funds, pension plans, hedge funds and venture capitalists to generate alpha over the long run. Unfortunately, as we hope to demonstrate, for those still engaged in that quest, the hurdles to achieving alpha are getting higher and higher—the already low odds of success are persistently shrinking.

We’ll begin our story with a discussion of the history of asset pricing models and the important role they play in the quest for alpha.

Asset pricing models

Building on the work of Harry Markowitz, the trio of John Lintner, William Sharpe and Jack Treynor are generally given most of the credit for introducing the first formal asset pricing model, the Capital Asset Pricing Model (CAPM). It was developed in the early 1960s.

The CAPM provided the first precise definition of risk and how it drives expected returns. Asset pricing models such as the CAPM allow us to understand whether an active manager who outperforms the market has generated alpha, or whether that outperformance could be explained by exposure to some factor.

This is an important issue because active managers charge relatively high fees for the “promise” of alpha. If their outperformance can be explained by exposure to one or more factors—also often referred to as beta, or loading, on the factor—there was no actual outperformance, or alpha, on a risk-adjusted basis. If that is the case, the high fees charged by active managers can no longer be justified.

Exposure to various factors can be obtained in a less expensive way through lower-cost vehicles, such as index mutual funds and exchange-traded funds (ETFs). In other words, if an active manager’s above-market performance was due to loading on certain factors, investors paid a high price for alpha but actually received beta. And that exposure can be obtained more cheaply.

The CAPM: A one-factor model

The CAPM looks at risk and return through a “one-factor” lens—the risk and the return of a portfolio are determined only by its exposure to market beta. This beta is the measure of the equity-type risk of a stock, mutual fund or portfolio relative to the risk of the overall market. The CAPM was the financial world’s operating model for about 30 years. However, like all models, it was by definition flawed.

Models are not like cameras that provide a perfect picture of the world. If models were perfectly correct, they would be laws, like we have in physics. Instead, models are engines that advance our understanding of how markets work and prices are set. Over time, anomalies that violated the CAPM began to surface.

In 1981, Rolf Banz’s “The Relationship Between Return and Market Value of Common Stocks” found that market beta doesn’t fully explain the higher average return of small stocks. In 1983, Sanjoy Basu found that the positive relationship between earnings yield (E/P) and average return is left unexplained by market beta. And in 1985, Barr Rosenburg, Kenneth Reid and Ronald Lanstein found a positive relationship between average stock returns and book-to-market ratio (B/M) in their paper, “Persuasive Evidence of Market Inefficiency.” The last two studies provided evidence that, in addition to a size premium, there also was a value premium.

The Fama-French three-factor model

The 1992 paper “The Cross-Section of Expected Stock Returns,” by Eugene Fama and Kenneth French, basically summarized and explained these anomalies in one place. The essential conclusion from the paper was that the CAPM explained only about two-thirds of the differences in returns of diversified portfolios, and that a better model could be built using more than just the one factor. Fama and French proposed that along with the market factor of beta, exposure to the factors of size and value explain the cross-section of expected stock returns (how average returns vary). Thus, there were three factors in the Fama-French model.

The Fama-French model greatly improved upon the explanatory power of the CAPM, accounting for more than 90 percent of the differences in returns between diversified portfolios. From 1927 through 2018, the annual average premiums were:

• Beta—defined as the average return of the total U.S. stock market minus the return of one-month Treasury bills: 8.3 percent
• Size—defined as the average return of the smaller half of stocks minus the average return of the larger half: 3.2 percent
• Value—defined as the average return of the highest 30 percent of stocks as ranked by B/M minus the average return of the lowest 30 percent: 4.7 percent

Prior to the development of the three-factor model, actively managed funds could produce higher returns than a benchmark, such as the Russell 2000 Index or the S&P 500 Index, by “tilting” their portfolio to either small stocks or value stocks, thus giving them more exposure to the size and value factors than the benchmark index. The fund would then claim that its outperformance was, in fact, alpha. Today, regression analysis would show that their outperformance was simply the result of a greater exposure to certain factors. In effect, what once was alpha had now become beta, or what is referred to as loading on a factor, which could be purchased in a less expensive way.

With the inclusion of the value premium the three-factor model went a long way toward explaining the superior performance of the superstar investors from the value school of Benjamin Graham and David Dodd. The anomaly these investors presented became less as alpha transformed into beta (loading on factors). Of course, this shouldn’t detract from how we should view the ingenuity of their work. After all, they employed these strategies before factors were added to the model. However, we aren’t yet done in shrinking alpha.

Adding momentum—the four-factor model

In 1997, Mark Carhart’s study “On Persistence in Mutual Fund Performance,” was the first to use momentum, together with the Fama-French factors, to explain mutual fund returns. Momentum was initially published by Jegadeesh and Titman in 1993 (who called it relative strength) and here is defined as the last 12 months of returns, excluding the most recent month. The momentum factor is the average return of the top 30 percent of stocks minus the average return of the bottom 30 percent as ranked by this measure. This new momentum factor made another significant contribution to the explanatory power of the model. For the period from 1927 through 2018, the annual average return to the momentum factor was 9.2 percent.

Since 1998, the four-factor model has been the standard tool used to analyze and explain the performance of investment managers and investment strategies. And once again, alpha had become beta—or loading on a factor—as the way to explain returns. Again, it is important to remember that this doesn’t take away anything from the active managers who were exploiting the momentum factor before academics added it to the model.

A recent contribution to the model, and one that helps further explain Warren Buffett’s superior performance, is from Robert Novy-Marx. His 2013 paper, “The Other Side of Value: The Gross Profitability Premium,” provided investors with new insights into the cross-section of stock returns. Novy-Marx found that profitable firms generate significantly higher returns than unprofitable ones, despite having significantly higher valuation ratios.

Controlling for profitability, here defined as revenues minus cost of goods sold divided by assets, increases the performance of value strategies, particularly when value is defined by book-to-market. The most profitable firms have earned average annual returns that are 3.7 percent per year higher than the least profitable firms. This idea has been extended to a quality factor, which captures a broader set of quality characteristics. In particular, high-quality stocks that are profitable, stable, growing and have a high payout ratio outperform low-quality stocks with the opposite characteristics...

Table of contents

• Contents
• About the Authors
• Chapter 1: The Quest For The Holy Grail: What Was Once Alpha Becomes Beta
• Chapter 2: The Pool Of Victims Is Shrinking
• Chapter 3: The Competition Is Getting Tougher
• Chapter 4: Is The Market For Alpha Overgrazed?
• Chapter 5: Why Do Investors Ignore The Evidence On Actively Managed Funds?
• Chapter 6: What You Can Do
• Chapter 7: Asset Allocation
• Conclusion
• Appendix A: Does Indexing/Passive Investing Get You Average Returns?
• Appendix B: Active Management: The Odds Of Achieving Portfolio Alpha
• Appendix C: The Value Of Security Analysis
• Appendix D: The Performance Of Active Managers In Bear Markets
• Appendix E: For Actively Managed Funds How Long A Track Record Is Enough?
• Appendix F: Should Investors Prefer Dividend-Paying Stocks?
• Appendix G: Are Professional Investors Prone To Behavioral Biases?
• Glossary
• References
• Publishing details