A trader working after the Nasdaq opening bell ceremony on April 18, 2019 in New York City.
Kena Betancur | Getty Images
Stock picking has a terrible track record, and it’s getting worse.
That’s the thesis of Larry Swedroe and Andrew Berkin’s book, “The Incredible Shrinking Alpha,” just out in its second edition.
Swedroe is chief research officer for Buckingham Wealth Partners and author or co-author of 18 investment books.
I spoke with Swedroe as he was preparing the book for publication. Below are edited excerpts from our conversation.
How bad is active management?
It’s bad and it’s getting worse. Every year, S&P Dow Jones Indices does a study on active versus passive management. Last year, they found that after 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent are trailing the index.
Your main thesis is that most active managers underperform their risk-adjusted benchmarks. How come so few fund managers beat the market?
There are several reasons. First, active stock picking is based on a false notion — that the market is somehow mispricing stocks. The evidence is that the market is highly, though not perfectly, efficient — available information is digested rapidly and reflected in market prices. Stock pickers can’t identify underpriced stocks with any regularity.
Second, the supply of capital chasing performance has dramatically expanded in the past few decades. In the 1950s, there were fewer than 100 mutual funds and only a few hedge funds. Today, there’s more than $3 trillion in hedge funds and a lot more than that in mutual funds. That’s a lot of money chasing performance, even with the economy expanding.
Third, the pool of victims has been collapsing. If you go back 60 years or so, 90% of all stocks were bought by people like you and me. Today, that number may be 10%. And investors are increasingly putting their money into index funds that just mimic the overall market.
We know from all the research that retail money is dumb money on average. The research shows that on average, the stocks they buy go on to underperform after purchase and the stocks they sell go on to outperform. And now there are fewer dumb investors to take advantage of.
What about the Buffetts?
So how do you explain the small group of superstar investors who do outperform — the Warren Buffetts of the world?
There is a small pool of superstar investors, but it has become a lot easier to replicate what few successful strategies there are. Academics have become very good at figuring out what is working and what is not when it comes to stock picking. For example, Warren Buffett is a famous stock picker. His record has been very carefully examined. Turns out, the main reasons for his success are twofold: He buys companies that are cheap and are very high quality. By “high quality,” I mean they have low debt-to-equity ratio, low earnings volatility, high margins, and high asset turnover.
Stocks with these characteristics have tended to do well because they have a competitive advantage in general. For Buffett, it’s the overall strategy that works, not the stock-picking skills. That, along with the discipline to stay the course, never engaging in panic selling, along with the leverage provided by his insurance companies, explains the success of his holdings in public companies.
In the past, executing that strategy — buying high quality stocks that are cheap — used to require a lot of work. But today, you can replicate a lot of this with an ETF at a very low price. You don’t need to hire Warren Buffett or pay a hedge fund manager a 2% fee and 20% of the profits. That doesn’t take anything away from the fact that Buffett is a great manager who was doing this decades before the academics uncovered his secret sauce.
That strategy would be called “quality” combined with “value.” Buffett made money on that strategy for decades. Is it not possible to make money on that strategy now?
Yes, but it’s easy for anyone to access that strategy now using mutual funds and ETFs, and the cost of implementing passively manage strategies is getting close to zero. For example, you can buy the Fidelity Total Market Index Fund (FSKAX) for just 15 basis points. And you can also buy the iShares Quality ETF (QUAL) for the same 15 basis points.
You note in your book that even Warren Buffett has had trouble generating outsized returns.
Yes. Over the last 15 calendar years ending in 2019, Berkshire Hathaway returned 9.4% annually, slightly outperforming Vanguard’s Total Stock Market Fund (VTSAX), which returned 9.1%. In the prior 20 years, 1985-2004, Berkshire outperformed the S&P 500 by more than 10 percentage points per year, 23.5% versus 13.2%.
There’s a broader problem: Any time there is a trend, it tends to be eliminated by competition among investors for higher returns.
So being the first to find that strategy is what matters?
If you want to get that yacht, yes. After that, if the strategy is successful, everyone copies you and it gets progressively more difficult to get outperformance.
Other successful strategies
You said Buffett was successful because of his value and quality strategy. Are there any other strategies that have proven successful?
In addition to value and quality, there is evidence that size (small cap tends to outperform large cap) and momentum are also useful strategies. By momentum, I mean the average return of the top 30% of stocks versus the bottom 30% of stocks. But once again, you can buy these factors using low-cost ETFs. There is no reason to pay a manager high fees to do it.
You’re saying that even that small group of managers who outperform produce most of their outperformance not from picking stocks (alpha), but from investing in broad styles?
Yes. Years ago, some people figured out that if you tilted a portfolio toward small caps, or toward value, you could produce some outperformance. But these investors weren’t producing much alpha — they weren’t picking stocks — they were picking investment styles, what we call factors today. These factors can now be replicated cheaply, and the more people pile into them, the less effective they will become.
Again, this does not detract from the originality of the work of superstar investors like Warren Buffett and Benjamin Graham and David Dodd. The point is that the available pool of alpha — true outperformance — is shrinking as the market evolves.
Is this true of all investing strategies? For example, growth stocks — mostly tech stocks — have outperformed value stocks for the better part of a decade. Will that strategy eventually fail to outperform as well?
Yes. All risk assets go through long periods of underperformance. If that were not true then there would be no risk for long-term investors. Most investors would be shocked to learn that the S&P 500 has underperformed riskless one-month Treasurys for three periods of at least 13 years (1929-1943, 1966-1982, and 2000-2012). This means long-term investors must be disciplined. Diversification is your friend protecting you from having all your eggs in the wrong basket.
Robinhood and the ‘dumb money’
You say the pool of victims is collapsing. Who’s replacing the dumb money?
Smarter money. Institutional money. They are trading with each other. Today’s active manager is more highly skilled than their predecessors. As the competition has gotten tougher, it’s tougher to generate outperformance.
Who are you talking about when you say “dumb” money? And why is a pool of “dumb” money so important for active managers?
Active managers need victims they can exploit, and that usually means retail investors. The research indicates on average active retail investors underperform their benchmarks, even low-cost index funds, even before costs or taxes.
Why is that?
One reason is they trade too much. But they also exhibit really perverse stock picking. They tend to buy stocks that have sub-par returns and they sell stocks that go on to earn above-average returns.
Is that what Robinhood investors are likely doing?
I have no doubt some are doing well as momentum traders. But they are not picking stocks — they are playing momentum without any real knowledge of what these companies are doing. They don’t have an edge, and experience tells us that this ends badly. The ones making the real money are the people on the other side — that’s why high-frequency trading firms are so eager to get their order flow. One way Robinhood makes money is by selling its order flow. They are now being investigated for failing to adequately disclose this to investors.
It’s so easy to trade stocks on your phone now, it’s almost like stock trading is a proxy for sports betting.
Yes, this kind of betting activity lights up the same part of your brain that gets lit up when you are sitting in front of slot machines.
Why even the best managers don’t beat the market long-term
So why not just buy those few fund managers that beat the market?
The big mistake everyone makes is they assume the future will look like the past. It doesn’t. Past performance of active managers does not indicate future performance. It has no predictive value.
Why is that?
It’s likely because of mean reversion. In the long run — and I am talking over decades — everything tends to smooth out. Institutional investors will typically fire a fund manager who outperforms after three years and hire someone who has been outperforming. Studies indicate this is a bad strategy — you’re essentially buying a fund manager who has expensive holdings because he or she has been outperforming, and firing the manager who has cheaper holdings.
So you’re buying high and selling low. The opposite of what you’re supposed to do.
And the few managers that outperform — it’s all because of luck?
I don’t doubt that some managers have stock-picking skills, but yes, for those who outperform it’s mostly a matter of luck. And the ones who are successful see increased cash flows that creates the seeds of destruction for future outperformance.
Do high-speed traders beat the market?
Where does high-speed trading and quantitative analysis fit in? In its most simplistic form, quantitative analysis seeks to profit from relationships between numbers — there may be a relationship between, say, the wheat crop in Nebraska and the S&P 500 that is statistically valid. Is there any evidence that quantitative analysis produces alpha?
The track record of Renaissance Technologies shows that high frequency trading can generate alpha by exploiting what might be called micro-inefficiencies in the market. Firms like them are extracting profits from the rest of investors. And individual investors when they trade are likely facing firms such as Renaissance on the other side. They should be asking who the sucker is in that trade.
Will passive investing rule the world?
Don’t we still need active management to pick stocks? What happens if we all just become index investors?
Today about 50% of the market is in passive investments. As the trend to passive continues, the remaining players are more and more skillful. I think that the percentage of passive investing can get much higher, likely to 90%, and there would still be enough active traders to make the market efficient.
There are investors who work to keep the market efficient. For example, if a stock price was perceived to be too expensive you would see more IPOs and secondary offerings by companies raising cheap capital. And you would see more companies using their stock to buy up other companies. If prices were perceived to be too low you would see more stock buybacks, acquisitions, and private equity taking companies private.
For example, if Tesla goes way up, the company could take advantage of that by issuing a lot of new shares, which would likely push prices down.
Why stock picking still survives
If the evidence does not support active stock picking as a strategy, how come it’s still so popular?
It’s not — the public is finally catching on. Though the trend is slow, the amount of money going to active stock management has been declining for more than two decades.
The main issue is that Wall Street is engaged in a propaganda war. Wall Street wants you to believe active management works so you’ll pay them the high fees. It is not in the business interest of the financial advice industry to recommend passive strategies. The financial press goes along with this because promoting the latest stock predictions from Wall Street gurus makes for a good story. It doesn’t help that most investors have very little financial education and don’t understand anything about investing, so it’s easy to prey on their ignorance.
Here’s what investors should do
What should investors do? Is relying on active management really a loser’s game, as Charlie Ellis described it in his famous book, “Winning the Loser’s Game?”
For starters, write an investment plan that is based on your unique ability and ability to take risk. I discuss how to do this in my other book, “Your Complete Guide to a Successful and Secure Retirement.” And then write that plan down, sign it, and stay the course, only rebalancing along the way. And ignore the noise of the market.
Most investors are better served owning low-cost index funds like the S&P 500 and the Russell 2000 and not bothering to pay an active manager a higher fee to pick stocks or funds. They don’t need to own 50 mutual funds or ETFs to have a broad portfolio.
How many do they need?
You could do it with as few as three investments. You need a broad U.S. stock fund. You need a broad international fund. And you need to own bonds. For taxable accounts I recommend owning certificates of deposit. With CDs you get better returns than Treasurys with a lot less risk than owning bond funds. And there is no cost!
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