There is overwhelming evidence showing traditional active management is a losing strategy, but investors of all kinds still use it.
In this week’s episode, I’m joined by Dr. Andrew Berkin, author of The Incredible Shrinking Alpha: How to Be a Successful Investor Without Picking Winners.
Listen now and learn:
- Why it’s difficult to outperform the market
- Why the opportunity to outperform is shrinking
- Clear strategies to help you improve your likelihood of success
Listen Now
Show Notes
Andrew Berkin, Ph.D., is head of research and oversees the development and implementation of Bridgeway’s statistically driven, evidence-based efforts.
Not only has Andrew published articles in peer reviewed journals, he is a reviewer for and served on the editorial board of the Financial Analysts Journal. Andrew earned his Bachelor of Science with honors in physics from the California Institute of Technology and a Doctor of Philosophy in physics from the University of Texas.
The reason I asked Andrew to join me for this episode is to discuss one of his two books, The Incredible Shrinking Alpha: How to be a successful investor without picking winners.
This is one of the books I give out most, particularly when someone wants to know why stock picking and active management is a loser’s game, so I was thrilled when Andrew asked me to endorse the second edition in 2020.
Here is what I said in the book:
There is overwhelming evidence showing traditional active management is a losing strategy, but the allure of alpha still attracts investors of all kinds. Berkin and Swedroe clearly and succinctly describe why the pursuit of alpha is unlikely to help you achieve your goals and offer strategies to improve the likelihood of success.
Peter Lazaroff, CIO of Plancorp and author of Making Money Simple
I hope you enjoy our conversation. Here are some of my notes.
What is Alpha? (1:10)
Alpha is basically outperformance of a fund. But not just any old outperformance, it’s outperformance versus a specific, appropriate risk-adjusted benchmark.
So alpha is not just, say, your stocks in a given fund are outperforming the S&P 500 or doing great — it’s understanding what appropriate risks are being taken by the fund and what’s appropriate to compare it to. And that’s why the importance of risk adjustment really comes in.
Why People Actively Manage Their Investments (3:04)
It’s very difficult to capture alpha, and available alpha is shrinking. Nonetheless, people are still seeking it out.
Why? Andrew suggests the reason is not all that different from why people play the lottery or gamble at casinos even though they know the odds are against them.
For starters, people don’t want to settle for average and believe people can do better. In a similar vein, people think that hard work translates into outperformance or alpha. And there are also people who are just intrinsically optimistic and always believe things will go well.
But the point that Andrew says is really crucial is that we simply don’t educate people on the very basics of finance and investment management. So even the most educated people are unprepared for the very basic investment skills required for investment success.
The thing is, good investing doesn’t have to be complex nor does it even require outperformance. As Warren Buffet said in his 1994 Berkshire Hathaway letter:
“Ben Graham taught me 45 years ago that in investing, it is not necessary to do extraordinary things to get extraordinary results.”
The Implications of Efficient Market Hypothesis on The Pursuit of Alpha (7:14)
Efficient Market Hypothesis says that all the information about securities, such as stocks, is already currently reflected in their prices.
Prices reflect the collective wisdom of all investors of which there are lots of very skilled money managers. There’s not a lot of free money lying around. That’s what makes finding alpha so difficult.
To gain an advantage, you’ve got to have either better information than everyone else or be so much better at interpreting the available information than everyone else. That’s why the efficient market makes it so hard to outperform because you’re playing against everyone collectively.
The Paradox of Skill (11:00)
The single most influential idea for me personally in understanding the challenges with seeking alpha is the paradox of skill.
If you look at someone like Roger Federer, the greatest tennis player of his generation, every match he played was against one individual tennis player.
Federer didn’t necessarily have the best serve or the best forehand or the best defense or best net game or whatever the skill might be. But what made him the best tennis player in the world was that he had the best combined total set of skills. And that’s what enabled him to beat people on a reasonably consistent basis.
With the stock market, though, it’s not that you are buying and selling against any one other person. Prices are set by the entire market.
In essence, that entire market is the collective wisdom of everyone. It’s essentially like you’re playing tennis against a player with the best forehand, the best serve, the best volley, the best backhand, the best defense, etc.
This gets us to the paradox of skill.
At the time of writing The Incredible Shrinking Alpha, Roger Federer had never lost a first round match in a tennis tournament. He is typically playing against Top 100 players — very good players — but as you move up into the later rounds you start playing against better and better people. And still his winning frequency was incredibly impressive, but he won less frequently because his skill advantage over the later round players became less because the competition is so much better.
That’s an important point: as the competition becomes better, it becomes much more difficult to win.
With investing, people don’t fail to beat the market because they’re not smart.
Oftentimes, money managers are incredibly smart. But there’s a huge number of incredibly smart and well-armed people with more access to data than ever before. They’ve got access to more computing power, different techniques, and people with a broad set of skills that are looking at accounting information, doing programming, crunching numbers, etc.
The high level of skill and competition is one of the big reasons it’s so difficult to beat markets and add alpha.
Winners Don’t Keep Winning (17:50)
When a fund outperforms (due to skill or luck), people take notice and money starts to flow into the fund. As the size of inflows grows, it becomes difficult to put all that new money to work in the same fashion that led to the initial outperformance.
Consider managers that do specialized stock selection; they typically want to invest only in their very best ideas. But if they outperform and money starts to flow into the fund, investing only in their best ideas becomes much more difficult for a few reasons.
First, there are regulations against holding too much of a stock by an entity or given fund.
Additionally, as you seek to buy more and more of a stock, the transaction costs to do so become higher. Buying a few thousand shares of something is generally pretty easy to do, but fund inflows may require you to buy a few million or tens of million shares rather than just a few thousand shares.
And at the point where your trading becomes a much greater percentage of the typical trading volume of that security, you begin to see more market impact in your orders to buy those securities. That’s because other people notice the outsized volume and begin making their manager pay more and more for shares.
If a manager doesn’t want to keep paying more and more in trading costs — and those trading costs, by the way, come directly out of the returns to the fund — the manager is forced to have greater diversification amongst the securities. In other words, they have to invest money in areas that aren’t necessarily their best ideas.
Not only does that dilute the best ideas, it moves the fund closer to a closet index fund. In other words, as the fund starts to hold more and more securities, it starts to more and more resemble that very index that it’s supposed to beat.
Finally, when a manager tends to do very well, it attracts attention and people start trying to reverse engineer what’s making them so successful.
If it’s kind of luck, people may figure that out. But if there are certain techniques or things that they’re using, types of stocks that they’re picking, there’s a lot of attempted reverse engineering going on. That also makes the advantage quite fleeting.
Zero-Sum Game (22:30)
The entire stock market has to be held by somebody.
You’ve got some people who are indexing, they’re holding exactly the index. And other people are competing, and trying to find the best ideas. Others may be using quantitative approaches to choose holdings. There are also people that work for companies that use stock compensation that creates holdings. But in sum, the entire market is held by everybody.
And so on average, the entire market has to give the return of the entire market. That, in essence, is what is meant by a zero sum game. If one person is doing better, someone else is doing worse.
One of the reasons why finding alpha has become so much more difficult is that so much more money is managed by professional money managers as compared to “mom and pop” retail investors. That means there are fewer people that are easier for professionals to exploit.
Even though there are lots of types of market participants out there, the amount of money that’s managed professionally has grown tremendously and become one of the key hurdles of finding alpha (and why it’s been shrinking).
The zero sum game nature of active management, where in aggregate, we all earn the market return, means that our return in aggregate is the market return minus our costs. That’s created a trend to lower expenses, making passive investing more appealing,
It’s also contributing to the cycle where lower cost drives the investors to become passive, which shrinks the pool of investors that can be exploited by professionals and then raises the hurdle for generating alpha. And even though the absolute skill level of these active managers is going up and has never been higher, it’s getting harder and harder to generate alpha because the exploitable people are gone.
From the book:
“The trend to lower expenses is making passive investing even more of a winner’s game. And that is contributing to a virtuous circle — lower costs are helping drive more investors to become passive, shrinking the pool of victims that can be exploited and raising the hurdles for the generation of alpha.”
Strategies For Investment Success (27:00)
Investing is not just about returns — it’s about risk and return. So start by figuring out what risks you want to take. That can be asset classes (stocks, bonds, cash, etc), domestic vs international, or factor exposures (value, profitability, etc), etc.
Next, diversify appropriately, according to the amount of risk that an investor can handle.
A third thing is to invest in funds with a very systematic, evidence-based rules based type of construction. Examples are index funds or factor funds.
From there, the emphasis should be on low costs, whether that’s expense ratios, trading costs, or taxes.
And finally, stay disciplined. If all this is tough to do on your own, seek professional help.
Resources
- The Incredible Shrinking Alpha: How to be a successful investor without picking winners by Andrew Berkin, PhD
- EP 62: The Collective Wisdom of Financial Markets
- S&P Persistence Scorecard
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About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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