Passive investing guru Larry Swedroe was in town on June 20 to give a presentation on his tenth and latest book, The Quest for Alpha. It was a treat to meet him: “Hello, my name is Larry, too,” I said introducing myself prior to his presentation. “Hi, I’m Larry one,” he quipped back, producing chuckles around the table.
Swedroe’s book (peppered with a collection of humorous stories) and seminar marshal an imposing array of evidence from peer-reviewed academic journals against the quest for the “Holy Grail” of alpha (defined as attempts to beat the market through stock picking and market timing). He deploys a range of quotes from numerous high-profile active investors—like Warren Buffett and Peter Lynch—that support passive index investing as the solution for the vast majority of professionals and individuals. Regarding alpha as a strategy, he finds that while periods of outperformance may be found, very little that is persistent enough to suggest anything more than lucky streaks within a vast landscape of mediocrity, weighed down by fees and taxes.
But let’s not beat the dead horse of mutual funds, and go instead straight to professional investment management at pension plans. “If anyone could beat the market, it should be large pension plans,” declares Swedroe. Yet, the studies show the vast majority of pension plans fail to do so.
One might have expected better. Pension funds have the clout and resources to hire the cream of the crop from the ranks of active investment managers—and at the lowest cost. They do indeed conduct exhaustive due diligence—and hire managers that have outperformed benchmarks by an average 3 percentage points over the three previous years.
But, according to academic research, this performance does not carry over. Returns for the star managers average out to virtually the same as the benchmark over their subsequent three years advising the pension fund.
Half of the hired managers are fired at the end of their 3-year review periods. Then, in a process “reminiscent of Einstein’s definition of insanity,” the process of hiring managers with the best past performance repeats again at the pension funds.
Past performance similarly fails to signal future returns in other areas like hedge funds, individual investing, and behavioral finance, reports Swedroe. He is particularly critical of hedge funds, which he thinks are no more than “compensations schemes” for the managers. As well, the incentive structure of 2% annual fees and 20% of profits creates “agency risk,” or the tendency to “play” and take excessive risks with their clients’ money. There could be a few years of stellar gains but then comes the big blow-up.
Individual investors are not spared either. For example, the Mensa (high IQ) Investment Club underperformed by over 10 per cent a year for 15 years, as highlighted by Canadian Capitalist and Michael James on Investing (both in attendance at the seminar).
One exception to persistence in outperformance is the field of private equity. However, “the distributions of returns looks like a lottery ticket,” and would require broad diversification that only large institutions, and not individuals, can achieve.
Thanks to Cameron Passmore and PWL Capital Inc. for the invitation to attend the event.
Mr. Swedroe is Principal and Director of Research at St. Louis-based Buckingham Asset Management. Buckingham is the leading distributor of Dimensional Fund Advisors (DFA) funds in the U.S. PWL Capital, the organizer of the event, is a leading supplier of DFA funds in Canada and also builds portfolios of exchange-traded funds for clients.
DFA funds are index funds only sold through advisors. They are based on the work of academics Eugene Fama and Kenneth French and tilt toward value stocks and small-cap stocks. Fama and French provide evidence in their studies that these asset classes historically deliver higher returns than the overall market.