Bloomberg TV recently invited me onto their new show, Bloomberg GO, for a short debate on active versus passive investing with David Barse, the CEO of Third Avenue Management.
Barse stated that funds offered by Third Avenue, which has more than $8 billion in assets under management, had been able to beat their index benchmark. He then admitted that alpha was hard to deliver because the competition is tough. He also asserted that delivering alpha is what his firm wants to do, that it’s intellectually challenging and that Third Avenue works hard to do it.
I certainly agree that it’s difficult to deliver alpha. And, as demonstrated in The Incredible Shrinking Alpha, which I co-authored with Andrew Berkin, the task has become increasingly difficult over time with fewer and fewer success stories.
With that said, I would add that investors surely don’t care if Third Avenue finds generating alpha intellectually challenging. Nor do they care if the firm works hard at it. Investors don’t confuse effort with results. So let’s go to our trusty videotape to see if Third Avenue has, in fact, been delivering alpha.
Third Avenue’s investment strategy and philosophy is based on the work of legendary value investors Benjamin Graham and David Dodd. Quoting from the firm’s website: “Third Avenue Management analyzes opportunities based on the balance sheet quality and financial position of companies that issue securities. Our analysis of financial strength informs our judgment of intrinsic value. Once we determine our assessment of what an enterprise is worth, we invest only when we can do so at a significant discount. We buy strength when it is misunderstood and undervalued.”
Given this statement, I conclude that the proper benchmarks to which the returns of their funds should be compared are not market-like indices (such as the S&P 500). Instead, they should be compared to value indices. Or, better yet, to comparable passively managed value funds, which also incur costs and trading expenses, in the same asset classes.
Thus, to determine if Third Avenue has outperformed passively managed funds, I’ll compare the returns of three of their funds – the Third Avenue Small Cap Value Fund (TASCX), the Third Avenue International Value Fund (TAVIX) and the Third Avenue Value Fund (TAVFX) – to the comparable funds run by Dimensional Fund Advisors (DFA) and where available to a comparable Vanguard index fund. (In the interest of full disclosure, my firm, Buckingham, recommends DFA funds when constructing client portfolios.) We’ll begin with TASCX.
Morningstar classifies TASCX as a small-value fund. For the 10- and 15-year periods ending October 13, 2015, TASCX returned 5.20% per year and 8.34% per year, respectively. The fund’s percentile rankings (first percentile is the best) over those periods were 90 and 91, respectively.
In other words, despite the hard effort Barse assured viewers that Third Avenue applies, the fund managed to underperform all but about 10% of the small-value funds that had managed to survive.
DFA’s U.S. Small Cap Value Fund (DFSVX) returned 7.49% per year over the 10-year period (outperforming TASCX by 2.29 percentage points per year) and 10.94% per year over the 15-year period (thus outperforming TASCX by 2.60 percentage points). The other comparable fund from the same asset class is the Vanguard Small Cap Value Index Fund (VSIIX). Over the same 10- and 15-year periods, VSIIX returned 8.37% per year (outperforming TASCX by 3.17 percentage points per year) and 9.92% per year (outperforming TASCX by 1.58 percentage points per year).
While TASCX is mostly a domestic fund, it does maintain the freedom to buy international stocks. Morningstar shows that non-U.S. stocks currently make up about 5% of the fund’s holdings. Being able to shift allocations whenever international stocks look like a better value should be an obvious advantage for TASCX. Unfortunately, that advantage never materialized. Even worse, DFA’s International Small Cap Value Fund (DISVX) also outperformed TASCX over both the 10-year and 15-year periods, returning 6.31% per year over the 10-year period (versus 5.20% for TASCX) and 11.16% per year over the 15-year period (versus 8.34% for TASCX).
Strike one.
The right benchmark
During our debate, Barse stated that Third Avenue had consistently beaten its benchmark over the long term. However, the data shows that not only did TASCX underperform, but they managed to underperform by wide margins. These margins far exceeded the differences in expense ratios. Expense ratios for TASCX, DFSVX and VSIIX are 1.10%, 0.52% and 0.08%, respectively.
Perhaps, like many mutual funds, Third Avenue was using as its benchmark the S&P 500 Index. That would have been an appropriate benchmark when we lived in the single-factor world of the Capital Asset Pricing Model (CAPM) where beta was the single factor used to explain the difference in returns of diversified portfolios.
With that in mind, we’ll take a look at how TASCX performed relative to the Vanguard 500 Index Fund (VFIAX). Over the 10- and 15-year periods ending October 13, 2015, VFIAX returned 7.71% per year (outperforming TASCX by 2.51 percentage points per year) and 4.55% per year (underperforming TASCX by 3.79 percentage points per year), respectively. So, we have a split decision with TASCX outperforming for the 15-year period but underperforming by 2.51 percentage points for the last 10 years.
But the single-factor CAPM world hasn’t existed for more than 20 years now. Since the 1992 publication of Professors Eugene Fama and Kenneth French’s paper, “The Cross-Section of Expected Stock Returns,” we have compared funds to more appropriate benchmarks – as I did here.
Non-domestic funds
So far, we have seen that Third Avenue’s domestic equity fund failed to outperform. We’ll now turn to their funds that invest globally and internationally. Perhaps there’s evidence that Third Avenue outperformed in these supposedly less efficient markets.
We’ll begin by examining the Third Avenue Value Fund (TAVFX), classified by Morningstar as a global mid-cap value fund. Currently, Morningstar shows that about 64% of its holdings are in domestic equities and about 27% are in international equities – though obviously that can vary over time.
Given its classification as a global mid-cap fund, we’ll compare the fund’s returns to the returns of DFA’s domestic and international large- and small-cap value funds. For the 10-year and 15-year periods ending October 13, 2015, TAVFX returned 2.88% per year (with a percentile ranking of 95) and 5.76% per year (with a percentile ranking of 24), respectively.
The table below shows the returns for TAVFX and five value funds managed by DFA.
|
10-Year Return (%)
|
15-Year Return (%)
|
Third Avenue Value (TAVFX)
|
2.88
|
5.76
|
DFA U.S. Large Value (DFLVX)
|
7.54
|
8.53
|
DFA U.S. Small Value (DFSVX)
|
7.49
|
10.94
|
DFA International Value (DFIVX)
|
3.70
|
6.23
|
DFA International Small Value (DISVX)
|
6.31
|
11.16
|
DFA Emerging Markets Value (DFEVX)
|
5.79
|
10.79
|
TAVFX underperformed, no matter which mix of DFA’s large- and small-value funds you employed or which mix of domestic and international funds you selected. In the supposedly inefficient asset class of international small-value stocks, DISVX earned a first-percentile ranking. How can anyone claim the markets are inefficient when a passively managed fund earns a first-percentile ranking?
Strike two.
And, finally, we turn to the Third Avenue International Value Fund (TAVIX), which Morningstar classifies as a small-mid value fund. Since it doesn’t have a 15-year period, we’ll look at the fund’s 10-year returns. Over the period ending October 13, 2015, TAVIX returned just 1.75% per year.
Morningstar puts the DFA International Small Cap Value Fund (DISVX) in the same category. As shown in the preceding table, DISVX returned 6.31% per year, outperforming TAVIX by 4.56 percentage points. Keep in mind that TAVIX also has the ability to shift assets around the globe, which the DFA fund does not. About 11% of TAVIX’s current holdings are U.S. stocks. Obviously, that advantage just didn’t seem to show up. TAVIX can also hold emerging-market stocks. The DFA Emerging Markets Value Fund (DFEVX) returned 5.79%.
Strike three. You’re out!
Not only did Third Avenue’s funds fail to outperform in each of the cases I analyzed, but they underperformed by wide margins. Maybe, just maybe, alpha is a lot harder to deliver than many, including David Barse, think. The Third Avenue funds I looked at certainly weren’t generating alpha or beating appropriate benchmarks.
An article I wrote in January 2014 gives this piece an amusing coda—though Third Avenue’s management wouldn’t think so. In that article, I commented on what the firm’s chairman Marty Whitman wrote. In the Third Avenue Fund’s October 2013 annual report to shareholders, Whitman severely criticized the research of recent Nobel Prize-winner Eugene Fama. Whitman called Fama’s work “utter nonsense, sloppy science, plain stupid, and unscholarly.”
Coincidentally, for many years, Fama was head of research for DFA.
Now, you would think that before denigrating the work of a Nobel Prize winner in his field of expertise, you would have extraordinary proof and data to offer. Unfortunately, Whitman offered none. If he had looked at the data, as I have done today, he would have saved himself a great deal of embarrassment.
Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.
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