Warren Buffett and the Superinvestors of Graham-and-Doddsville: A Performance Update
Should advisors expect legendary value investors, like Warren Buffett, to deliver alpha to investors in the future? A look back at Buffett’s 15-year track record, as well as the two funds he identified in 1984 as “superinvestors,” shows that passively managed alternatives offer better prospects for the future.
In 1998, Charles Ellis wrote Winning the Loser’s Game, in which he presented evidence that, while it is possible to generate alpha and “win” the game of active management, the odds of doing so are so poor that it’s not prudent for investors to try. At the time, roughly 20% of actively managed mutual funds were generating statistically significant alphas (meaning they were able to outperform an appropriate risk-adjusted benchmark). Subsequently, in our book, The Incredible Shrinking Alpha, my co-author Andrew Berkin and I presented evidence demonstrating that today this figure has collapsed to only about 2%.
Our book also describes several major themes behind this trend toward ever-increasing difficulty in generating alpha:
- Academic research is converting what once was alpha into beta (exposure to factors in which you can systematically invest, such as value, size, momentum and profitability/quality).
- The pool of victims that can be exploited is persistently shrinking. Retail investors’ share of the market has fallen from about 90% in 1945 to about 20% today.
- The amount of money managed by sophisticated investors chasing alpha has dramatically increased (20 years ago hedge funds managed about $300 billion, today it’s about $3 trillion).
- The costs of trading are falling, making it easier to arbitrage away anomalies.
- The absolute level of skill among fund managers has increased.
This last point confuses many investors. They think that if the absolute level of skill in the mutual fund industry has increased, it should be easier to produce alpha. However, what so many people fail to comprehend is that in many forms of competition (such as chess, poker or investing), the relative level of skill plays a more important role in determining outcomes than the absolute level of skill. What’s referred to as the “paradox of skill” means that even as skill level rises overall, luck becomes more important in determining outcomes since the level of competition is also rising.
On this point, Ellis, one of the most respected people in the investment industry, noted in a recent issue of Financial Analysts Journal that “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”
Thus, according to Ellis, the “unsurprising result” is that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees.” So, even though the absolute skill level of active managers may be increasing, it’s getting harder and harder to generate alpha (even if you have Warren Buffett-like skill) because the level of competition is also increasing.
We can see evidence of the increasing difficulty of generating alpha by looking at recent returns from an investor that most would consider the greatest of his generation, Warren Buffett. As well, we can look at the returns of the Sequoia Fund (SEQUX) and the Tweedy, Browne Value Fund (TWEBX), the two public mutual funds with 15-year track records that Buffett identified in a 1984 speech, The Superinvestors of Graham-and-Doddsville. Buffett was speaking to commemorate the 50th anniversary of the publication of Benjamin Graham and David Dodd’s book, Security Analysis.
In 1984, Buffett had the benefit of hindsight in selecting those two “superinvestors.” In order to determine if outperforming well-structured passively managed funds has become more difficult since then, we’ll examine the performance of Berkshire Hathaway (BRK.A), SEQUX and TWEBX over the most recent 15-year period. We will then compare the returns earned by these “super” value investors with the returns of the passively managed, structured value funds from Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) Data is from Morningstar and covers the period ending July 1, 2016.
I should note that DFA funds can be purchased through some 529 and 401(k) plans but, generally, are available only through an advisor. An investor would incur fees from that advisor; those fees can vary greatly (in some cases, they are very low) and cover the full range of financial planning services the advisor provides. Also, John Hancock recently introduced a series of ETFs that are managed through DFA (with expense ratios that differ from the DFA funds cited in this article). Those ETFs can be purchased directly by investors.