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In the revised edition of The Incredible Shrinking Alpha, Larry Swedroe and Andrew Berkin make the case that investors are better off choosing passive investments because markets have become more efficient as managers became more skilled.
Their case is predicated on four dynamics at work in markets at all times. Empirically oriented practitioners and academics in finance are constantly at work creating and revising models that forecast expected returns. These models are informed by the same sources of information used by active managers to make active bets on securities. In this way, academic finance commoditizes the proprietary edges that active managers use to produce excess returns, effectively transmuting alpha into beta.
Active managers are always trying to hire the most talented analysts and portfolio managers, who are in turn leveraging the most advanced technology and data sources to gain an edge over the competition. Excess return is always a zero-sum-game because every dollar harvested by one investor above the return of the market must be “donated” by another investor. As managers become more skilled and equip themselves with better tools, they arbitrage away the edges that produced alpha in the first place. Markets become more efficient, which diminishes opportunities to produce excess returns.
It follows that if active managers are producing less reliable excess returns, investors will find active management less attractive at the margin. Unsurprisingly then, investors have been abandoning actively managed funds in favor of index products for most of the last decade. This further complicates the job of active managers since the investors most likely to abandon active management are those who have the least skill to choose active investments. Definitionally, active managers profit from the mistakes of unskilled investors. If there are fewer unskilled investors in the market, the pot of excess returns grows smaller.
Paradoxically, while individual investors have been selling actively managed funds to buy index products for many years, institutional investors, like pensions, insurance companies, and endowments, have never been so enamored with active investments. The authors cite a study showing that institutional allocations to hedge funds grew from zero to 6%, and allocations to private equity increased from 3% to 11%, over the 20-year period ending in 2016. This despite the fact that returns to alternative investments in excess of simple replacements (like allocations to small-value stocks and REITs) declined precipitously over the same period. This behavior may seem confusing until one recognizes that institutions typically operate under a strict required-return objective. With bond yields on a steady decline and high stock valuations implying low returns, it is less surprising that many institutions might “take a shot” at low-probability active bets.
These bets have not paid off, with alternative sleeves underperforming simple index alternatives.
In an effort help investors identify faulty logic that leads to counterproductive investment decisions, Larry and Andrew explore why many investors continue to choose active products despite overwhelming evidence to the contrary. They describe the motivations of the investment industry, which earns enormous fees on active products and the trades and deals facilitated by these funds. The protestant work ethic, which preaches that hard work should be rewarded, also contributes to decisions to back active managers. Investors are often overconfident in their ability to choose managers despite the overwhelming odds against them. Also, investors often feel that a move to passive amounts to giving up the chance to achieve “above average” returns and denies them access to the exclusive “in crowd.” Lastly, in an interesting cognitive twist, investors like to be able to blame active managers for their underperformance; investors fear they’ll only have themselves to blame for underwhelming passive investments.
In this revision of the book, the authors add substantially to the prescriptive sections of the original. They map out a helpful framework that any investor might use to create a portfolio that espouses the lessons from the book. The framework describes how to be selective about the risks to take; how to use diversification to minimize portfolio risk; why investors should prioritize systematic and transparent investment products based on academic evidence; the importance of getting value for the fees that are paid; and how to stay committed to the process when the going gets tough.
Larry and Andrew added a comprehensive section on asset allocation strategies that covers many of the steps an advisor might follow so that investors can do a great deal of legwork on their own. They discuss the dimensions of risk tolerance; the mix of stocks versus bonds; the case for international and factor-based diversification; alternatives like commodities and real estate; tax management; and many other nuanced but meaningful aspects of creating an investment policy. They even provide a list of recommended mutual funds for every category an investor might consider. And there are seven appendices that take a deep dive into some of the more technical topics adjacent to the core concepts covered in the main chapters that are definitely worth reading.
This book is an ode to passive management.
Larry and Andrew use meticulous logic to persuade investors to step off the active train and join the wave of passive investing. If pressed, I would have liked to see more discussion about the merits of different forms of indexing. One might argue there is a substantial difference in theory and practice between capitalization-weighted indexing and so-called “factor” or “style” indices. The authors present a compelling framework for how to think about the merits of factor strategies and concede that factor strategies decay substantially post-publication. But some investors may struggle to reconcile the long-term academic evidence with the performance of many factor or style strategies in the past decade.
Nevertheless, investors will benefit from internalizing the overwhelming evidence against discretionary active management. And for those investors who are motivated to act in accordance with the book’s recommendations, the authors provide a detailed roadmap to help investors deploy a thoughtful, high-value systematic solution.
This was a great read and one I recommend for individuals and advisors.
Adam Butler, CFA, CAIA, is co-founder and chief investment officer of ReSolve Asset Management. ReSolve manages funds and accounts in Canada, the United States, and internationally.
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