Jensen found that mutual funds didn’t outperform the market as a whole. This wasn’t entirely surprising and doesn’t, on
its own, endanger the mutual fund mythology. On average,
fund managers don’t outperform the market.
But a good advisor can still identify the talented managers
who will outperform in the future, right? Unfortunately, Jensen also found no evidence of fund persistence. Yesterday’s
winners didn’t necessarily outperform in the future.
One would think that Jensen’s research debunking the
myth of consistently outperforming fund managers (measured
by alpha, also known as Jensen’s alpha) would strike a blow
in the remarkably efficient marketplace for actively managed
mutual funds. Fortunately for the investment management
industry, while stock pickers tend to be ruthlessly efficient,
fund investors are not.
A Scientist’s View of Investing
Scientists propose theories that are supposed to explain reality.
The CAPM is a theory which suggests that average returns on
financial assets are explained by beta, or the amount of systematic risk they exhibit compared to the market.
Scientists then test whether beta does in fact explain mutual fund returns. Generally it does, but sometimes it doesn’t.
When theories don’t do a great job of explaining reality, then
scientists propose new theories.
Maybe there is more to asset returns than just beta? Maybe
investors prefer larger to smaller companies? Maybe investors
tend to crowd into popular stocks and drive their prices up
while leaving unpopular stocks to outperform?
These alternative theories of asset returns are also known
as factors. The rise of factor-based investing stems from return anomalies observed by scientists over the years. This is
the way science works. When a theory doesn’t do a perfect job
of explaining reality, then scientists test new theories that help
refine our knowledge of causation.
The original investing factors that, when combined with
beta, do a consistent job of explaining fund performance over
time are the size of the firm and the price investors are willing
to pay for a dollar of profit (otherwise known as value). Investors have enjoyed a higher performance from choosing stocks
from small firms with cheap prices.
The so-called Fama/French three-factor model has dominated academic finance for nearly three decades. Scientists
found that many of the smartest fund managers were merely
the best at identifying these factors before the academics were
able to figure them out. Once they controlled for factors, the
excess performance of these superstars faded away.
Scientists have since identified additional factors. Today’s
winners also tend to outperform in the short run, a phenomenon known as momentum. Firms that trade
less frequently tend to outperform, known as
the liquidity effect. More profitable firms also
tend to do better.
Evidence-based investing is about identifying the characteristics of stocks that have outperformed in the past, and building portfolio strategies that
overweight stocks that have these particular characteristics.
It isn’t about finding good companies. It’s about finding
companies that have the right factors. Instead of inspecting
underground cables, a financial economist inspects whether
a firm is small, cheap, profitable, or illiquid.
In his recent book “The Incredible Shrinking Alpha” (an easy
and essential read for any advisor), Larry Swedroe, director of
research for Buckingham Strategic Wealth, lays out the convincing argument that the investment industry spends far too
much time chasing any hint of Jensen’s alpha, and not enough
time paying attention to science.
This point has also been made by Eugene Fama’s frequent
co-author Ken French, professor of finance at Dartmouth. In
a 2008 presidential address to the American Finance Association, French estimated that over $100 billion is spent chasing
elusive returns that cannot be explained by beta.
Swedroe and others point out that the actual alpha that
can be captured by skilled investors is just a fraction of this
amount. French estimates that 0.67% of the total stock market value is lost each year by investors who can’t let go of the
active management story.
It appears that the ability to instantly make low-cost trades
coupled with the remarkable flow of new information have
further driven down opportunities for exploiting market mis-pricing. If it costs less than 10 basis points to fully capture
beta, then fund managers needs to earn their keep if they are
charging an additional 50 or 100 basis points to manage assets.
In other words, you could pay a fund manager $1,000 on
a $1 million portfolio to capture beta. If you pay an additional
$9,000 for something extra, is that a good investment? You’ve
Evidence-based isn’t about finding good
companies. It’s about finding companies
that have the right factors.