Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?

Andrew Stotz 00:00
Hey, fellow risk takers this is your worst podcast host Andrew Stotz from a Stotz Academy and today, I'm continuing my discussion with Larry swedroe, who, for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645. Larry is unique because he understands the academic research world as well as the practical world of investing. And today, we will discuss a chapter from his recent book enrich your future the keys to successful investing, in fact, it's going to be chapter four. Why is persistent outperformance so hard to find? Larry, take it away? Yeah,

Larry Swedroe 00:41
well, I think the first answer to the question, the most basic one is that the evidence shows that markets are just very highly efficient. They're not perfectly efficient. And but I think it's important, let's define what we mean by the words efficient. What an efficient market means is that the price is the best estimate we have of the right price. We don't know the right price until after the fact. Right. And so, right. So the way you can argue like in the late 90s, there was a bubble in, you know, high tech stocks, and.com stocks, but to show that the markets are really inefficient, you have to show that people were able to persistently exploit such Miss pricings. And the evidence is overwhelming that that just isn't the case. Recent studies as far back as 2010, Gene fama and Ken French, we've discussed their papers Skill versus luck. And they found that less than 2% of active managers were generating statistically significant alphas or outperformance against appropriate risk adjusted benchmarks, which is less than what you would randomly expect, given the 10s of 1000s of investors, you know, who are trying morning saw just published, in fact, their persistence scorecard. And in almost every category, there was persistence that was less than what was randomly expected. There were a couple of categories that was greater. But the overall numbers were, you know, showing that the evidence is there was no persistence greater than randomly. So that's the most important thing. But there is another important thing, which is what I've called the fact that pursue system successful act of management sows the seeds of its own destruction. Now, what do we mean by that? Jonathan Burke wrote a brilliant paper. back I think, in 2004 or so the myths of active investing, maybe it was the five minutes of active investment. And what he pointed out is the logic, let's say that there is a great money manager who is outperforming he's delivered outperformance for now, what's going to happen to that fun, Andrew? It's gonna get lots more assets, right? Andrew is going to want to invest in this fun, right, and he's going to get so much more assets, that there's only one of two things that the fund can do, it either has to keep buying larger blocks of the same stocks, which means its market impact costs, when it goes to trade are going to go way up, and inhibiting their ability to outperform, because that will increase the hurdle, the higher expenses of trading. The other alternative is to own more stocks and diversify. Now you look like venture a closet index fund, and your extra costs really only get applied to the pot that's differentiated, which is getting smaller and smaller. So if at some point, you've got 50 basis points, more expenses, and you're, you're 50% differentiated. Well, you have a hurdle of 1%. But what if you're on now only 20% differentiated? Well, now you got a two and a half percent turtle, and then you got the costs of the trading and stuff. So what Burt was pointing out is that that cessful active managers gets more assets, their performance will deteriorate because of these diseconomies of scale. So money moves to the next best manager. And then the same process happens until all managers have the same risk adjusted expected return and that's what we see the Morningstar shows they have five star funds, which are recent Apple get inflows and the poor performance get outflows, right. And so that ruins their ability or an increase. That's really the biggest hurdle that's one investors simply don't think about is that the very success undermines their future success. So

Andrew Stotz 05:23
let's review a few things. First of all, Brooke wrote his paper in 2005. And the persistence, I'll have a link in the show notes to the persistent scorecard, which I'm looking at right now. And it shows remaining in the top half over five years, which is what it looks like they're measuring. And as you said, it looks like all multicap funds are actually performing last, their 4.9% are remaining, versus what they would expect about 6.3%, just from random distribution. So that's a very interesting fact. But one of the questions I have for you there is that, is that the way all things work? Or is there something unique about the market? So for instance, let's look at business. We oftentimes say that, if you have a high return on invested capital, it's going to get competed away. But yet, we have persistence. Look at you know, Amazon, now many, many years, Microsoft many, many years of persistence. So how does someone understand that the market is different from what is technically a free market in business? Well,

Larry Swedroe 06:33
it's a really good question. And we happen to know the answer thanks to study again by Gene fama. I think Ken French was his co author on this paper. And what they found is that abnormal earnings growth, okay, so if by that we mean, if an earnings growth on average grows with the nominal GDP, and for argument's sake, let's say it's 3%, inflation and 3% growth, so you should be growing 6%. And the corporate profits tend to grow in line over the long term with nominal GNP. So if you're growing at 16%, you're abnormal growth is 10. All right. So that's our starting point. And what they found is that people understand that abnormal earnings growth is not likely to persist for competitive reasons, right. But they actually found that the reversion to mean of abnormal growth happens much faster than the market actually anticipates, or investors anticipate. And that rate is 40% per annum. So if your excess growth was 10%, the next year it's likely to be 6% excess growth. And then after that, it'll be you know, 3.6%, excess growth. And the market thinks that these companies that are growing, so will continue to grow much faster, and their reversion to mean of abnormal growth will not continue to and that's why growth stocks ultimately tend not to justify, if you will, their higher P e is in the sense that they get lower returns than value stocks, whose by the way, poor earnings tend to revert to the mean faster than the market. And so poor earning companies because competition leaves tends to improve. Now, of course, there's going to be some exceptions to that NVIDIA would be the classic example. But we can all name many companies like Polaroid and call it ACC and digital equipment and data Gen who was the invidious of the day in Intel, who had spectacular earnings growth, no one had better earnings growth than for example, Xerox, and it was good, you know, virtually disappeared. Right? So, you know, people point to exceptions, and that becomes their frame of reference. And so we do have evidence there of markets competing away excess profits, in the same way that investors if you will compete away excess returns from highly skilled active investors.

Andrew Stotz 09:29
And am I correct in saying that paper looks like it came out in 1997, called forecasting profitability and earnings by fama and French, and I see mean reversion of about 40% per year. My

Larry Swedroe 09:40
memory is at least pretty good. It's pretty good at this age.

Andrew Stotz 09:45
Yeah. I'm going to put that one in the show notes, because I think that's really critical. And the last thing that you mentioned about it that's so critical, is that our minds latch on to the one or two, like Microsoft like Amazon and those are extremely rare exceptions.

Larry Swedroe 10:03
Yeah, that's true. It's the that's phenomenon is true. A recency bias and headline bias, you know, there's an airplane crash, and then people are afraid to fly because of there was a crash. Well, people are afraid of the Boeing, you know, incidents. And yet it is much safer today to fly in a Boeing plane than to drive to your grocery store. Most people don't think about that. But the data shows very compellingly that that's the case. I

Andrew Stotz 10:37
did a study about I don't know, maybe it was 1010 years ago, where I looked at return on invested capital of companies in Asia. And what I tried to look at and say, what, what, group them into quintiles and then say, Where were they in 10 years, on average. And what I found was that they, they reverse, they reverted towards the mean, but they didn't get to the mean. And part of my conclusion from that was that strongly profitable companies do decline in their profitability, but they can maintain an above average level of ROI see, but not excessively, above average. And I found on the other side, the same for the poorly performing ones.

Larry Swedroe 11:22
Yeah, so But the lesson from what I hope investors take is, it's irrelevant. If the market already anticipates that you don't have any knowledge that the market does. So if you know, or believe that at company XYZ, and Thailand is generating 20% Return On Equity when the average company is and right. And you even think it is deteriorate some, but if the market thinks that's going to happen, that's already built into the price. There's nothing you can do to earn excess returns, unless you believe and know that it's reversion to the mean will happen slower than the market does, or faster, and then you could short the stock. So that's the problem. You have to have information that the market doesn't already know. And the logical answer when you think about it, or look yourself in the mirror and ask, gee, do I know something Warren Buffett and Goldman Sachs and Renaissance technology don't know? And if you can't honestly answer that question, yeah, I've got inside information, and they just don't know it, then you shouldn't try to trade on it, because you're taking idiosyncratic risks that you could diversify away. But

Andrew Stotz 12:45
let's look at a situation like the.com bubble where Warren Buffett was refused to participate in all the.com stuff. And he just stayed with his methodology. And he's, you know, he didn't get the boom, and he underperformed pretty massively. And then eventually the.com Bubble crashed, and he looked like a pretty smart guy. So my question to you is when when the market participants are pushing up the price of the overall market to such an extreme? Is that really like, is that the right price? Or are they just all wrong? How do we proceed that?

Larry Swedroe 13:21
Yeah, it's a great question. And fama has said, How do you know it's a bubble? We only know until after the fact, and therefore you shouldn't try, I believe I have a slightly different view, I actually believe you can determine if there is a bubble. And the way one metric that tells you that if the expected return is lower than the rate of return on risk free, Treasury invested Protected Securities. So in the late 90s, the tips yields were higher than the cape 10 ratio, which is the inverse of the P E. And so you were getting with the K 10. In the 40s, two and a half percent or 2%, you know, expected real return to equities, when the expected real return to tips was known. There wasn't expected it was higher. And that told me that there was a bubble. In fact, I left all of the growth stocks in 98, and went to a total value approach for that very reason. Although it hadn't quite got to that level. But it was getting close. And I said I should be a big risk premium for stocks, not a small risk premium. And of course, I was wrong for a couple of years. Two more years. And you may remember that Alan Greenspan, in December of 96 famously said the market was irrationally exuberant, so he was wrong for three and a half, or three and three and a quarter years anyway before the bubble broke. So my view is this the vast majority investors should just build an asset allocation plan, rebalance, and stick with that means when there's a bubble, you're taking advantage of it, and you're gonna sell some high to buy this stuff that hasn't performed. If you're a little more adventuresome, and you believe you have the knowledge and the discipline to stay the course, knowing your timing could be one, buy yours, as I was, and Warren Buffett was, then when you get really extreme valuations, then you can move your asset allocation, depending on how aggressive you want to be, but be prepared to be wrong, the odds of you're getting the timing right are close to zero. So you have to have the discipline and you know, you could be wrong for years. And there could even be some event happens that you could be wrong permanently. So, you know, there are regime changes in the economy and politics and things that can happen. So that's the problem, I would tell people, you can tell when there is bubble light, when sentiment is high, and volatility is low, and everyone thinks that the world everything is safe, then there'll be likely some event that no one can predict will happen. And you get what some people might call a Minsky moment, named after a famous economist, and the whole thing explodes and crashes. And you may not even be able to point to a single event, it just magically happens. And those bubbles burst. Like they burst with the real estate market in the US in a way. And you know, we may have a bubble happening in Mac seven, for example, or at least some of those socks.

Andrew Stotz 16:58
That's it. That's not that's a whole nother topic. But I know, you talked about the paper about scale effects, scale effects, and you talked about the idea of trading costs and the like, I'd love for you to go through that a little bit. And that, I think, is the final point of this chapter.

Larry Swedroe 17:17
Yeah, so we all know that active management isn't free. That the costs of doing your due diligence, interviews, market research, gathering insight, information that gives you an advantage over the overall market isn't cheap, you gotta hire really smart people, mathematicians, economists, status scientists, now AI people to scam reports, all of this stuff. And then you have the trading costs, the bid offer spreads, and most importantly, market impact costs. Now, this is a really important point. The average individual investor has gained dramatic advantage, or an improvement in their trading costs over the last 4050 years. When I was a kid, and first trading and buying individual stocks, their bid offer spreads were typically stock might be 10, bid 10, and a half assed and there was a 5% commission on that. So you might have a 5% spread. And then you're paying a 5% commission to the broker, you're a 10% behind before he even started, right? With the decimalisation of pricing prices. And basically, you know, often commission free or almost free trading, when you want to buy or sell 100 or 200 shares of stocks, you know, the costs have come way down. But the problem is, those narrow spreads have eliminated the incentive for market makers who used to exist the maker market and bid 10 and a half ass and be willing to buy, let's say, a million checks, because there was a big spread to protect them against people might have more information than men. Right? Well, those spreads are gone. So guess what happened? The market makers disappeared. And now the people who are making the markets of the high frequency traders, and well they'll make the market is for 100 or so shares. And when they see your buying, they're gonna stop moving the price against you, and driving the price away. So you have to be a very patient trader. And that's why for example, dimensional fund advisors recently have told me that almost all of their traits and 100 share lots. That's it, because they don't want to be moving the market. It's become so expensive. So when you get more assets, you're gonna have to either diversify as we talked about and then you It's almost impossible to beat them off, because you look like them on draft up a differentiated portfolio, your active share has to be high. Okay. But if you do keep a high active share, that means you're loading up on a very small number of stocks. And now your market impact costs are gonna go way up. And that's the real problem.

Andrew Stotz 20:27
And it's a little bit hard for people to understand because you would think that the bigger the institution gets, you know, the cheaper it becomes. But what you're saying is that your footprint just stepping into the water. If you're a huge player, you have a market impact cost that an individual doesn't have. Yeah,

Larry Swedroe 20:47
the market, partly for the reasons we've already covered, there are no more market makers, the bid offer spread as lower, has become much more illiquid, for those reasons. And on top of that, we have had a dramatic shift where we 30 years ago, 1% of the market was passive. Today at some people estimate 50%, or maybe even more. So that means all those traders who provided liquidity have gone. They are just sitting in buying and holding, there was a recent paper called The illiquid Markets Hypothesis by a University of Chicago professors. And they now estimate that because the markets have become so illiquid, that $1 of new cash flows, is driving asset prices $5. So you could see if you're trying to buy stocks, how you could easily be moving the market against yourself, when you're having to buy large amounts. And that's why, for example, when dimensional fund arises, when they started out 35 years ago, or so, actually, almost 40, actually 40 years ago, running small, you know, value funds, their average market cap was much smaller than it is today, because they only had a small amount of dollars under management, they became so successful with this strategy. It's now as I think $600 billion plus, you know, fund complex. And to keep a small value fund today, the average market cap last I look was north of two and a half billion you know, so it's not so small, but they have to do it. Keep their trading costs down. So now still get the same type of markets are efficient risk adjusted returns, but you're losing some exposure to the smallest deepest value stocks, because you now own say 2500 of them, versus a fund like Bridgeway small value fund might only own 600. And their average market cap, probably something closer to a billion dollars. So it has a higher expected return for that reason.

Andrew Stotz 23:22
Such an interesting discussion in this chapter I found very fascinating. And, Larry, I want to thank you for another great discussion about create growth, creating, growing and protecting our wealth. And I'm looking forward to the next chapter, which is chapter five great companies do not make high return investments for listeners out there who want to keep up with all that they're doing. Follow me on Twitter at Larry swedroe. And also on LinkedIn. This is your worst podcast host Andrew Stotz saying, I'll see you on the upside.