ISMS 40: Larry Swedroe – Market vs. Hedge Fund Managers’ Efficiency

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Quick take

In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake 30: Do You Fail to Understand the Tyranny of the Efficiency of the Market? And mistake 31: Do You Believe Hedge Fund Managers Deliver Superior Performance?

LEARNING: Discovering anomalies or mistakes reinforces and makes the market more efficient. Hedge fund managers demonstrate no greater ability to deliver above-market returns than do active mutual fund managers.


“Unfortunately, the evidence is hedge fund managers demonstrate no greater ability to deliver above-market returns than do active mutual fund managers.”

Larry Swedroe


In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake number 30: Do You Fail to Understand the Tyranny of the Efficiency of the Market? And mistake 31: Do You Believe Hedge Fund Managers Deliver Superior Performance?

Mistake number 30: Do You Fail to Understand the Tyranny of the Efficiency of the Market?

According to Larry, the Efficient Market Hypothesis (EMH) is the most powerful hypothesis or theory because the very act of discovering anomalies or mistakes reinforces and makes the market more efficient. When somebody discovers an anomaly, it gets published, people read about it, exploit it, and the anomaly typically will disappear or shrink dramatically.

Pricing anomalies present a problem for those who believe in EMH. However, the real question for investors is not whether the market persistently makes pricing errors. Instead, the real question is: are the anomalies exploitable after considering real-world costs?

Mistake number 31: Do You Believe Hedge Fund Managers Deliver Superior Performance?

Hedge funds, a small and specialized niche within the investment fund arena, attract lots of attention. Hedge fund managers seek to outperform market indices such as the S&P 500 Index by exploiting what they perceive to be market mispricings. Studying their performance would seem to be one way of testing the EMH and the ability of active managers to outperform their respective benchmarks.

Over the last 20 years, hedge fund managers have underperformed one-month Treasury bills by something like 1.4% for T-bills to 1.2% for hedge funds. A study by AQR Capital Management covered the five-year period ending January 31, 2001. The study found the average hedge fund had returned 14.7% per year, lagging the S&P 500 Index by almost 4 ppts per year.

The 2006 study, “The A, B, Cs of Hedge Funds: Alphas, Betas, and Costs,” covered the period from January 1995 through March 2006 and found the average hedge fund had returned 8.98% per year, lagging the S&P 500 Index by 2.6 ppts per year.

Hedge fund investing appeals to investors because of the exclusive nature of the club. It also offers the potential of great rewards. Unfortunately, the evidence is hedge fund managers demonstrate no greater ability to deliver above-market returns than do active mutual fund managers. At the same time, investors in hedge funds were earning below-market returns. They were (in many cases) assuming far more risk — although they were probably unaware they were doing so.

In addition to these risks, hedge funds also tend to be highly tax inefficient and show no persistent performance beyond the randomly expected, meaning there is no way to identify the few winners ahead of time.

Did you miss out on previous mistakes? Check them out:

About Larry Swedroe

Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.


Read full transcript

Andrew Stotz 00:02
Hello risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, and today, I'm continuing my discussions with Larry swedroe, who's the head of financial and economic research at Buckingham wealth partners. You can learn more about his episode and his story at episode 645. Larry deeply understands the world of academic research, especially about risk. And today, we're going to discuss two chapters from his book investment mistakes even smart investors make and how to avoid them. And the first mistake we're going to talk about is mistake 30. Which is Do you first of all, you got to think 30. That's already a lot of mistakes. Larry has really got them all in this book, that you fail to understand the tyranny of the efficiency of the market and 31. Do you believe hedge fund managers deliver superior performance? Larry, take it away?

Larry Swedroe 00:52
Yeah, well, it's kind of funny. You mentioned I originally wrote a book called Rational investing in irrational times. And that was came out in 2002, after the bubble broke, and there were 52 mistakes in that book. But then wrote a sequel because I got up to 77. If I write it today, we'd probably be well over 90, we discuss some further mistakes, already, like people allowing their political biases to impact their investment. The speaking

Andrew Stotz 01:26
speaking of books, you have a new book coming out, you

Larry Swedroe 01:30
have called enrich your future. It's a collection of stories that I've told over the years to help people understand difficult financial concepts, concepts, by relating analogies to them. So I'll just mention one, to give people an idea about the book. So most people know that Galileo was the one who figured out that the Earth revolves, did not the sun did not revolve around the earth as Copernicus had espouse. And the Catholic Church preached as gospel, he figured out that it was the other way around. And yet, many people are unaware that the Catholic Church in prison, Galileo put him under house arrest, because he was so famous, didn't want to put them in a real prison. He was on the house arrest for preaching this. You know, and this what the problem is, was that Galileo, what he believed, and the evidence was logic was there that the scientists advising the Pope told the pope that Galileo was right. But they were still burning people at the stake for, you know, making such blasphemous statements. They didn't burn Galileo, luckily, but it really wasn't until several 100 years later, where the Catholic church actually admitted they were wrong. Now, what does that have to do with investing in this telling of stories? Well, the Catholic Church didn't want to admit it was wrong about that, because then people might say, well, if they're wrong about that, well, maybe they're wrong about lots of other things. So they kept insisting that Galileo was wrong, when the whole world knew he was right. And so what does that have to do with investing? Well, Wall Street doesn't want people to know that passive or systematic investing, as we've discussed, is the winning strategy most likely to allow you to achieve your goals. Why don't they want it because they make more money when you trade and pay high fees for active managers never going to tell you the truth? Right? It's a question of whose interest of avodat and it wasn't in the Catholic Church's interest to tell the truth, which they knew. And it's not in Wall Street or the financial media's interest, because passive investing is boring. Just say read Larry's book or John Bolton's book, be a passive investor, develop a plan and stick to it, and you won't have to tune into Jim Cramer anymore, you'll get to spend a lot more time on more productive and more joyful pursuits. So that's what the book is about. It's a collection of 40 or so stories that help people understand difficult concepts. A lot of the issues we've discussed, like why great companies may not making great investments, how the point spread, equalizes the risk and betting on sports and PE ratios and book to market ratios. Do the same in the world of investing. So for anyone who's interested in really learning and getting educated you Seeing Simple Stories and analogies to help make these difficult concepts easy, I highly recommend the book and

Andrew Stotz 05:06
it's called enrich your future, the keys to successful investing, you can get it on Amazon and mine arrives on Tuesday. So I'll have a link to that in the show notes, too. So anybody who wants to, you know, click on that to get it? And let us let us now I mean, I don't know how you write all the stuff you write, Larry, I mean, it's really is impressive. But let's talk about do you fail to understand the tyranny of the efficiency of the market? Yeah,

Larry Swedroe 05:32
so I, to me, of all the theories about investing, the efficient market hypothesis is the most powerful hypothesis or theory, because the very act of discovering anomalies or call them errors in the theory, mistakes, whatever reinforces and makes the market more efficient. By what do we mean by that? So I'll give you an example. In the academic research, there, people are looking for anomalies that they can exploit to generate excess returns. And one of the anomalies that was discovered, for example, was one that companies that built up large amounts of accruals. So taking in earnings early, before, maybe the sales were 100%. Certain, for example, okay, tended to have poor returns relative to companies that didn't have high accruals. So that paper, it gets published showing high excess returns. And immediately the anomaly disappears. Why? Because people who run hedge funds and institutional money managers read about this even before it's published. They read it in the academic, you know, circles, where it's posted on websites, like the social services, Research Network, which I read every day, we'll look at the latest research, a gets published. And then as a good example, supporting that there was a paper I think it was written in somewhere around 10 years ago, pontiff and McLean are the authors, they found that once a pop anomaly was published, almost immediately, a third of it disappeared. So the excess returns shrank, and then over time, they tend to go down. Now, if an anomaly is one that has no risk logic to it, then probably when it's discovered, like an accrual anomaly, all right, then it's going to disappear entirely.

Andrew Stotz 07:50
And with no risk logic, it means that you're getting a risk, you're getting a return at a low risk, and that can't survive for very long.

Larry Swedroe 07:59
It's not like smaller companies are riskier than large companies. Stocks are riskier than bonds. Junk bonds are riskier than treasuries. So they all have to have risks. So it's a compensated risk. It's a compensator risk, accrual brim, there's no logic to it, right? Everyone knows about it, and it's behavioral. There's no more risk there. Okay, it's well known. So those should go away value. When it gets published that a lot of people, let's say the value premium is 4%. But if there's risk stories behind it, and value companies tend to be have more volatile earnings, their volatility, the stock prices higher, they have more fixed assets. So when you get a recession, they can't cut their expenses. isn't that big plant and equipment, so they have more operating leverage, as well as more financial, they're riskier. Okay, well, the premium was 5%. While a lot of people say, Hey, that's a big premium, and money flows in the premium shrinks, may be a third of it goes away, but the premium itself should never disappear. Just says stocks are riskier than safe bonds. Everybody knows there's been a premium historically, about 7%. But you can't arbitrage that risk away. Stocks will always be risky. Their premium may vary over time, for various reasons, but you cannot arbitrage it away. So let's use another example to help people understand this. There was a well known effect called January effect. So that gets published. Okay, well, first of all, it turns out that the effect only was there on paper. Why? And the January Effect is was that stocks outperformed in January of To the other months, so you could go long the stocks in January and then get out and you got this premium. Okay? And it was especially true, it was a small stock phenomenon. So go long, small go short lived in January, well, it gets published. And what would you do? Andrew, if you knew that small stocks were going to outperform in January,

Andrew Stotz 10:25
I'm going to buy them in December. Yeah. And but

Larry Swedroe 10:30
I know, I'm even smarter than you. I know, Andrews, pretty smart, he's gonna buy it in December, I'm gonna buy it in November, and someone smarter than me buys it. And then of course, the phenomenon disappears. And that's exactly what we see with these anomalies, especially ones that are behavioral related. And they tend to disappear. So that's the thing about the efficient markets hypothesis, when somebody discovers an anomaly, it gets published, people read about it and exploit it. And the alarm anomaly typically will disappear if or shrink dramatically. And by the way, in the case of small stocks, that never really was an exploitable anomaly, small cap stocks, and it was really micro cap stocks. You know, they've nominally may have said they outperformed by 3%. That's a lot. But these was such tiny stocks, that it cost you 4% to trade it, and you couldn't exploit it. Now, what it did tell you is if you own those stocks already, don't sell them in December, sell them in February, right. So there is even some information there. So that's the idea behind this concept that the efficient market hypothesis is so powerful, that once an anomaly is discovered, it tends to disappear. Yeah,

Andrew Stotz 12:00
and in this particular chapter, you're, you're talking a lot about the behavioral behavioral camp, you know, the people that say, we can take, we can take advantage of, you know, misbehaviors, and yet, measuring the performance of the people that are experts in behavioral finance, and let's say in behavioral investing, you find out even they can't do it. And so, you know, that I found fascinating. Yeah,

Larry Swedroe 12:31
the book covers a couple of mutual fund families, including one run by a Nobel Prize winning economist. And they point out these anomalies, but they were the ones who published it, then they go to say, well, we've got this data, we can take it to the market and show people the historical past results. But that by then everyone knows about these anomalies. And it's very hard to exploit them because people react and, you know, take advantage of that. Alright, and now I will point out this, there is something that's called the lottery effect. People are generally as investors risk averse. That's why there's such a large equity risk premium factor has been called the equity risk premium puzzle. The premium historically seems to be too big at 7% Given the volatility of stocks, right, but it's there because people hate that left tail risk when stocks go down 4050 60% 90% as they did in the Great Depression, so you gotta give me that big premium to capture mind money and get me to invest. However, when it comes to lotteries, for example, those same people who buy insurance to protect against all things, become speculators, and make dumb investments from a financial perspective, because they have a preference for what mathematicians would call, right tail skewness kurtosis or big fat right tails, like a lottery ticket. Now, if you know the math of lotteries, typically, the state or the government is taking 50 cents of every dollar. So that means when you buy a lottery ticket for $1, your expected return, if you do it 1000s of times is minus 50%. And the median return is minus 100%, or the right mo are in mo almost all of them are below and you got a small number of people that win and there's a big fat tail. That's way out on the right side where a very tiny minority win a big amount. So people have this tendency to buy stocks that look like lottery tickets, say hertz was going bankrupt in the middle of the pandemic, because it was trading at 60 cents. So I can only lose 60 cents. If it comes out of buy, I can make 10 bucks. But in return or more, well, they forget, you can lose 100%, not 60 cents, but 100% of your money. And it turns out that stocks and bankruptcy 99% of them never returned a penny. And there are stocks that have high investment. I think we've talked about this, but it's not high investment and low profitability. These penny stocks that are, you know, lottery tickets, they have over the decades underperformed T bills. So that's an anomaly. And the problem is you can't short them. It's so expensive and risky, as people who tried to short Gamestop found down and the stock went from almost nothing up to almost 500 If my memory serves and then collapsed again, in a you know, on a famous short squeeze. So people are afraid to short them. But especially now since social media has allowed these retail investors to gang up and all, you know, go after that big hedge funds, there was a big hedge funds, I think was Melvin capital loss $4 billion, and how to shut down in this short squeeze even though they were right, they gave us stock eventually went down. But they were dead in the long term. So those risks of shorting and the high costs of borrowing the securities means that people can't arbitrage that risk away. So what you could do with that information is you can't short them because it's too risky. But you can avoid buying. Hmm,

Andrew Stotz 16:54
I want to follow up on two things from every time I talk to you, I have to get off the call and do some work and look at stuff and think about stuff. So I went to the fama French. And I think it's Ken French's website where he's got his data on the factors. And I went back, he's got the factor of premiums from 1964 to 2003, that he's calculated. And you know, I broke it down kind of by decade just to see what's been going on. But just to review the fact that premiums, so market premium, which I guess you would say is equity risk premium is was 7.8%. That's from 1964 to 2003. So 2023 2023 Correct. And that's market beta. It's cool. Okay, market beta, and then small was 2.1. And you mentioned something as you were speaking, which is, you know, the cost of executing in a small cat, I assume that these do not include any transaction costs. He's just doing poorly, you know, pure calculations. So to take advantage of that 2.1% premium is just probably going to go away once you actually execute. Then

Larry Swedroe 18:09
just take a moment on that because there's a real problem. Small cap premium is really unfortunately polluted by these lottery stocks, these penny stocks, stocks and bankruptcy, etc. If we can call them junk. Cliff Asness of AQR, Capital Management, wrote a brilliant piece. I think he called it saving the size premium by eliminating the junk. So if you screen out these lottery stocks, the size premium becomes much bigger. And that's what fun families like dimensional AQR Bridgeway Alpha architect, they all Blackrock screen out these really bad small stocks, even the s&p 600 has incorporated quality screens into their fund construction rules. Is

Andrew Stotz 19:08
that guys size premium or junk problem? Sorry, do you think it's size? Is it his article? Size matters if you control for John? Yes, yeah. And SSRN where you mentioned earlier? Yep. Yeah, exactly. There's some homework. And when you look at the volatility of the small, small cap premium, it's much more volatile than any other factor where period was 13, and the lowest was 2.7. That's a biggest spread out of all the different factors which supports that idea.

Larry Swedroe 19:41
I would argue also that the size premium is probably shrunk today, because of the Sarbanes Oxley Act, which made it so much more expensive to be public that small companies are not going public. They're staying private. Until there may be a billion dollar market cap, which isn't really so small anymore, right? At least relative what used to be considered small. And therefore, you want that size premium, you may have to go to more private markets to catch it. Obviously, the smallest stocks still have a premium, they're riskier than the largest stock, but you're not able to buy really small companies any longer. Or it's much, you know, now, the trading costs are much lower because they're not so tiny and as illiquid in many cases. But that's a real problem. Today, do you know that 25 years ago, there were over 8000 stocks today, there's like 30 537, well, that

Andrew Stotz 20:48
that brings another thing that I wanted to mention. Instead, I went back and looked at the different indices, you know, we were talking about s&p indices, and we were talking about Wiltshire and all that. And so I went to look at the Wilshire it gives me the most information on their site that I could pull together. And for the Wilshire 5000, it now has 3400 stocks. And and then there's, they still call it their wills are amazing. And, and then, but also, that just raises the point, like, Who the heck is getting any compensation at the New York Stock Exchange. If you are running an exchange, where the number of companies listed on your exchange is falling year after year after year? Wouldn't that be failed performance if that was your goal to list companies on your exchange? Well,

Larry Swedroe 21:39
it's not they're doing it Sarbanes Oxley, which was meant to supposedly protect consumers in some way, providing more transparency in accounting rules. But it also impose all kinds of costs and risks. And it's made it so much more expensive to be public. But lots of people think it's just not worth the effort until you get so big. And you really need capital at still at that point. So I was never an investor much in private equity, I've changed my view there, one, because the fees have come down quite a bit. You don't have to pay two and 20 to get top performing funds as well. But the other side is you just can't really access that size premium. And these were the biggest growth opportunities come when companies are much smaller, it's rare that they've launched stocks, like an Nvidia or Apple provides spectacular returns, that's really rare. But the smaller companies have a much better chance to do that. And

Andrew Stotz 22:50
this is why you know, one of the things that I have is I have a data set of about 26,000 companies worldwide that I then try to produce into like a standardized balance sheet and p&l to try to calculate ratios for my teaching and from my own research. And every time that I do screenings based upon market cap and average daily turnover, what I find out is that now China has more large and liquid stocks than America.

Larry Swedroe 23:21
And they're all they've got four times the population. So maybe that makes sense. Well,

Andrew Stotz 23:26
and there's also China, unlike other countries in Asia, because of the Communist Revolution, and nationalizing the assets, when they bought those assets out to the market, they had huge chunks of those assets that they put into the market, as opposed to the typical family in Asia will say, Okay, I want to put 10% of my company in the market, and I'm gonna hold 90% of the shares. And so they actually, the average daily volume for a lot of large companies in Asia can be very small. But this also explains why every time that I hear you, as well as others talk about small, you really are talking small value, most of the time and value premium is the next premium, we said small premium was 2.1 value is 3.8. And so it sounds like it's not worth it to play in the small premium space. Maybe small value combines those two factors. And that gives you a little bit more worthwhile I

Larry Swedroe 24:25
would add the literature is pretty clear. What you want is to avoid what are called Valley traps, stocks that are crashing, right and they're becoming they were lodged in growth. Now this small value, but there's a good reason. Maybe they're headed for bankruptcy. And so what you want to do is add a profitability screen to that dimensional building on the work of Robert Novy Marx in 2013. added that screen a recent paper For that I'm just writing up today looked at this and found that, you know, as we've talked a small growth anomaly is the real problem. Small growth stocks have far underperformed large growth stocks, even though small growth stocks are riskier than large growth stocks, right? But they fire under the law. And it's this lottery effect problem which pollutes that data. So you have to include I think profitability, and all of a sudden, if you include profitability is a screen, there's an index, you can research. Since you've mentioned Ken French's website, there's a small profit robust profitability screen of research index that fama and French had, I imagine it's on Ken site, I know it's on dimensionals website, which I have access to. And, you know, the returns to small cap low profitability, are both well below the market. And the returns to small cap high profitability are over something like 14% a year. So that's the screen. You said

Andrew Stotz 26:15
in a small robust profitability.

Larry Swedroe 26:19
Yeah, there's a fama French research index, that's called the fama French small, robust profitability research index, okay. And I'm just wrote up that paper there, give me a moment here, I can actually pull it up because I just finished working on it today to write up this paper finding that how default risk is really a problem. It's not properly price, and it's this lottery effect is my explanation. You know, for that. So here's the data. My computer's pulling it up now. All right. So if you look at the fama French small cap research index, since July is 63, it's returned 11.7%. The farmer France us small but weak profitability. So the bottom 30% of profitability stocks return just nine three, but the US Small, robust profitability, the top 30%, return 14 And it had less volatility than this week, profitability stocks. So that's why when I invest, I personally use funds that a small value but screen for profitability or quality, as well as well as negative momentum. So you're not buying these value traps. So I would not buy a small value fine, we talked about this, don't just buy a fun based on its descriptive name, you want to look for make sure it's got these exposures to the factors you want. And the research here shows you want profitability, because markets are inefficient pricing, these default risk stocks because of these limits to arbitrage that prevent the sophisticated investors like Melvin capital from correcting Miss pricings because he lost 4 billion and doing that, and we've seen a lot less shorting activity, by the way by hedge funds since that action that happened. So there's going to be more Miss pricings more overpricing more bubbles happening in the future than would be the case because of the ability for retail investors to legally gang up.

Andrew Stotz 28:53
So, we said market beta 7.8 from 1964 to 2023 Small cap, this is fama French data, small size of factor from 1964 to 2023 2.1, value 3.8% Premium profitability 3.9 and investment 3.6. Now,

Larry Swedroe 29:15
investments of people understand just profitability is high profitability, return stocks versus low profitability stocks and their return investment is companies with low investment minus the return of companies with high investment. So in general, companies with low investment outperform companies with high investment and the worst group of stocks to own is the combination of high investment with low profitability. The odds are you're headed for bankruptcy, but not always is Amazon proof. Yeah. And well, that's what keeps the hope alive.

Andrew Stotz 29:58
And I believe that the measure if they're using for investment is asset growth, total assets. Yeah. And that could be distorted. If a company is building up cash assets could be growing. And that would be maybe lower risk. But, but I think about like Coca Cola when I used to work at Pepsi, the parent company is really just selling syrup. And they've got the bottling operations owned by others. And so, you know, they can expand pretty massively have a highly profitable product without a huge amount of investment. And I think when you look at Warren Buffett's gains on that the investment factor to me is a significant one there, so

Larry Swedroe 30:37
then a higher one. But what you want to look at, because there are companies like Google that have high investment, but are highly profitable, as long as their profits are exceed their cost of capital, you want them to be high investment, right? So that's something you want to look at. So the killer is high investments with low profitability. All right,

Andrew Stotz 31:03
let's look at do you believe hedge fund managers deliver superior performance? That you don't believe that? Well,

Larry Swedroe 31:13
research is somewhat limited until a brand new paper just came out. But here's what the research has found us relying on public Lee available. Vendor databases, and this are self reporting. So it's a problem of hedge funds. Over the last 20 years, these genius hedge fund managers underperform, totally restless one month treasury bills, something like 1.4%, for t bills to 1.2% for hedge funds. Well, that tells you pretty much everything, you know, at least I thought so. There's a brand new paper out for the first time that went and looked at sec, what are called PF filings, private filings that have now been required for like 20 years now. So they've dug up the private filings for a hedge funds as well, who don't report on the public database. Now, you may ask, one of the things that people thought is, boy, there's got to be a, you know, downward bias here. People who are not reporting, why aren't they reporting because their returns are bad. So it's overstating their returns? Right? Turns out, it's actually the opposite is true. So I might have thought the returns are even worse than the public databases were that you also have what are called incubator biases, some hedge fund, Andrew Stotz hedge fund company comes up with 10 Different hedge funds using exactly the same strategies, but they buy different securities. And they only roll out the one that did well shut down the others that will fund it with their own capital. And they only report to the databases backfilling after the fact the returns are those. So that's called backfill bias. And this other problem of incubator bias. Turns out, when you look at the hedge funds, who don't report, many of them are maybe companies like Renaissance technology, they don't need to be in the public databases, because they don't even take any new money. They're not looking to raise assets. They know that if they took in a lot more assets, they wouldn't be able to have the same kind of profitability, because growth of assets creates problems, right? Your trading costs go up and stuff. So that's a problem. You can execute maybe your best ideas as well. So they tend, in fact that this paper showed that while the public database companies continue to get cash inflows, despite the horrific returns, that's an anomaly, right? Why are people pumping in the industry is that $6 trillion? It was 300,000,000,025 years ago. Why are people pumping money in? Right? Turns out that these other non public funds have had negative growth in their assets slightly. They're returning more capital than they're taking in, and these funds have generated some alpha. Now, what's the problem there? You can't bind this to him. Yeah, because Yale's and orphans of the world, you know, are the ones giving them money, right. And they're probably negotiating slightly lower fees than you and I would get. So it doesn't do any good likely for the typical retail investor or even a high net worth investor, you may not have access to these superior performance. And even this paper found what the research has shown prior that in the publicly available databases, there is no evidence of persistence of performance. So even if you found the manager have a good track record, it told you nothing about the future, because they would get assets coming in the cash flows would undermine their ability to generate, or it might have been locked in the first place. And also past returns could be because these anomalies existed, they get published, and then the anomalies disappear. And so, you know, you can't exploit them. There is some evidence of persistence in the non public funds, who do keep their scale small. So they can exploit these still little anomalies that exist in the marketplace. But they know if they took in a lot more assets, they wouldn't be able to generate the returns. Even companies like Renaissance technology, you know, stop taking outside money shut down funds, because they actually had poor returns with those funds, and they only run they're basically their own money now.

Andrew Stotz 36:31
So my final question of this episode is, with Jim Simmons of Renaissance capital, and Ray Dalio, where they just lucky,

Larry Swedroe 36:44
I don't know clearly, I think neither case they were lucky, they employed brilliant mathematicians, you see a high frequency trading exploiting little micro inefficiencies in the market. I don't think that was locked. I think there clearly was some skill there and the knowledge to hire world class mathematicians and physicists to apply their skills to find these little micro, you know, anomalies in the market. But the vast majority of the hedge fund world says that if there was success, either the anomalies are gone, and they're no longer exploitable. The competition has gotten much tougher, because everyone now hires or a class mathematicians and physicists, not just at hedge funds, but if you look at Eduardo Repetto, runs Avantis. His research, he's literally a rocket scientists that you know, you know, in real time, he worked on missiles and that kind of stuff. So that, you know, it's very difficult to exploit these now. And anyone interested in that subject, I'd suggest reading my book, The Incredible Shrinking alpha is showing scanning much harder to exploit. And a lot of the returns, by the way, are exploitable, because they are investing huge amounts of money in these pipes that give them access to trading in milliseconds faster than everybody else. And if the SEC would simply impose rules that would say, if you put in a bid or an offer must stay there for at least five seconds, a lot of their profits would go away.

Andrew Stotz 38:42
So I'm just thinking of a song. I remember when I was a kid by Dr. John, I've been in the right place. But it must have been the wrong time. Maybe they just came at the right time where the anomalies were there. They exploited them with their systems, they got the benefit of that the market got the benefit of becoming more efficient. And if they were to start today, exactly what they were doing in the past, they couldn't produce those kinds of returns.

Larry Swedroe 39:08
I think that's a fair statement. But it doesn't mean they still can't generate these excess returns, as long as the rules are in their favor allowing this exploitation by talking yourself closer to the where the info the day there is allowing you to get the information just microseconds faster than everybody else. And stuff but and you know, there are smart people that I continue to find anomalies, and I'll have to keep finding new ones. Because once they found then other people hear about it. People quit Renaissance to go somewhere else to start their firm. And now they've got the knowledge and it spreads. It's a real problem. 50

Andrew Stotz 39:50
Rabbits lined up for Race, One of them's going to win, but it's pretty much impossible to pick out which one it's going to be. All right, Larry. Well, we've taken enough Your time I really appreciate, you know all that you share. And as I say you, you, I'm writing down stuff all the time that I'm now going to go out and look at. But you really clarify one thing for me today about the why there's not a lot of focus on just small cap. It's you know, and Cliff Asness, I've seen the research that you've mentioned in the stuff that you've talked about, focus on small cap value profitability, and you end up getting some better, better opportunities in that space. And so I just want to thank you for another great discussion to help us create, grow and protect our wealth for listeners out there who want to keep up with all that Larry's doing, which I dare you to just go to at Swedberg at Twitter or x. And also you can find him on LinkedIn. This is your worst podcast hose Andrew Stotz saying, I'll see you on the upside.


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About the show & host, Andrew Stotz

Welcome to My Worst Investment Ever podcast hosted by Your Worst Podcast Host, Andrew Stotz, where you will hear stories of loss to keep you winning. In our community, we know that to win in investing you must take the risk, but to win big, you’ve got to reduce it.

Your Worst Podcast Host, Andrew Stotz, Ph.D., CFA, is also the CEO of A. Stotz Investment Research and A. Stotz Academy, which helps people create, grow, measure, and protect their wealth.

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