- Buckingham Wealth Partner’s chief research officer, Larry Swedroe, and Bridgeway Capital Management’s head of research, Andrew Berkin, tell Business Insider why alpha from active funds is shrinking based on evidence from the second edition of their book, “The Incredible Shrinking Alpha”.
- Swedroe and Berkin dispel Wall Street’s myths explaining why active management generally isn’t a winning game for investors and provide tips for a passive investing strategy.
- “Why are you playing in a game, competing against people with far more skill, resources, time and effort?” Swedroe said.
- “Where you get into trouble is when your portfolio doesn’t do as well and you sell out, and typically people are selling at the worst possible times,” Berkin said. “And so know what you’re buying and stick with them.”
- Visit Business Insider’s homepage for more stories.
Actively managed funds are underperforming their benchmarks. Buckingham Wealth Partner‘s chief research officer and top investing author, Larry Swedroe, and Bridgeway Capital Management’s head of research, Andrew Berkin, want to tell investors about it.
Berkin and Swedroe, co-authors of recently updated bestselling investing book, “The Incredible Shrinking Alpha”, told Business Insider about why alpha from stock picking and active investing is shrinking.
Most investors don’t know about passive investing, because financial institutions on Wall Street can earn more and gain more coverage with active investing, Swedroe said.
“Wall Street needs and wants you to believe that active management is the winning game, because that’s the winning game for them,” Swedroe said. “If you don’t trade a lot and aren’t willing to pay big fees to get alphas, they go out of business. The media is complicit because passive is a boring story. You tell once and it’s done.”
According to new evidence presented in the book, 80% of actively managed US large-value funds underperformed their benchmarks over a 15 year period ending June 2019. The picture is even worse for small-value actively managed funds, as 87% have underperformed their respective benchmarks.
This underperformance is happening even before investors take into account taxes, trading fees and expense ratios.
Outperformance from active managers is shrinking
Active fund managers promise to deliver outperformance for clients, this also known as positive alpha.
Over the years, alpha has been shrinking. Berkin and Swedroe identified that one of the reasons for the decline is that much of what was thought to be alpha is, in fact, beta.
In the book, beta is defined as the exposure of a stock or mutual fund to a common characteristic such as market capitalization or high profitability. These characteristics are known as factors.
Many superstar investors, such as Warren Buffett, identified these factors long before academics. But over time as academics have discovered the factors and research has become more widely available on how successful active fund managers leverage factors in their stock picks.
Access to better technology and data combined with research has meant there are fewer opportunities for fund managers to beat the market or capitalize on market inefficiencies.
And investors now have the more accessible option to gain exposure to these factors through indexes, or passively managed mutual funds, instead of paying high fees to a fund manager to pick the best stocks with those characteristics.
Stock picking is a zero-sum game
One of the reasons active investors have been successful throughout the years is through the exploitation of bad behavior of retail investors, who typically don’t have the same discipline as big guns like Buffett.
Individual investors typically buy stocks that go on to earn sub-par returns and sell stocks that go on to earn above-average returns, the book showed.
It is a zero-sum game for lone investors. Institutional investors often come out on top, as they make up 90% of those who trade and have better technology and expertise, Swedroe said.
“Why are you playing in a game, competing against people with far more skill, resources, time and effort?” Swedroe said. “Unless it’s like going to Las Vegas, and you take $500, and it’s entertainment. But I wouldn’t take my IRA, or retirement account, to the casinos. And Robinhood investors should not be taking their retirement accounts to the Wall Street casino, because they are likely to lose, the research shows that the vast majority of them underperform.”
The good news is the number of individual investors in the stock market is continuing to decline, which means fewer victims for active funds to target, which also means less alpha is being generated.
Online platform Robinhood has given rise to a new generation of retail traders. However, Berkin does not believe this will result in active fund managers seeing a significant increase in alpha, because the amount of new unsophisticated money will be spread out thinly amongst a number of forces.
What can investors do next?
For investors who are worried about the shrinking alpha from active investing, Berkin and Swedroe recommend passive investing. Investors can either explore investing in an index, such as the S&P 500, or a structured investment fund where the fund is set up to have systematic rules that define its investing strategy.
In the book, Swedroe and Berkin list a number of different funds for investors to consider depending on which factor they are interested in. For example, for market beta, investors could select Fidelity Total Market Index Fund (FSKAX) or, for momentum, investors could select the AQR Large Cap Momentum (AMOMX) fund.
In addition to reading the book, Swedroe recommends new investors explore Morningstar to understand the various aspects of funds they are considering, as well as spending more time educating themselves generally about investing.
“All factors will go through bad periods and if you don’t understand it, you won’t have the discipline to stay the course,” Swedroe said. “I really believe that’s the key — get yourself educated. Education is the armour that protects you from your stomach. I have yet to meet a stomach that makes good decisions. Heads make much better decisions than stomachs.”
Berkin also emphasizes the importance of education – knowing what you are buying and the implications for your portfolio.
“Where you get into trouble is when your portfolio doesn’t do as well and you sell out, and typically people are selling at the worst possible times,” Berkin said. “And so know what you’re buying and stick with them.”
If you must active invest….
And if you must actively invest, then stick to a low-cost, low-turnover fund that is focused on its area of expertise and know your exposures, Swedroe said.
“I believe that what investors should focus on is putting the odds in your favour because the world is uncertain and then really the best we could do is estimate the odds of anything happening,” Swedroe said. ” … And that’s what the book is all about. Tell us about the odds of you winning the game of active management? The research shows – you’re highly unlikely, but not impossible, that you will underperform.”