Alpha Falling By The Wayside?
On November 15, 2006, Andy Serwer, the managing editor of Fortune, wrote an article entitled: The greatest money manager of our time. Serwer waxed poetic about the virtues of Bill Miller, the fund manager for Legg Mason Value Trust, which had $20 billion in assets at that time. Serwer noted that Miller had outperformed the stock market for 15 years “through the tech bull market, then the crash, and now the recovery.”
Miller’s stock picking methodology added to his mystique. He ran a required book club for his underlings. He was the chairman of a think tank founded to study “complexity.” Others marveled at his ability to converse with Nobel laureates in physics. Serwer noted that Miller held a “dog’s breakfast” of stocks ranging from Amazon to Eastman Kodak.
Being an investment guru was good to Miller. He bought a yacht named Utopia, complete with a heliport, gym, and a Jacuzzi. He owned over $270 million in Legg Mason stock at the time and his annual compensation was estimated to be a good chunk of the $132 million a year in revenues generated by his fund.
Miller’s winning streak ended in 2005, but Serwer remained captivated by his expertise. He breathlessly noted that, after Joe DiMaggio’s famous 56 game hitting streak ended, he started another 16 game hitting streak. The message was clear. Miller was that rare breed: A stock picker with a remarkable skill.
If you followed Serwer’s advice, you had rough sledding. According to one observer, since 2005, his fund “gave back” all of his outperformance including a loss of a whopping 55 percent in 2008.
In December 2007, just before the big crash that hit financial and homebuilder stocks the hardest, Miller spoke to the press and suggested that many financial and homebuilder stocks were still good investments. Recently, Miller stepped down as portfolio manager of his fund.
According to Weston Wellington, vice president of Dimensional Fund Advisors, Miller’s fall from grace isn’t necessarily conclusive evidence of the failure of active management. Wellington notes that Miller’s fund expenses were a steep 1.75 percent. The blended fund expenses of a globally diversified portfolio of stock and bond index funds would be one-third of those fees or less. The difference in fees provides a “stiff headwind” for any stock picker to overcome.
Assuming Miller possesses the rare expertise of a successful stock picker, it ended up doing his investors little good. The benefits of his winning streak were transferred from the pockets of investors in his fund to him and his firm.
Miller’s demise as a stock picker is representative of what happens every day on Wall Street. Money earned by U.S. investors is handed over to brokers, advisers, and fund managers. It’s a no-lose deal for the advisers and managers, who take their cut whether they perform or not. For investors, especially those chasing returns and searching for the next investment guru, it’s often a loser’s game, causing them to underperform the market.
There is growing awareness of the inherent unfairness of this system. Maybe the next move will be to occupy Utopia.
There is a growing awareness of the "inherent unfairness of this system." And there is a growing awareness that 'chasing alpha' is a fool's paradise. This is the point Niels Jensen underscores in his December Absolute Return Partners Letter, The Facts They Don't Want You To Know About, an absolute must read for all investors, especially institutional investors chasing after hedge funds and active managers.
Mr. Jensen begins by asking:
What have Bill Gross, John Paulson, Anthony Bolton and Bill Miller all got in common? They are all ‘rock star’ fund managers who have fallen on hard times more recently. Life in the fund management industry is not what it used to be like. Life is tough even for the supremely skilled. Markets are changing, fund managers are struggling to adapt and clients are growing restless as a result.
If I told you that the composition of an average UK equity fund changes by 90% a year, would that startle you? How would you feel if I added that the 20 funds with the highest turnover returned just 4.7% to investors in the 3 years to the end of March 2011 whereas the 20 funds with the lowest turnover returned 16.8% over the same period?
From the same source: Out of 1,230 funds across 12 different strategies, only 35 fund managers produced a performance consistent enough to earn their fund a place in the top quartile in each of the last three years (upper half of chart 1). In a universe of 1,230 funds, over a three year period and completely disregarding skill, the expected number of funds consistently ranked in the top quartile is 1,230*0.253=19.22.
In other words, more than half the 35 managers were there not because of skill but because, statistically, someone was always likely to ‘over-achieve’. This leaves about 15 fund managers out of a universe of 1,230 – ca. 1% - who could with some right claim that they have consistently been in the top quartile.
Indeed, extreme volatility is confounding even the best fund managers, most of which are underperforming their benchmarks in 2011. Even Soros Fund Management laid off a handful of analysts and portfolio managers in recent months. Some fund managers have closed shop, retired while others are trying to adapt to this environment, but the question remains why are institutions doling out huge fees for such underperformance, allowing fund managers to continue raking the big bucks? What are investors suppose to do?
Mr. Jensen concludes with some recommendations (and keep in mind, he's part of the industry):
- Stick with people, not firms. In our industry the key assets walk out of the door every evening and, if they do not return the next morning, neither should you.
- Identify an investment strategy you are comfortable with. Whether you believe in value, growth or something entirely different is less important. All active managers have their ups and downs, and it is when the going gets tough that it becomes critical that you are entirely onboard with the fund manager’s investment approach.
- Prohibit high frequency trading (HFT). HFT uses powerful computers and sophisticated software to take advantage of microscopic inefficiencies in markets around the world. HFT models will often sell a security within a few milliseconds of having bought it. Does that add any economic value to financial markets? I don’t think so. Does it create unwarranted volatility occasionally? I very much believe so. Although I am not in favour of the much discussed financial transaction tax proposed by the Germans and the French, ironically, a modest transaction tax (if it were global) would wipe out all HFT based strategies, and the world would be a better place as a result.
- Don’t invest in hedge funds for performance reasons. Do it because it is one of the few areas where you can truly diversify your investment risks. For example, the average managed futures fund was up well over 20% in 2008% when most asset classes collapsed.
- Consider multi-strategy funds as an alternative to funds of hedge funds. The downside is that you concentrate your manager risk but you often achieve better strategy diversification and more attractive returns. Multi-strategy funds outperformed funds of hedge funds by approximately 3% last year and they are on target to do so again this year (see here).
- Do not disregard sound advice. Those of us who have worked in the industry for decades know where many of the pitfalls are and can help investors stay clear of most of them. Just make sure your interests are aligned with those of your adviser.
- Or you can simply do as the 1.5 million people in the UK who, according to a survey conducted earlier this year by Schroders, hold all their equity investments in a single company. Not my preferred approach, but who am I to challenge the wisdom of 1.5 million people?
Maybe those 1.5 million Brits are active equity traders which take concentrated bets on one company at any given time. Highly unlikely, but that is my preferred approach in this market, taking concentrated bets on a few companies, moving in and out of cash. Whatever the case, institutional investors really need to rethink their hedge funds strategy and start taking some more intelligent risk in their alpha and especially on their beta portfolios.
Below, John Roque, head of technical analysis at WJB Capital Group, speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "InsideTrack." He discusses SALLY, alternatives to equities, why chasing alpha is a fool's paradise and why many of today's winners will be tomorrow's losers (just like some 2011 losers will be 2012 winners). Importantly, he also emphasizes that "alpha this year has a different definition," namely, "missing Netflix, Green Mountain and other stocks on the way down," mitigating downside risk. Not as sexy as the video in my previous comment on Norway's butter crisis, but good interview, well worth listening to (h/t, All Star Charts).