Warren Buffett’s portfolio construction skills are what got him where he is.
In 2013 AQR wrote a paper called “Buffet’s Alpha“, and deconstructed sources of Warren Buffet’s returns over the years. They found that “Buffett’s returns appear to be neither luck nor magic, but, rather, reward for leveraging cheap, safe, quality stocks.” Which is exactly what Buffett did. He bought quality and less volatile or safe stocks and then he levered up his portfolio about 1.7x with insurance float and that explained his outperformance. The insight here is that if Buffett had bought some other stocks with the same characteristics, his performance would not be any different. Buffett’s portfolio construction skills are what got him where he is. Not that he isn’t a great stock picker. But too much emphasis is put on the latter and too little on the former.
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What matters, however, is that Graham and Buffett figured out these insights far before anyone else and stuck to them for years. And that matters a lot. There are many ways of using factors or what are popularly called factors, style, risk premia or “smart beta”. The most robust way is to use systems-based investing process.
Let us take a step back and look at what investors are really looking for. The holy grail of investing actively, for hundreds of years now, can be described as the discovery of an “edge”. This “edge” or Alpha could be either superior information, analysis or behaviour. Over the years information and analysis has been democratized due to technology disruption and regulatory interventions. A fund manager today gets the quarterly and annual reports at the same time (in most cases) as a retail investor. And technology has ensured that powerful analytical tools are available at affordable costs to small funds and DIY investors. The active management industry has lost most of its analytical and informational edge. The only edge that remains and will perhaps endure for a long time is behavioural edge.
Also, what was earlier Alpha can now be explained simply by exposure to a factor i.e. Market, Value, Size, Momentum, Low Volatility. These factor portfolios can be made available in a cheap wrapper.
The factors mentioned above have two reasons why they exist:
- Risk Premium or reward for taking risk
- Systematic Behavioural Errors or who is on the other side of the trade
Who is on the other side of the trade?
Medallion’s thirty-year performance of 66 percent pre fees and 39 percent post fees is well documented. But that fund is capped at $10 billion and is not open to outside investors since 2003. So good luck getting into that one. What is important to Medallion’s success was and is—who is on the other side of their trades. Simons seems to think it could be “the manager of a global hedge fund who is guessing on a frequent basis the direction of the French bond market.” Or, as Bob Mercer, his partner says, “It’s a lot of dentists.” Basically, discretionary investors and traders who are guessing on a regular basis and have no real edge.
Author and Investor, Charles Ellis, wrote the classic investment book, “Winning the Loser's Game,”. Ellis cited a study revealing that in professional tennis, 80 percent of points are won but in amateur tennis, 80 percent of points are lost. A huge gulf exists between the skill and ability of professional investors and their amateur counterparts; whose actions are often just emotional speculations. Unlike amateur tennis players, amateur investors play in the same field as professionals at the same time. These are Bob Mercer’s “dentists”.
Ironically the biggest issue with active management is that too many very skilled participants are competing in the game. With the growth of passive investing, there are fewer “dentists” making systematic errors and it has become harder for active investors to beat the competition and the benchmark.
How does one harvest “behavioural alpha” or win the “Loser’s Game”?
Daniel Crosby, in his book “The Behavioral Investor”, argues that taking the best from Passive and Active investment strategies and investing a third way—A system-based implementation of factor portfolios is the way to harvest “Behavioral Alpha”.
The most robust and well-known factors or “smart beta” used are
4. Low Volatility
The question often asked is if everybody knows about them, why do they still work? Why haven’t they been arbitraged away? The same reason knowledge of awareness of diets and exercise doesn’t make people healthy and fit. Self-discipline and the ability to stick to the plan over time.
Factor investing works because they work over-time and not all the time. These factors are certain to deliver risk and expected to deliver returns over time. No Pain, No Premium.
The few that are available in India are ICICI Low Vol ETF which is a single factor ETF. Two multifactor options are the recently launched ICICI Alpha Low Vol ETF and DSP Quant Fund. Over the series, we will look into these factors, funds and other vehicles and show how to use them in your investing journey.
—Anish Teli is Managing Partner and Fund Manager at QED Capital Advisors. The views expressed are personal
Disclaimer: Nothing in this article should be construed as investment advice. This is purely for educational purposes only. Please consult an investment advisor before investing.