WSJ columnist Jason Zweig is a common target for my rebuttals. Ironically mostly because his writing is so amazing I religiously read his pieces. In the "The Incredible Shrinking Fund Manager"s he argues the Alpha delivered by star managers can be explained by them leaning on factors that have been identified to do better by academics. This culminates in the bottom line:
"Viewed this way, almost every active stock picker becomes effectively interchangeable with an index fund or a combination of them charging much lower annual fees."
I agree with the bottom line; the reasoning Zweig follows to get there is faulty. In fact it is so shaky investors who take it for granted are at risk of doing something stupid. He explains the outperformance of managers after the fact by stating you could have achieved the same results by buying an ETF that corresponds with the manager's factor choices.
The assumption is managers' factor choices will remain consistent in the future. This will be true for some, but it is impossible to say if a particular manager is just milking a factor as much as possible within his or her mandate or if his or her bottom-up fundamental analysis led to overweighting of a particular factor.
After the fact a researcher can easily mistake the latter for a strategy that can be replicated with a low-cost ETF. Listening to the academic you would switch your assets to the low-cost ETF expecting another decade of outperformance with less fee drag. Meanwhile, the manager, after a decade of outperformance, starts finding better opportunities elsewhere within the mandate and is no longer overweighting the factor it leaned on so heavily (consciously or not).
How ludicrous (but interesting) this gets is when researchers (Andrea Frazzini and others 2012) show Warren Buffett's performance can be chalked up to exposures to value, low-risk and quality factors. You would almost start thinking you can buy a few factor ETFs and top the Forbes 500 20 years later.
Conveniently, the researchers look at Berkshire Hathaway (BRK.A) (BRK.B). With Berkshire Hathaway Buffett's wasn't as focused to generate as high a return (or risk-adjusted return) as possible. Under the Berkshire Hathaway umbrella, Buffett's investment style is significantly different from his style in the partnership era.
Just by reading all the partnership letters I'd say quality and low-risk (as it is defined academically) played much less of a role while value played a much larger role. We can't know for sure why. We know some of the reasons are a matter of personal preference like Buffett's desire to enjoy himself at work.
Could it be his and Charlie Munger's fundamental analysis started to indicate companies (which happened to be quality) were better investments? More recently, we've seen another shift in the duo's stock picking with them starting to buy more capital intensive business like Burlington Northern. If and when Buffett ever ends his career we can go over it and argue: if you held a small cap value ETF from 1956 to 1969. Switched into a multifactor U.S. large cap quality value ETF in 1970 you would have approximated Berkshire's returns from its stock picks. Maybe, if you did. But that's a really big if.
Even if you wanted to go at it Buffett style by building a portfolio geared toward the value, low-risk and quality factors, how can you actually accomplish that? It's relatively easy to buy value and quality stocks. For example the magic formula is a screen that accomplishes it. It is impossible to buy low-risk stocks post-ante. You have to understand the difference between Buffett who bought stocks (that apparently turned out to be low-risk post-ante) is decidedly different from you buying low-risk stocks (low volatility ETFs?) post-ante. Morningstar ranks all ETFs based on a mutliplier of the fair value of its constituents as determined by its analysts. You know what is the most overvalued ETF? The Powershares Standard & Poor's 500 Low Volatility (SPLV).
Zweig gives the interesting example of Fidelity Contrafund manager Will Danoff. Profiled in a previous "Intelligent Investor" column the guy beat the S&P 500 by an average of 2.9 percentage points per year for the past 26 years. Now Zweig contends this record loses a bit of its luster when analyzed with new techniques:
Adjusting for the riskiness, size, valuation and recent momentum of Contrafund's holdings, its outperformance drops to 1.9 percentage points annually since 1990, according to Wharton Research Data Services, a financial-analysis group at the University of Pennsylvania. That's still impressive, although no longer eye-popping.
He then quotes Larry Swedroe as saying:
Recently introduced exchange-traded index funds specializing in large growth companies with high momentum could probably come close to mimicking Contrafund's future performance unless Mr. Danoff discovers a new source of return or changes his style, says Mr. Swedroe.
It suddenly looks like Danoff was just lucky. He happened to invest in large cap, growth and momentum factors just when these were set to outperform. Something I've chronicled in different articles (like: "Longest Period Of Growth Stock Dominance Since WW II") as it will inevitably end.
Not incidentally, I also read Zweig's column about Danoff, and there's one very interesting paragraph in the context of the point I'm making:
He expects to add "a couple dozen" small and mid-sized companies to Contrafund's 340-plus holdings "to provide more growth in a low-growth environment."
Exactly at the time Larry Swedroe says Danoff's performance could be captured by an index fund specializing in large growth companies, Danoff's mind is already on small- and midcap companies while managing a fund with $112 billion in assets under management.
Zweig ends his article:
A few years from now, your plumber may be a former mutual-fund manager.
To which I'll say good for them; it's an honest and important job that's well positioned not to be disrupted by the robots.
I hope the plumber doesn't get too many unpaid bills from people who owned low-volatililty ETFs to replicate Buffett's performance.
Disclosure: No positions in stocks mentioned.
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