Swedroe: An Active Manager Strikes Out

November 23, 2015

Bloomberg TV recently invited me on to their new show, Bloomberg GO, for a short debate with David Barse, CEO of Third Avenue Management, on active versus passive investing.

After stating that funds offered by Third Avenue, which have more than $8 billion in assets under management, had been able to beat their index benchmark, Barse admitted that alpha was hard to deliver because the competition is tough. But he also asserted that it’s what his firm wants to do, that it’s intellectually challenging and that Third Avenue works hard to do it.

I certainly agree that it’s difficult to deliver alpha. And as demonstrated in my book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, the task has become increasingly more difficult over time, with fewer and fewer success stories.

That said, I would add that investors surely don’t care if Third Avenue finds generating alpha intellectually challenging. Nor do they care if the firm works hard at it. Investors don’t confuse effort with results. So let’s go to our trusty videotape to see if Third Avenue has, in fact, been delivering alpha.

Setting Up The Comparison

Third Avenue’s investment strategy, or philosophy, is based on the work of legendary value investors Benjamin Graham and David Dodd. Quoting from the firm’s website: “Third Avenue Management analyzes opportunities based on the balance sheet quality and financial position of companies that issue securities. Our analysis of financial strength informs our judgment of intrinsic value. Once we determine our assessment of what an enterprise is worth, we invest only when we can do so at a significant discount. We buy strength when it is misunderstood and undervalued.”

Given this statement, we can conclude that the proper benchmarks to which we should compare the returns of their funds are not marketlike indexes (such as the S&P 500). Instead, they should be compared to value indexes. Or better yet, to comparable passively managed value funds (which also possess costs and trading expenses) in the same asset classes.

Thus, to determine if Third Avenue is outperforming passively managed funds, we’ll compare the returns of three of their funds—the Third Avenue Small Cap Value Fund (TASCX), the Third Avenue International Value Fund (TAVIX) and the Third Avenue Value Fund (TAVFX)—to the comparable funds run by Dimensional Fund Advisors (DFA) and, where available, to a comparable Vanguard index fund. (In the interest of full disclosure, my firm, Buckingham, recommends DFA funds when constructing client portfolios.) We’ll begin with TASCX.

Is That Alpha?

Morningstar classifies TASCX as a small value fund. For the 10- and 15-year periods ending Oct. 13, 2015, TASCX returned 5.20% per year and 8.34% per year, respectively. The fund’s percentile rankings (first percentile is the best) over those periods were 90 and 91, respectively.

In other words, despite the hard effort Barse assured viewers that Third Avenue applies, the fund managed to underperform all but about 10% of the small value funds that had managed to survive.

DFA’s U.S. Small Cap Value Fund (DFSVX) returned 7.49 percent per year over the 10-year period (outperforming TASCX by 2.29 percentage points per year) and 10.94% per year over the 15-year period (thus outperforming TASCX by 2.60 percentage points).

The other comparable fund from the same asset class is the Vanguard Small Cap Value Index Fund (VSIIX). Over the same 10- and 15-year periods, VSIIX returned 8.37% per year (outperforming TASCX by 3.17 percentage points per year) and 9.92% per year (outperforming TASCX by 1.58 percentage points per year).

I would add that while TASCX is mostly a domestic fund, it does maintain the freedom to buy international stocks. Morningstar shows us that non-U.S. stocks currently make up about 5% of the fund’s holdings. Being able to shift allocations whenever international stocks look like a better value should be an obvious advantage for TASCX. Unfortunately, that advantage never materialized. Even worse, DFA’s International Small Cap Value Fund (DISVX) also outperformed TASCX over both the 10-year and 15-year periods, returning 6.31% per year over the 10-year period (versus 5.20% for TASCX) and 11.16% per year over the 15-year period (versus 8.34% for TASCX). Strike one.

The Right Benchmark

During our debate, Barse stated that, over the long term, Third Avenue had consistently beaten its benchmark. However, the data shows that not only did TASCX underperform, it managed to underperform by wide margins, margins that were far in excess even of the differences in expense ratios. Expense ratios for TASCX, DFSVX and VSIIX are 1.10%, 0.52% and 0.08%, respectively.

Perhaps, like many mutual funds, Third Avenue was using as its benchmark the S&P 500 Index. That would have been an appropriate benchmark when we lived in the single-factor world of the capital asset pricing model (CAPM), where beta was the single factor used to explain the difference in returns of diversified portfolios.

With that in mind, we’ll take a look at how TASCX performed relative to the Vanguard 500 Index Fund (VFIAX). Over the 10- and 15-year periods ending Oct. 13, 2015, VFIAX returned 7.71% per year (outperforming TASCX by 2.51 percentage points per year) and 4.55% per year (underperforming TASCX by 3.79 percentage points per year), respectively. So we have a split decision, with TASCX outperforming for the 15-year period, but underperforming by 2.51 percentage points for the last 10 years.

It’s important to understand, however, that the single-factor CAPM world hasn’t existed for more than 20 years now. Since the 1992 publication of Professors Eugene Fama and Kenneth French’s paper, “The Cross-Section of Expected Stock Returns,” funds are compared to more appropriate benchmarks—which is what we did.

Nondomestic Funds

So far, we have seen that Third Avenue’s domestic equity fund failed to outperform. We’ll now turn to its funds that invest globally and internationally. Perhaps there’s evidence that Third Avenue outperformed in these supposedly less efficient markets.

We’ll begin by examining the Third Avenue Value Fund (TAVFX), classified by Morningstar as a global midcap value fund. Currently, Morningstar shows that about 64% of its holdings are in domestic equities and about 27% are in international equities—though obviously that can vary over time.

Given its classification as a global midcap fund, we’ll compare the fund’s returns to the returns of DFA’s domestic and international large- and small-cap value funds. For the 10-year and 15-year periods ending Oct. 13, 2015, TAVFX returned 2.88% per year (with a percentile ranking of 95) and 5.76% per year (with a percentile ranking of 24), respectively.

The table below shows the returns for TAVFX and five value funds managed by DFA.

Fund 10-Year Return (%) 15-Year Return (%)
Third Avenue Value (TAVFX) 2.88 5.76
DFA U.S. Large Value (DFLVX) 7.54 8.53
DFA U.S. Small Value (DFSVX) 7.49 10.94
DFA International Value (DFIVX) 3.70 6.23
DFA International Small Value (DISVX) 6.31 11.16
DFA Emerging Markets Value (DFEVX) 5.79 10.79

Note that TAVFX underperformed, no matter what mix of DFA’s large and small value funds you employed, and no matter what mix of domestic and international funds you selected. I would also add that, in the supposedly inefficient asset class of international small value stocks, DISVX earned a first-percentile ranking. How can anyone claim the markets are inefficient when a passively managed fund earns a first-percentile ranking? Strike two.

Working On Strike 3

Finally, we turn to the Third Avenue International Value Fund (TAVIX), which Morningstar classifies as a small/mid value fund. Since it doesn’t have a 15-year period, we’ll look at the fund’s 10-year returns. Over the period ending Oct. 13, 2015, TAVIX returned just 1.75% per year.

Morningstar puts the DFA International Small Cap Value Fund (DISVX) in the same category. As shown in the preceding table, DISVX returned 6.31% per year, outperforming TAVIX by 4.56 percentage points. Keep in mind that TAVIX also has the ability to shift assets around the globe, while the DFA fund doesn’t.

About 11% of TAVIX’s current holdings are U.S. stocks. Obviously, that advantage just didn’t seem to show up. TAVIX can also hold emerging market stocks. The DFA Emerging Markets Value Fund (DFEVX) returned 5.79%. Strike three. You’re out!

Not only did Third Avenue’s funds fail to outperform in each of the cases we analyzed, they underperformed by wide margins. Maybe, just maybe, alpha is a lot harder to deliver than many—including David Bars—think. The Third Avenue funds we looked at certainly weren’t generating alpha or beating appropriate benchmarks.

Perhaps an interesting coda to this piece is an article I wrote in January 2014. I commented on Third Avenue Funds’ October 2013 annual report to shareholders, in which firm chairman Marty Whitman severely criticized the research of recent Nobel Prize-winner Eugene Fama, calling his work “utter nonsense, sloppy science, plain stupid, and unscholarly.” I’d note that, for many years, Fama was head of research for DFA.

Now, you would think that before denigrating the work of a Nobel Prize winner in his field of expertise, you would have extraordinary proof—and certainly data—to offer up. Unfortunately, Whitman offered neither. If he had even looked at the data, as we have done today, perhaps he would have saved himself a great deal of embarrassment.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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