In a recent article, Wall Street Journal columnist Jason Zweig noted that Berkshire Hathaway’s stock had underperformed the S&P 500 Index over the 10 years ending in 2017, 7.7% versus 8.5%.
Zweig hypothesized that the reason for the underperformance is that the size of Berkshire Hathaway’s portfolio has grown so large that it creates a burden that is difficult to overcome. “Too much money” is a long-known problem for active managers because success contains the seeds of future failure as cash flow, and the problems that come with it, swamps skill.
While size can become a problem for active managers, I suggest there is a far more important factor at work. As my co-author Andrew Berkin and I discuss in our book, “The Incredible Shrinking Alpha,” the market has become an increasingly difficult competitor. We provide four explanations: academics have converted alpha into beta; the pool of victims that can be exploited has dramatically shrunk; the competition has become increasingly skillful; and the supply of capital chasing alpha has increased.
Today I’ll focus on the publication of academic research converting what once were sources of alpha into common factors (beta), removing sources of excess risk-adjusted returns. To address this issue, we’ll take a brief walk through the history of modern financial thinking.
William Sharpe and John Lintner are typically given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). CAPM provided the first precise definition of risk and how it drives expected returns. It looks at returns through a one-factor lens, meaning the risk and return of a portfolio is determined only by its exposure to beta.
Beta is the measure of the equity-type risk of a stock, mutual fund or portfolio, relative to the risk of the overall market. CAPM was the finance world’s operating model for about 30 years. However, all models, by definition, are flawed, or wrong. If they were perfectly correct, they would be laws, like we have in physics. Over time, anomalies that violated CAPM began to surface.
The more prominent ones:
- 1981: Rolf Banz’s “The Relationship Between Return and Market Value of Common Stocks” found that beta does not fully explain the higher average return of small stocks.
- 1981: Sanjoy Basu’s “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks” found that the positive relationship between the earnings yield (earnings/price ratio) and average return is left unexplained by beta.
- 1985: Barr Rosenburg, Kenneth Reid and Ronald Lanstein found a positive relationship between average stock return and the book-to-market ratio in the paper “Persuasive Evidence of Market Inefficiency.”
The 1992 paper “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French basically summarized the anomalies in one place. The essential conclusions from the paper were that the CAPM only explained about two-thirds of the differences in returns of diversified portfolios, and that a better model could be built using more than just the sole factor of market beta.