Swedroe: Klarman’s Indexing Jabs Miss

September 30, 2015

For many market observers and participants, billionaire Seth Klarman resides in the same “ZIP code” that Warren Buffett once called the home of superstar investors: “Graham and Doddsville.”

Klarman is the well-regarded founder and CEO of the Baupost Group, a Boston-based private investment partnership with nearly $30 billion in assets under management. He has also authored a book on value investing, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.”

One of my firm’s clients recently asked if I would read the book and provide my thoughts on it. Initially, I discussed why Klarman’s claim that indexing assures mediocre returns was wrong. Today I’ll take on some of the other assertions Klarman makes that don’t hold up to scrutiny.

Inefficient Markets?

We’ll begin with the following: “Value investing is predicated on the belief that the financial markets are not efficient.”

That statement would surely come as a great surprise to professor Eugene Fama, who recently won the Nobel Prize in economics for his work on efficient markets theory and capital markets research. Fama, who headed the research team at Dimensional Fund Advisors (DFA), helped develop DFA’s value investment strategies, which are all based on the idea that markets are highly, if not perfectly, efficient. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Basically, after ranking stocks by their book-to-market ratio, DFA’s value funds buy all the equities that meet the definitions of their buy-and-hold ranges, and they do so on a market-cap-weighted basis. In other words, DFA isn’t performing any fundamental analysis, which Klarman clearly considers vital to successful investing. Klarman writes: “Hundreds of billions of dollars are invested in virtual or complete ignorance of underlying business fundamentals, often using indexing strategies.”

Market Price Over Fundamentals

While Klarman believes that fundamental analysis is the key to successful value investing, DFA’s strategy is based on the belief that the market price is the best estimate of the correct price. By using this strategy, the firm has managed to compile a long track record of outperforming the vast majority of active value managers, managers who, like Klarman, argue that the market makes persistent pricing errors.

Using Morningstar data, the table below lists the percentile rankings of DFA’s value funds for the 15-year period ending Sept. 18, 2015.

Morningstar Percentile Ranking (as of Sept. 18, 2015)

Fund 15-Year Period
DFA U.S. Large Value III (DFUVX) 4
DFA U.S. Small Value (DFSVX) 23
DFA International Value III (DFVIX) 9
DFA International Small Value (DISVX) 1
DFA Emerging Markets Value (DFEVX) 6
Average DFA Ranking 9

Even with survivorship bias in the data (about 7 percent of funds disappear every year), DFA’s passively managed value funds on average outperformed 91 percent of the surviving actively managed value funds. What’s more, that’s on a pretax basis. Because the greatest expense for actively managed funds held in taxable accounts is typically taxes (due to their higher turnover), on an after-tax basis, DFA’s performance almost certainly would have looked even better.

If Klarman is correct and ignoring “underlying business fundamentals” assures mediocre results, how did DFA funds achieve such superior performance relative to funds practicing fundamental analysis?

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