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?

Indexing A Self-Defeating Strategy

In his criticism of indexing, Klarman declared: “It becomes a self-defeating strategy when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis.” Let’s see if that holds true.

Over the last four decades, there has been an inexorable trend toward indexing (and toward passive investing in general) as more and more investors (both individual and institutional) abandon active management in favor of passive strategies.

Given that trend, if Klarman is correct in his assertion, then the percentage of active managers outperforming their appropriate risk-adjusted benchmarks would be increasing. Yet we’ve seen exactly the opposite occur. In our book, “The Incredible Shrinking Alpha,” my co-author Andrew Berkin and I show that the percentage of active managers outperforming has been on a persistent decline.

Active Outperformance Rare

For example, Mike Sebastian and Sudhakar Attaluri—authors of the study “Conviction in Equity Investing,” which was published in the summer 2014 issue of The Journal of Portfolio Management—found that the percentage of skilled managers (those able to generate statistically significant alpha) was about 20 percent in 1993, but by 2011 had fallen to just 1.6 percent.

This last result matches closely the findings from a 2010 paper, “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” The authors, Eugene Fama and Kenneth French, found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill.

Our book also provides an explanation for the inexorable trend toward fewer and fewer active managers who succeed in their quest for alpha. Our explanation shows why Klarman’s assertions are based on false beliefs.

Defying Klarman’s Contention

Klarman claims that as more investors adopt passive strategies, the market will become less efficient. But because the evidence shows that fewer active managers are outperforming, even while trading costs have come down significantly, we can conclude the market has in fact become even more efficient, defying Klarman’s contention.

As we describe, the reasons are simple. First, those abandoning the game of active management are likely the very investors who active managers were exploiting (the sheep waiting to be sheared). As the less-skilled leave the game, the competition gets tougher, making the market more efficient and harder to outperform.

Second, the skill level of the remaining active investors has increased greatly over the years. Quoting from our book:

Active Manager Smarter Than Ever

“Charles Ellis, one of the most respected people in the investment industry, noted the following in a recent issue of the Financial Analysts Journal. He wrote that ‘over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition … They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.’ Legendary hedge funds, such as Renaissance Technology, SAC Capital Advisors and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases.

“For example, Eduardo Repetto, the co-CEO of Dimensional Fund Advisors (DFA), has a Ph.D. from Caltech and worked there as a research scientist, and DFA’s co-CIO Gerard O’Reilly also has a Caltech Ph.D. in Aeronautics and Applied Mathematics. And co-author Andrew Berkin, the Director of Research at Bridgeway Capital Management, has a Caltech B.S. and University of Texas Ph.D. in physics, and is a winner of the NASA Software of the Year award. According to Ellis, the ‘unsurprising result’ of this increase in skill is that ‘the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees.’”

Better Skilled, But Not Better Performance

In our book, we also cite the work of Lubos Pastor, Robert Stambaugh and Lucian Taylor, authors of the August 2013 paper, “Scale and Skill in Active Management.” The authors, whose study covered the period from 1979 to 2011 and more than 3,000 mutual funds, concluded that fund managers have become more skillful over time.

They write: “We find that the average fund’s skill has increased substantially over time, from -5 basis points (bp) per month in 1979 to +13 bp per month in 2011.”

However, they also found that higher skill levels have not been translated into better performance. They reconcile the upward trend in skill with no trend in performance by noting that “growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack.”

Paradox Of Skill

The authors also came to another interesting conclusion: the rising skill level they observed was not due to increasing skill within firms. Instead, they found that “the new funds entering the industry are more skilled, on average, than the existing funds.”

The increasing skill of the competition creates what is called the paradox of skill. As average skill increases, it becomes more difficult to outperform by large margins (the standard deviation of outcomes narrows). And this is exactly what we are seeing.

The above graph shows the rolling five-year average standard deviation of excess returns in U.S. large-cap mutual funds during the last 45 years. You should expect to see wide dispersions when there are large differences in the level of skill. The demonstrated trend of declining dispersion in excess returns fits with our narrative, indicating competition is getting tougher.

‘Pure’ Indexing Problems

To be fair, Klarman does point out that there are some negatives to what I would call “pure” indexing—a strategy using funds whose sole objective is to replicate the returns of their benchmark index, avoiding, or at least minimizing, any tracking error. Following such a strategy can impose excessive trading costs as funds are required to buy liquidity.

However, to address such problems, the passively managed funds my firm uses (AQR, DFA and Bridgeway Capital Management) avoid the pure replication approach and use patient trading strategies (such as the use of algorithmic trading programs and block trading) to minimize trading costs. In other words, passive investing doesn’t automatically mean you have to be a pure indexer.

Well-designed passively managed funds take the positives of indexing—such as broad diversification, low turnover and its relatively high tax efficiency—and maximize them. They also take the negatives—such as inclusion of all stocks even when academic research suggests investors are better off screening them out (for example, penny stocks, IPOs and stocks in bankruptcy), forced realization of short-term capital gains and being a demander of liquidity—and minimize or eliminate them.

Klarman Couldn’t Be More Wrong

Klarman concluded his thoughts on this issue by stating: “I believe that indexing will turn out to be just another Wall Street fad.” While one of my favorite expressions is that, when it comes to making forecasts, “my crystal ball is always cloudy,” it refers only to market/economic forecasts. In this case, I am confident in saying that I don’t think it’s possible for Klarman to be more wrong.

“The Incredible Shrinking Alpha” identified four trends that explain why it’s getting harder and harder for active managers to outperform. And there doesn’t seem to be any reason to believe these trends will reverse. In fact, all the evidence suggests they will continue. And that will make active management, and the quest for alpha, an ever-more-difficult endeavor at which to succeed.


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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