This process effectively converts what was once alpha (a scarce resource) into beta (a common factor). And because beta is cheap to access, investors no longer need to pay the high fees of active management to benefit from exposure to stocks with these traits.
A good example of this process of converting alpha into beta is the 2012 study “Buffett’s Alpha,” authored by AQR researchers Andrea Frazzini, David Kabiller and Lasse Pedersen.
They found that, in addition to benefiting from the use of cheap leverage provided by Berkshire Hathaway’s insurance operations, Warren Buffett bought stocks that are safe, cheap, high-quality and large.
The most interesting finding in the study was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys. Thus, the quality factor was “born.” And now many passive funds incorporate it into their fund construction rules.
When Analysis Doesn’t Help Performance
Let’s turn now to Marks’ query about investing in a fund in which no one is analyzing anything. Let me offer a very different perspective on the question. Today we have more actively managed mutual funds, and more hedge funds, than we have individual stocks. Active funds still control perhaps two-thirds of investment dollars. These active managers analyze the valuations of stocks. It’s their actions that are setting prices. If they think a stock is overvalued, they will either avoid it or sell the stock short.
In other words, passive investors aren’t investing in something no one is analyzing. Instead, they are investing in assets on which tens of thousands of active managers have offered their opinions through their actions. That’s the wisdom of crowds at work.
The evidence shows that such wisdom—the wisdom of the market’s collective opinion—is very hard to beat.
As my co-author Andrew Berkin and I showed in our book, “The Incredible Shrinking Alpha,” today only about 2% of active managers are generating statistically significant alpha. I would add that active managers have performed just as poorly in bear markets as they have in bull markets. In other words, while passive funds go down in bear markets, the average active fund goes down even more.
Given the trend toward passive management, one might ask: At what point will there not be sufficient managers analyzing stocks to ensure that prices are the best estimate of the right price?
While I don’t think anyone knows that answer, surely it’s far less than the tens of thousands we have today. Perhaps even a few hundred would be enough. In fact, it wasn’t until 1950 when the number of mutual funds topped 100. That number was still only at about 150 in 1960. And we didn’t seem to have any problems allocating capital and setting prices efficiently then.
Today we have more than 9,000 mutual funds and probably more than 10,000 hedge funds. Do investors really need all those active managers to ensure capital is allocated efficiently? It doesn’t seem likely.