Is there such a thing as a “perfect” value investor? And if so, what does that investor’s fund look like?
James Montier thought he knew the answers when he penned his 2006 article “The Perfect Value Investor.” At the time, Montier was the director of global strategy at Dresdner Kleinwort Wasserstein, a London-based investment bank. He is now at Boston-based Grantham Mayo van Otterloo (GMO).
As Montier noted, Bob Goldfarb, chief executive of the legendary Sequoia Fund, was asked by Columbia University professor Louis Lowenstein “to select ten dyed-in-the-wool value investors who all followed the essential edicts of Graham and Dodd.”
Goldfarb came up with nine. His final list of “tried and tested” value funds was as follows: Clipper, FPA Capital, First Eagle Gold, Legg Mason Value, Longleaf Partners, Mutual Beacon, Oakmark Select, Oak Value and Tweedy Browne American Value. In 2006, this fund’s name was changed to Tweedy Browne Value.
By way of background, Goldfarb and the Sequoia Fund were included among “The Superinvestors of Graham-and-Doddsville” that Warren Buffett identified in a 1984 talk. An endorsement from Warren Buffett is a pretty hefty credential in anyone’s book.
Characteristic behaviors of the best value investors
Montier used Goldfarb’s list to identify these six traits of “some of the best value investors:”
Highly concentrated portfolios.
No need to know everything and the ability to avoid getting caught up in the noise.
A willingness to hold cash.
Long time horizons.
An acceptance of bad years.
Preparedness to close funds.
Of these six common traits, passively managed value funds possess three:
That leaves three traits that passively managed value funds don’t have in common with Goldfarb’s “great value managers.” Unlike the “great value managers,” passively managed funds don’t concentrate portfolios. Instead, they broadly diversify. One of the major tenets of modern portfolio theory is that diversification reduces risk without reducing expected returns. Thus, broad diversification is a good trait. According to the Uniform Prudent Investor Act, “Because broad diversification is fundamental to the concept of risk management, it is incorporated into the definition of prudent investing.”
Passively managed funds also don’t hold cash, another trait Montier identified as common among the “best” value investors. Russ Wermers – author of the 2000 study “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses” – found that non-equity holdings reduced returns for the average actively managed equity fund by about 70 basis points per year. In addition, as an actively managed fund increases its holding of cash, investors lose control over their asset allocation, which determines the majority of risk and expected return of a portfolio.
The last of the three traits that Montier attributed to great value investors not found in passively managed funds is the need to close to new investors. Such a need is unlikely to impact passively managed funds, especially funds focused on large-cap stocks, because they don’t concentrate portfolios. Thus, they don’t face the type of market impact costs that active funds can incur when trading large positions.
Out-of-sample performance
In making his selections, Goldfarb had the benefit of hindsight. He knew the performance records of each of the funds he chose. There very well may have been other value managers with all the same characteristics who didn’t perform as well. Hindsight bias is the inclination to see past events as if they were predictable.
Behavioral studies have found a strong human tendency toward this bias. But, unfortunately, investors cannot buy yesterday’s returns; they can only buy tomorrow’s. So we’ll ask a new question. How did the legendary value managers perform “out-of-sample”? Were the funds’ past outperformances predictive?
To find the answer, we’ll compare the performance of Goldfarb’s selections to the performance of the passively managed large value-fund operated by Dimensional Fund Advisors (DFA). (Note that this fund is the one my firm, Buckingham, recommended during the period in question.)
The table below shows the annualized returns, annualized standard deviation, and quarterly Sharpe ratios for each of Goldfarb’s picks for the nine-year period from 2006 through 2014. The annualized standard deviation and Sharpe ratios are based on quarterly data due to the shortness of the period.
Fund |
Annualized Return (%) |
Annualized Standard Deviation (%) |
Quarterly
Sharpe Ratio |
Clipper (CFIMX) |
4.81 |
19.28 |
0.14 |
FPA Capital (FPPTX) |
6.45 |
22.22 |
0.17 |
First Eagle US Value A (FEVIX) |
7.98 |
11.46 |
0.31 |
Legg Mason Value (LMVTX) |
1.46 |
22.82 |
0.06 |
Longleaf Partners (LLPFX) |
6.07 |
22.40 |
0.17 |
Mutual Beacon Z (BEGRX) |
5.96 |
16.96 |
0.18 |
Oakmark Select (OAKLX) |
8.63 |
19.08 |
0.23 |
Oak Value (OAKVX) |
N/A |
N/A |
N/A |
Tweedy Browne Value (TWEBX) |
6.30 |
14.22 |
0.21 |
Average |
6.70 |
18.56 |
0.18 |
DFA US Large Value (DFUVX) |
8.01 |
22.02 |
0.20 |
While the S&P 500 Index is not an appropriate risk-adjusted benchmark for a large value fund, during this period it produced an annualized return of 7.99%, its annualized standard deviation was 17.08 and its quarterly Sharpe ratio was 0.23.
Of the nine funds Goldfarb identified as “dyed-in-the-wool value investors,” all of which followed the essential edicts of Graham and Dodd, only one managed to provide investors with a higher return than DFA’s large-value fund. The average return of the eight funds that survived to the end of the period was 6.70%. The one outperformer did so by just 0.62 percentage points, while the worst underperformer did so by 6.55 percentage points, or more than 10-times as much. Three of the nine funds did produce higher Sharpe ratios, though only one did so by more than 0.03.
We’ll now take a more in-depth look at the sources of each fund’s returns.
The table below shows the results of a five-factor – beta (market), size (SMB), value (HML), momentum (UMD) and quality (QMJ) – regression for each fund, as well as the fund’s alpha and r-squared. The data cover the same period, January 2006-December 2014.
Fund |
Market
|
SMB |
HML |
UMD |
QMJ |
Alpha |
R2* |
Clipper (CFIMX) |
0.98 |
-0.25 |
0.24 |
-0.12 |
0.15 |
-3.22 |
0.92 |
FPA Capital (FPPTX) |
0.81 |
0.53 |
0.00 |
-0.03 |
-0.23 |
+1.68 |
0.85 |
First Eagle US Value A (FEVIX) |
0.62 |
0.05 |
0.03 |
-0.03 |
0.02 |
+2.00 |
0.93 |
Legg Mason Value (LMVTX) |
1.14 |
0.01 |
-0.04 |
-0.18 |
0.05 |
-6.25 |
0.93 |
Longleaf Partners (LLPFX) |
1.03 |
0.20 |
-0.16 |
-0.10 |
-0.15 |
-1.16 |
0.87 |
Mutual Beacon Z (BEGRX) |
0.81 |
0.03 |
0.10 |
-0.07 |
-0.02 |
-0.15 |
0.92 |
Oakmark Select (OAKLX) |
1.06 |
0.05 |
0.20 |
-0.18 |
0.19 |
-0.16 |
0.90 |
Tweedy Browne Value (TWEBX) |
0.76 |
-0.07 |
0.28 |
-0.10 |
0.24 |
-1.12 |
0.90 |
DFA US Large Value (DFUVX) |
1.10 |
0.06 |
0.40 |
-0.07 |
0.05 |
-0.04 |
0.98 |
*R2 (r-squared) is a statistical measure that represents the percentage of a fund’s returns that can be explained by the model. A high r-squared indicates that the model does a good job of explaining returns.
Just two of the nine “perfect” value investors produced alpha during the period. The average alpha for the eight surviving funds was -1.05, or 1.01 percentage points below the -0.04 alpha of the DFA fund. Even passively-managed funds have expenses, including the expense ratio and trading costs, so a small negative alpha should be expected even from a pure index fund. DFUVX has an expense ratio of 0.27%, which is greater than its negative alpha.
The DFA fund maintained the highest loading on the value factor, while two of the “perfect” value funds actually had negative loadings, one had a zero loading, and one had virtually no exposure at all (0.03). In addition, just three of the “perfect” funds had a higher loading on the quality factor than the DFA fund.
Survivorship bias
There are no data available for the Oak Value Fund because it no longer exists. Its returns are buried in the great mutual fund graveyard in the sky.
The fund was started in 1993 and typically held 20 to 30 stocks. In September 2010, the fund sponsor, Oak Value Capital Management, announced that it had agreed to be bought for an undisclosed amount by RS Investments, a San Francisco firm. It was then renamed the RS Capital Appreciation Fund (RCAPX). In January 2013, the fund’s management team was fired and its assets were later merged into the RS Growth Fund.
The lack of data here is a good example of survivorship bias at work. Funds that perform poorly are eventually either merged into another fund within the family or they are liquidated. In either case, the fund’s poor performance disappears. Thus, the average return earned by investors in “perfect value” funds was lower than shown in the table.
From 2005 through its liquidation in March 2013, the fund earned a return of just 2.87% and produced a Sharpe ratio of just 0.09. If we included those figures in the average, the average return for the nine perfect value funds would be 6.3% instead of 6.7% and the average Sharpe ratio would be 0.17, not 0.18.
Given the evidence, the question remains: Why wasn’t Goldfarb able to identify the future outperformers?
Why wasn’t the past a good predictor?
One explanation for the overall failure of Goldfarb’s “perfect” funds to outperform the passively managed DFA large-value fund and to generate alpha after he had selected them is that the historical results were lucky outcomes. Given the large number of active managers trying to generate alpha, we would expect some to succeed purely by chance. Perhaps all Goldfarb did was successfully identify those funds that got lucky.
A second explanation was provided by Jonathan Berk in his paper, “The Five Myths of Active Portfolio Management.” Berk explained that investors observe outperformance and rush to invest with the managers they perceive as the best. But greater assets under management only increase the hurdles to generating alpha.
A third explanation is that the market has become more efficient over time. As discussed in my new book The Incredible Shrinking Alpha, the competition has become much tougher.
The skills of the competition have improved
Charles Ellis, one of the most respected minds in the investment industry, noted the following in the July/August 2014 issue of the Financial Analysts Journal: “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 like as Renaissance Technology, SAC Capital Advisors and D.E. Shaw hire world-class scientists, mathematicians and computer scientists to help them uncover mispricing. And MBAs and Ph.D.’s from top schools like the University of Chicago, The Wharton School and MIT flock to investment management armed with the latest powerful computers and massive databases.
At DFA, co-CEO Eduardo Repetto 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., but in aeronautics and applied mathematics. Andrew Berkin, my co-author and the director of research at Bridgeway Capital Management, has a bachelor’s degree from Caltech and Ph.D. in physics from the University of Texas. He is also 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.”
We see evidence of increased competition in the dramatic decline in the standard deviation of returns of fund managers. The chart below is from the paper
“Alpha and the Paradox of Skill” by Michael Mauboussin and Dan Callahan.
Even great value investors like Buffett (who also identified Tweedy Browne as one of his superstar investors from Graham and Doddsville) and Goldfarb of Sequoia have great difficulty in identifying the future outperformers. That’s why Ellis called active management a loser’s game. It is clearly possible to win the game of active management, as one of the funds identified by Goldfarb did produce a higher return than the comparable DFA fund. But the odds of doing so are so poor that it’s not prudent to try. Just like with the crap tables and the roulette wheel, the most likely way to win the game of active management is not to play.
Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.
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