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Weekend reading: Unpicking on Warren Buffett’s alpha

Weekend reading

Good reads from around the Web.

Regular readers will know I am that rare thing: a largely active investor who really should know better.

That’s why we have a big passive investing section here on Monevator, and why I suggest most readers direct most (or all) of their money towards passive portfolios.

That doesn’t mean I don’t think some individual investors – or fund managers, for that matter – won’t beat the market. In fact, I see no theoretical reason why some shouldn’t.

But that is a long way from saying I think you will, or that I will.

And it’s even further from saying that you can identify, in advance, a fund manager that can beat passive funds over the long-term – by a sufficient margin to pay for his or her costs, of course.

Just because something is possible – or even certain – doesn’t mean you should do it.

I guarantee you that someone will win the National Lottery tonight.

But I don’t think you should you put your life savings into lottery tickets.

Deconstructing Warren Buffett

Warren Buffett is one indisputable market beater, as far as I’m concerned.

Yet the lengths that some will go to in order to explain away his extraordinary success is, well, extraordinary.

Last week I included a link to an Economist article about some academic research that put Buffett’s out-performance mainly down to leverage (that is, cheap financing from Berkshire’s insurance float).

Never mind that Buffett was hammering the market for years before he had such leverage (in fact he was doing much better when he ran a smaller pool of money).

Like back-testers the world over, the wonks behind the paper didn’t let a little thing like dates and circumstances get in the way of their grand theory.

Anyway, I’ve now had a chance to read the full Yale paper, thanks to Monevator contributor The Analyst who sent over that link to the PDF.

In it the academics – with hindsight, obviously – apply half-a-dozen or so factors to Buffett’s results to ‘explain’ why he outperformed as a stock picker, on top of the gains he made by leveraging.

They even go so far as to create a synthetic Buffett screen, which they then apply back to several decades of market data, and say it would have done just as well as Buffett himself!

Newsflash: It’s not hard to see what someone has done, and then say that if anyone did it, they’d have got the same result.

To be fair, the academics several times that they consider Buffett’s talent to be exceptional – they point out that he executed their strategy 50 years before the academic underpinnings of their mimicking filters were widely accepted.

But that hasn’t stopped some pundits proclaiming that Buffett has been decoded, that you can replace him with a share screen, and that we might soon see ETFs that deliver what Berkshire did.

Which I think is a bit silly.

Buffett: Human, after all

If any active investor has an edge, then almost by definition it can’t be replaced with a screen or a mechanical strategy.

Even more importantly, Buffett himself was a living, breathing businessman who several times changed course as an investor over his six-decade long career. He went from Ben Graham ‘cigar butts’ to private companies to blue chip brands to buying mega-railroads.

Only this year he said he’d rather be buying residential real estate!

So I don’t think a mechanical ‘robo-Buffett’ would have a hope in hell of predicting what a real Buffett would do if he were to live to 140 and invest for another 60 years.

Unpicking Buffett’s edge as an academic activity is one thing – leaping to the conclusion that you can build and buy a Buffett ETF is quite another.

As for passive versus active, the man himself has said the average investor is best off in index funds.

So if you believe in Buffett, the most logical thing is to either buy shares in his company Berkshire Hathaway – or buy the market via a tracker.

Further reading

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

  • No behaviour gap? Dollar-cost averaging over-rated – Kitces
  • Richard Beddard reviews the Stockopedia screener – iii blog

Other articles

Product of the week: Hargreaves Lansdown is to offer up to a 0.5% a year loyalty bonus to SIPP clients. Many rivals already do, the FT reports.

Mainstream media money

Highlights from the wall of noise…

Passive investing

  • Interview: Vanguard on its index swap [Video]MorningStar
  • Race to cut ETF fees may leave investors in the dark – Reuters
  • Why are UK blue chips’ dividends delayed? – Munro Fund
  • 5 tips for fighting financial complexity – MorningStar
  • Passive funds continue to spank most active funds – Index Universe

Active investing

  • 25 years after Black Monday: Coping with volatility – Telegraph
  • Bullish outlook for gold – Telegraph

Other stuff worth reading

  • America’s jobs report: A gasp of life – The Economist
  • Digital currency: Brave new world or criminal haven? – BBC
  • True cost of going to university [Infographic]MoneySupermarket
  • US investors are still fleeing the stock market – Wall Street Journal
  • Men must act now to avoid gender-disadvantaged annuity rates – FT
  • Merryn: A brief history of hyperinflations – FT
  • The benefits of keeping your pension in cash – Telegraph
  • Castle Rock’s ‘mortgage revolution’ brings risks – Independent
  • Fox squirrels are long-term investors – Eureka Alert

Book of the week: There’s a new edition of The Permanent Portfolio out, and in both hardcover and Kindle formats you get a deep overview of Harry Brown’s investing strategy for all seasons. Permanent portfolio mania died down after gold stopped doubling, funnily enough, but still I think the approach is a valid one, and the core ideas are well worth thinking about. Note it’s a US publication, so some tax notes and similar won’t apply.

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{ 10 comments… add one }
  • 1 Drew @ ObjectiveWealth October 6, 2012, 1:46 pm

    It’s statistically interesting re: Buffet. I suppose you have to have extreme, opposite ends in order to have a normal distribution; some amount of variation. Imagine you put Warren Buffet at one end, the successful one, and suppose other investor identifies his method exactly and tries to copy it. By everyone all emulating his success there’s not enough room for us all to sit in that top centile. We all become average again, the goal posts have moved and you’ll have to try and identify what it is that’s making the ones who then achieve greater success get that way. If you don’t have the time or the stomach for that then index funds are understandably the best option!

  • 2 Rob October 6, 2012, 1:49 pm

    I read that and noted that they commented that his investments coincided with high volatility, but what they don’t note is that investing in volatility is not the same as investing in a fantastic company that has been underestimated by the markets.

    If you were to apply an academic analysis to Buffett, I think that what you should be taking out is his Hayek-like understanding of human spirits that create bubbles and busts.

    As a reader of Snowball, you’ll know how he was ridiculed during the tech boom for being a dullard, but that was his asset: the ability to know when animal spirits were causing misjudgements, to isolate himself from his herd mentality chemical makeup and to not make the mistake of being mistaken too often in his judgements. That is what makes Buffet special.

  • 3 Alex October 6, 2012, 5:55 pm

    1. Thanks, as ever, for your post.

    2. Those changes to Vanguard US fund benchmarks are interesting. When Vanguard launched here an ETF on (global) Emerging Markets, earlier this year, I noted the fund followed the FTSE Emerging Index, not the corresponding MSCI one. Hitherto all the (global) Emerging Markets ETFs I’d seen for the UK individual investor used the MSCI index. Further, Vanguard UK’s website didn’t provide any rationale for its choice of the FTSE Emerging Index.

    3. In June, I therefore asked Vanguard UK (enquiries@vanguard.co.uk) for an explanation. Its reply at the time was unconvincing: “I think Vanguard believed that they could offer either of them. The Mutual fund tracks the MSCI Index, so with the ETF tracking the FTSE index it offers investors diversification.” Note use of “I think”: hardly definitive, is it? As I said, I found this answer unconvincing at the time. The current US changes, and related announcements, suggest why Vanguard UK used the FTSE Emerging Index for its then new ETF.

  • 4 Salis Grano October 6, 2012, 8:28 pm

    A feature I find interesting and ingratiating about Buffett is the fact that in the BH letters he frequently discusses his investing mistakes. How many other financial stewards do that?

  • 5 ivanopinion October 7, 2012, 3:01 pm

    What I understood the Economist article to be saying is that Buffett’s incredible performance is explained by a combination of high leverage and very low funding costs (by being smart enough to borrow by writing insurance policies instead of overtly borrowing) AND investing in low beta companies. Many institutional investors such as mutual funds and pension funds are not allowed to borrow and so they cannot boost the return from low beta companies via leverage, so they tend to shun low beta companies because they provide a relatively low returns. The result is that there is high demand for high beta companies, which tends to mean that although they give higher returns than low beta companies in the returns are not high enough to compensate for the high beta. Other institutional investors can borrow, but, unlike Buffett, they generally have to pay higher interest rates because they are overtly borrowing and they also face a greater risk that loan funding might be withdrawn if they temporarily start to struggle. By using insurance premiums to fund the leverage, Buffett was able to weather temporary downturns in the performance of his investments, because the people buying insurance from his insurance companies did not even realise that they were effectively lending him money to leverage his investments.

  • 6 ivanopinion October 7, 2012, 4:39 pm

    Incidentally, that point about using the insurance businesses to provide low interest and stable funding is something that I doubt any ETF could replicate. Without it, an ETF would, at best, be paying higher interest costs and therefore make lower investment returns. At worst, when it goes through a rough patch the lender will start to get nervous and will call in the loan or demand even higher interest rates. Buffett was smart enough to spot that having a stable of in-house insurance companies would insulate him from these risks.

    It might be a bit of a shock to find out that it is not in fact Buffett’s stockpicking skills that explain the performance of BH. On the other hand, if the secret is more to do with the unique combination of cheap stable funding from insurance companies and leveraged investment in low volatility equities, this is something that is much more likely to survive after Buffett dies. Perhaps it is worth buying BH?

  • 7 gadgetmind October 7, 2012, 4:56 pm

    Shelby Davis also used a lot of leverage, usually around 50% of his portfolio, and the more his portfolio grew, the more he borrowed.

    He borrowed money from banks and at low rates and then invested in insurance and banking equities for higher (and rising) yields. As it happens, he was also stunningly good at valuing financial companies, and went out meeting CEO long before this is what analysts did, but his success was down to leverage, buying what no-one else understood or valued, and time, lots and lots of time.

  • 8 The Investor October 7, 2012, 11:54 pm

    Hi guys — Yes, the paper says that Buffett’s stock picking is adding alpha — and his Sharpe ratio etc is top of the table — but that this isn’t sufficient to explain BRK’s performance, whereas adding leverage (on top of the other factors) does.

    And I agree, ivanopinion — in fact, I hold BRK partly for that reason, as I was discussing with Monevator dividend-expert ‘The Analyst’ the other day. I suspect it’s undervalued, and I think it has legs post-Buffett (not that there’s an evidence he’s going anywhere… an acturial table would suggest he could well be in charge for another five years at least…)

  • 9 The Investor October 7, 2012, 11:55 pm

    @gadgetmind — I need to know more about Shelby Davis, I keep seeing his name around, and I’m pretty drawn to insurance stocks currently, too.

  • 10 gadgetmind October 8, 2012, 8:20 am

    There is Shelby Cullom Davis and there is Shelby Moore Cullom Davis, his son. Both are well known investors, as is the grandson, Andrew.

    I’ve just finished reading “The Davis Dynasty: 50 Years of Successful Investing on Wall Street” and it’s readable and entertaining throughout. I’m not sure there is much to take away from the grandfather’s methods other than his philosophy and patience, but there is plenty to pick up from the sons.

    Being a frugal investor, I picked up the book for a few quid second hand and I’m happy to pass it along the line if you let me have some contact details.

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