the Alpha Myth_w750

Fairholme and Sequoia—No Great Performance Here

the Alpha Myth_w750

Recently, we received a question from a client that we will paraphrase as follows: “While I know that the returns I have gotten from index funds have beaten the majority of active managers, would I not have been better off in funds like the Fairholme Fund (FAIRX) or the Sequoia Fund (SEQUX)?”

Of course, it is always easy to pick the winners after the race, and both of these funds have been given the distinction of having Morningstar’s Manager of the Year. Nevertheless, when we take closer look at their records, we see no reason why indexers should be jealous or regretful. For starters, the alpha charts shown below do not indicate the presence of skill at a 95% level of confidence.

 

Both funds had years where they fell well short of the Morningstar analyst-assigned benchmark (particularly 2011 for Fairholme and 1999 for Sequoia). For Fairhome, this shortfall may explain the wide gap between the ten-year annualized fund return of 10.82% (as of 4/30/2014) and the return realized by the fund investors of 5.56%.1 Adding insult to injury, Fairholme’s bad year came on the heels of being named Morningstar’s Manager of the Decade after which, it must have received a large influx of cash.

 The high level of volatility of the alphas caused us to question whether Morningstar’s benchmarks for the funds were appropriate, so we ran the style drift charts which show a tremendous variation in style over time.

 

To drive the point home, we constructed portfolios made up of IFA indexes that replicated the degree of small cap and value exposure of these two funds. The charts below show the alpha of the funds vs. the portfolio of indexes. The average alphas dropped by about 50% for both funds (compared to the alphas against Morningstar’s Russell benchmarks), and again we see no significant alpha at a 95% level of confidence. To establish skill as the explanation of alpha, we would need an additional 40 years for Fairholme and 465 years for Sequoia. We will not be holding our breath.

 

To summarize, while it is easy to find funds that have beaten a given benchmark, there is almost never a basis for concluding that manager skill is the explanation. Furthermore, choosing an active manager entails taking on the risk of falling very short of the benchmark, as happened with Fairholme in 2011 and Sequoia in 1980, 1999, and 2009. Many investors would sell out in response to such a year.

To answer the client’s question, while he may have gotten a higher return if he had held these funds for a long period of time, he would have had to endure some painful periods which calls into doubt whether he would have actually held on to the funds. Also, on a going-forward basis, there is no statistically valid evidence that he can expect a benchmark-beating return.


1Retrieved from Morningstar.com on 5/14/2014. For Sequoia, Morningstar does not carry the ten-year investor return.