Alpha Chart from Video

What About the Active Managers Who Have Beaten the Market?

Alpha Chart from Video

Question: The following is a comment submitted by mclaren855 in response to this IFA.tv video. "I want you to put a chart of Buffett, Peter Lynch, Walter Schloss, Liz Cheval or David Tepper, Mario Gabelli, Stan Druckenmiller, George Soros etc and prove your hypothesis on those charts. Sure the Index fund beats 80% of active management but there are 20% active managers who beat the crap out of the S&P."

Answer: In general, the four problems of alpha (the excess return above a risk-appropriate benchmark) we have repeatedly discussed are its rareness, its lack of persistence, the difficulty of identifying it in advance of its occurrence, and the explanation of what appears to be alpha as simply randomness (luck) or the result of taking on additional risks that had a positive payoff (beta).

Of the eight people named by this questioner, only one (Mario Gabelli) is a current mutual fund manager. We will have more to say about him later.

Below is the Alpha Chart for the famous Fidelity Magellan fund. Peter Lynch managed the Fidelity Magellan Fund from 1977 to 1990, during which time the fund's assets grew from $20 million to $14 billion, just in time to experience more losing years than winning years. More importantly, Lynch reportedly beat the Morningstar specified benchmark for 14 years. However, as you can see, starting in 1991, 15 of 23 years resulted in a negative alpha and only 4 years of those years had respectable alphas. The $14 Billion of investor's assets did not fare well. Based on the overall track record of Magellan, 24 years of returns data is required to be 95% confident of skill. Can you get 24 years of data from your active manager?

If Peter Lynch knew how to beat the market, why couldn't he teach his successors? Or, was it just luck? Why is it that only Peter Lynch and Bill Miller achieved such results if mispriced stocks are so easy to identify and exploit? How many other managers attempted the same feat? It is far more likely that markets are very efficient and extremely hard to beat with statistical significance.

We took a look at Warren Buffett's (Berkshire Hathaway's) alpha since 1980, relative to the Russell Large Value Index (Russell 1000 Value). It is important to note that many factors other than Buffett's stock-picking acumen have determined the returns received by Berkshire investors, particularly the extent to which the market price of Berkshire through time has reflected the market's expectation of the value added by Buffett's undeniable capital allocation ability, not to mention his rolodex which has facilitated some highly lucrative deals such as Berkshire's investment into Goldman Sachs during the depths of the 2008 financial crisis. One interesting note is the 30%, 40%, two 35%'s and two 60%'s excess returns in the periods prior to 1999. None of these huge excess returns over a benchmark are repeated after 1999. Buffett's value at the helm may have been fully priced into Berkshire's share price since that time. Splitting the overall time period into two approximately equal pieces illustrates this point. In the second period, the outperformance relative to the Russell 1000 Value Index is statistically insignificant. This can be seen by clicking on the buttons just above the chart. The first button reveals a statistically significant alpha for the entire period, but the second button indicates that almost the entire alpha occurred in the first period, and the third button shows that the alpha of the second period is not even close to statistically significant. Also see this section of Step 3 on Fortune Magazine's Most Admired Companies, including Bershire Hathaway.

The late Walter Schloss, like Buffett, was a disciple of Benjamin Graham (See The Luck of the Gecko) who privately managed money for 92 people from 1955 to 2000. He averaged a 15.3% annualized return compared to 12% for the S&P 500. Since Mr. Schloss was a highly disciplined value investor, we would argue that the S&P 500 was not the proper benchmark for him. If we look at IFA Small Value Index from 1/1/1955 to 12/31/2000, the return was 15.15%, which is comparable to those of Mr. Schloss. Please note that we are not saying that Mr. Schloss deserves no credit for delivering a great return to his shareholders. While the returns may be attributed to risk compensation, it required a great deal of foresight to realize that value (i.e., buying companies that sell at a low price compared to their book value) was a risk worth taking over a long period of time. 

Liz Cheval, who passed away earlier this year, was the founding chairman of EMC Capital Management, a managed futures firm with about $100 million in assets. According to this article in Bloomberg, from the time Cheval began trading in 1985, through 2/28/2013, she and her firm posted average annual returns of 21.1%, compared to 10.77% for the S&P 500 Index. However, the IFA Emerging Markets Value Index showed a simulated return of 18.88% from 1/1/1985 to 2/28/2013. Of course, managed futures have no relationship to the S&P 500 or Emerging Market Value stocks. Trading futures (and other derivatives) is a zero sum game before costs and a negative sum game after costs. For investors who are naïve enough to believe that there is a Liz Cheval out there waiting to take their capital in exchange for a 20% return, we wrote this article

This leaves billionaires David Tepper, Stan Druckenmiller, and George Soros, all of whom are current or former hedge fund managers. Tepper has the distinction of being the highest earning hedge fund manager of 2012 at a cool $2.2 billion. His specialty is distressed companies, so he has likely benefitted from the value premium combined with leverage. Mr. Tepper's fund, Appaloosa Management, is not open to outside investors. Stan Druckenmiller's fund, Duquesne Capital, was closed in 2010 because he felt that he could no longer deliver the high returns that his investors had come to expect from such a large asset base of $12 billion. George Soros, who has become one of the richest men in the world largely at the expense of central banks such as the Bank of England, now only manages his family's fortune. As far as we are concerned, there is no point in trying to determine whether these guys had significant alpha, because even if they did, that alpha is not accessible to others, and certainly not to the person who asked the question above.

So here is where we stand on the eight names posed by the questioner above. Two are dead, one retired from asset management 23 years ago, and three do not accept any new investors. One of the two that are left (Warren Buffett) has been priced appropriately by the market so that investors have the same expected return as a risk-equivalent index fund. This leaves us with Mario Gabelli, whose company (GAMCO Investors) manages $43.5 billion as of 9/30/2013.

We identified 25 mutual funds that are managed by GAMCO that have at least five calendar years of data. Of those 25, 10 list Mario Gabelli as one of the managers. The table below summarizes the results of comparing these funds to their Morningstar analyst-assigned benchmark through 12/31/2012.

As you can see, the results for simple positive alpha are not much better than the flip of a coin and for Significant Alpha are nonexistent. Also see What's the Significance

The bar charts below show each of the 25 funds in detail. Since the historical alpha itself is so highly inconsistent, we are unable to rule out luck as the cause in any of the 25 funds.

While we are not saying that it is impossible to identify a manager who will deliver alpha in the future, chances are, by the time that news of this manager has reached you, one of the following will be true:

1)      The manager will be inaccessible to you.

2)      The manager will have so much more money to manage that instead of his 10 best ideas, you will get his 100 best ideas (this may apply to Mario Gabelli).

3)      The cost of engaging the manager will be much higher than it was before his alpha (e.g., James Simons of Renaissance Technologies now charges 5% of assets and 44% of profits)

4)      The market will set the price of accessing the manager so that buyers will be indifferent between the manager and an index fund (e.g., Warren Buffett).

To summarize, as we have said and we will continue to say, manager picking is a mug's game.