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Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
25th June 2024 • My Worst Investment Ever Podcast • Andrew Stotz
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In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 03: Persistence of Performance: Athletes Versus Investment Managers.

LEARNING:  The nature of the competition in the investment arena is so different that conventional wisdom does not apply. What works in one paradigm does not necessarily work in another.


“Active managers fail with great persistence not because they’re dumb, it’s just that they have a burden of costs, which makes it very difficult for them to outperform and overcome those costs.”
Larry Swedroe


In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 03: Persistence of Performance: Athletes Versus Investment Managers.

Chapter 03: Persistence of Performance: Athletes Versus Investment Managers

In this chapter, Larry expounds on why we do not see the persistence of the outperformance of investment managers. He also tries to help investors understand how securities markets set prices.

Skills versus luck

One of the most strongly held beliefs is that successful people succeed not through luck but through the skill of persistence over time. So, people assume that successful active managers must also result from this skill, not just luck. Larry explains that while this may be true for athletes where competition is one-on-one, it is not the case when it comes to investing.

According to Dr. Mark Rubinstein, competition for an investment manager is not other individual investment managers but rather the market’s collective wisdom. Further, Rex Sinquefield states that just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient. Many people fail to comprehend that in many forms of competition, such as chess, poker, or investing, the relative skill level plays the more critical role in determining outcomes, not the absolute level. The “paradox of skill” means that even as skill level rises, luck can become more crucial in determining outcomes if the level of competition also increases.

The cost of outperformance

When it comes to outperforming the market, Larry cautions that investment managers are not engaged in a zero-sum game. In pursuing market-beating returns, they face significantly higher expenses than passive investors. These costs, which include research expenses, other fund operating expenses, bid-offer spreads, commissions, market impact costs, and taxes, can pose significant financial risks. Investors must be aware of these potential pitfalls and factor them into their investment strategies.

According to Larry, small-cap stocks tend to outperform large stocks in the long term. This performance isn’t a size effect but a merger effect. Active managers fail with remarkable persistence in emerging markets because there are costs to exploit market inefficiencies, and the more inefficient the market is, the more the implementation costs.

Why conventional wisdom doesn’t apply in investing

In conclusion, Larry states that conventional wisdom states that past performance is a good predictor of future performance. It is conventional wisdom because it holds true in most endeavors, be it a sporting event or any other form of competition. The problem for investors who believe in conventional wisdom is that the nature of the competition in the investment arena is so different that conventional wisdom does not apply. What works in one paradigm does not necessarily work in another. Peter Bernstein said, “In the real world, investors seem to have great difficulty outperforming one another in any convincing or consistent fashion. Today’s hero is often tomorrow’s blockhead.”

Further reading

  1. Dr. Mark Rubinstein, “Rational Markets: Yes or No? The Affirmative Case,” Financial Analysts Journal (May-June 2001).
  2. Ron Ross, The Unbeatable Market (Optimum Press, 2002).
  3. Raymond Fazzi, “Going Their Own Way,” Financial Advisor (March 2001).
  4. Tim Riley, “Can Mutual Fund Stars Still Pick Stocks?: A Replication and Extension of Kosowski, Timmermann, Wermers, and White (2006).” January 2019.
  5. Robert Kosowski, Allan Timmermann, Russ Wermers and Hal White, “Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis, Journal of Finance (December 2006)
  6. Ralph Wanger, A Zebra in Lion Country (Simon & Schuster, 1997).
  7. Peter Bernstein, Against the Gods (Wiley, 1996).

Did you miss out on the previous chapters? Check them out:

About Larry Swedroe

Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.




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Andrew Stotz:

Low Risk takers, this is your worst podcast host Andrew Stotz, from a Stotz Academy, and today, I'm continuing my discussions with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his episode 645. Larry understands the world of academic research and investing so deeply. Today we're going to discuss Chapter Three in his book and rich, your future those keys to successful investing. We're going to be talking about Chapter Three persistence of performance, Larry, take it away. Yeah, so

Larry Swedroe:

one of the things that's probably a strongly held belief, and for logical reasons, is that people who are successful, it's not likely, you know, a result of luck. But as skill if to persist, since if the performance is persistent over periods of time, someone who's a great baseball player for three years is very likely to be a great baseball player for the fourth year, same thing of other sports. And so people assume that successful active managers must also be the result of this skill, and not just luck. And the problem is that we have a very, very, very different form of competition, when we think about a games or events, where you have one on one competition, versus what is the game of trying to outperform the market, where you're not competing one on one, but where you're competing with what's called the collective wisdom of the market. So let me explain what I mean by that. I'm kind of a high or middle 3.5 level tennis player, if I play against a low three, oh, player, someone, well, I'm just a bit better than I typically will win fairly easily, most of the time. 6162, you know, maybe I'll lose once in a while, but most of the time, I will dominate. And if I play up a level against the fourth row, they are going to be not that much better, but better than me. And the reverse will be true, I might win once in a while, but they're gonna win 90% plus of the time. So when you have one on one games of competition, like chess, for example, you have two players are rated fairly close, in chess with match points. The one who is the higher ranked player will normally win the vast majority of the events. And what that and the way to think about that, really, I think the best example that I came up with, is in tennis. So think about Roger Federer was probably the greatest player of tennis of his era, before Nadal and Djokovic came along. And the three of them are generally considered the greatest players of all time. Now. We know in you're playing in a Grand Slam tournament, you're playing against the top 128 best players in the world. And he never lost a single match in the first round in a Grand Slam tournament. Never, despite the fact he's playing in such great players. But he's better than that. Now, he may have lost the second round match once, you know, I don't know. But maybe he gets to the quarterfinals, and maybe last 20 25% of the time. And then he got to the semi finals, competitions now tougher. He's playing against one of the four best players in the world, likely, and now we may be loses 33% of the time, and in the finals may be lost 40% of the time, something like that. So you could see that as the competition got tougher, it got harder and harder for him to win. Alright, so there are two things we want to talk about here. So first is the difference in one on one competition. When he was Roger was playing against Djokovic, and Nadal is playing against Djokovic. Their competitive skills are so close, that the match could be determined to a great degree by luck, that somebody is sure tried to hit the tape and just dropped in, or the tape was it to go long, or someone missed the line by hair? The matches are so close, maybe the wind blew a ball slightly, etcetera. When the competition the skill level is that close lock often determines the outcome and not necessarily the higher levels of skill. Okay, that

Andrew Stotz:

that's totally totally makes sense. And I always say in like CFA research challenge, when the finalists student teams are competing, it's like, truthfully, the outcome by that time turns out to be a lot of luck, you know, depends on the company they're presenting, and whether a judge knows this, what they said, you know, that type of thing. And that's interesting. One of the other questions I have for you is if we take those three top tennis players of today, and we compare them to the three top tennis players of let's say, 30 years ago, has there been an accumulation of learning that's been going on, so not only are they the best today, but they've accumulated, maybe physical characteristics are one aspect. But then the other part is amount of learning about training and about peak performance.

Larry Swedroe:

That's a really interesting point, I would say this, first of all, you can't compare today to 30 years ago, because the playing with much better technology. The rackets are much better than, you know, the wooden rackets that beyond bog and McEnroe were playing with in the 70s. So you know, the greatest players in the world today wouldn't look like the greatest players, then the matches, if you watch a board, Mac, or match, the pace of the game is so much slower than it is today. But the players today have much better training methods. The physical mat training is much better understanding of diets and physical therapy and stretching all of the important training, weight training and running into they're in much better condition. You know, McEnroe never, I think won a Grand Slam event after 25 and Djokovic, and Nadal and federal winning well into the 30s and mid 30s. Because they're much better. But that's an extreme point, remind me I want to come back to that now, because that is something that's very relevant. Okay. And that shows you how tough it is to win when the doll was playing Djokovic, it's very hard for either one to win, even though they were the best player in the world, because the competition is so tough. So let's go back to this issue. So let's talk about Barry Bonds was generally considered whether he was aided by medical technology and hormone treatment stuff like that is another story but he was the certainly the best hitter of his generation. Okay, and he was stronger than most hitters, but not stronger than all it is. He had quick a bat speed than most hitters, but not all of it is. He was one of the fastest runners of the game. Early in his career. He was a very good field, or add tremendous power, but he wasn't the best in any one single thing. But what you have to remember about Barry Bonds was that he was competing one on one against the pitcher. And Barry Bonds managed let's say to bat 300 in his career, I don't remember exactly what he did. But imagine if he faced a pitcher who had Sandy Colfax, his curveball generally considered the best curveball ever. Christy Mathewson screwable I'll call humbled, screwball Walter Johnson's fastball, uh, Greg Madison's changeup, etc. You know, all in one person Barry Bonds might not it 300 He probably ordered 200 or 180 or something, and never would have hit 750 or whatever homeruns he managed to hit. He was competing one on one. When stock pickers are trying to compete against the market, there are outperform they're not competing against you or me. Or even Warren Buffett, which would be tough enough to outperform Buffett or Peter Lynch, or any of the other great fund managers that are competing against the collective wisdom of the market, as if Barry Bonds was competing against the pitcher with Sandy Colfax, his curveball Walter Johnson's fastball, Greg Madison's changeup, etc. That's one of the Competition is much tougher. And to bring in your point 30 years ago when my first book was published, Charles Ellis had written at the same time his book winning the losers game. And he pointed out that 20% of active managers pretax, or generating statistically significant alpha, that's still a loser's game, especially after taxes where that number would be more likely to be 10%. But the competition is so much tougher. 30 years ago, most people who were doing stock selection may have been a train, you know, coming out of college as a lit major, or an art history major. And they sent went to work for Salomon Brothers got trained today, everybody who's managing money pretty much. He's got a PhD, or an MBA in finance from a top university has the best data available with high speed computers. And you're working with teams of other brilliant PhDs. I mean, their head of Research at Avantis is a rocket scientist. You know, this isn't rocket science. That's literally what is a rocket is the same thing is true of people at dimensional. And my co author Andy Birkin, who heads the research or Bridgeway, also has a PhD in physics, and has won the NASA award for the best software are there. These are people with likely far more skills smarter than you. And they're spending 100% of their time doing it. And they can't win. Because the collective wisdom of the market is so in a competition is so tough. That's the problem that active managers have. And the result has been that by 2010, Gene fama and French took Ellis's data, renewed it, and found that less than 2% of active managers were generating statistically significant alphas. And that was less than you would expect, randomly by chance. So that's what you have to recognize. If you think you're smart, maybe you're a bio engineer, and you're studying a company and you're think you've got an insight into what's happening? Well, maybe you have insights that could allow you to exploit your me if we were competing one on one, but you're not, you're competing against the brilliant scientists of Renaissance technologies, and lots of other, you know, hedge funds and high frequency trading funds, that are paying multimillion dollar salaries and have the best computers and the best database. And now artificial intelligence to scan, you know, financial statements are better than any human could do it, and they're all gonna have that same data, how are you likely to get this advantage? To give you a likelihood of winning, that should say you should try to play the game? I just don't see how it's likely.

Andrew Stotz:

So okay, so to summarize, what you're saying is that, in the world of finance and investing in the market, you're, every time you go to trade, you're trading against the collective wisdom of all the best people. And you also in this chapter, talk about how majority of the people trading our institutions. So it's not like you're just trading against the smartest, you know, Tom, Dick and Harry, in the market, you're trading against the people that have the real resources. So that's the first thing. And the other question I have about that, though, is, does that mean that nobody outperforms outside of luck?

Larry Swedroe:

Now, I wouldn't say that there's probably a renaissance man somewhere who gains an edge, figure something out, maybe creates an artificial intelligence program that can read data, financial St. There's always new research coming up fact that and write up new research all the time. I just wrote up a new paper, which I thought was really interesting. That shows the size of fact, which is small cap stocks tend to outperform large stocks of the long term really isn't a size effect. It's a merger effect. So what he did is I went into the data and said, can I identify characteristics that predict that a company is likely to be taken over and if I buy those companies? I will gain that sides premium. And he found that totally subsumed the evidence of that And he saw his premium. That's fascinating. So the key then is that person could outperform. But soon as that published, that paper gets published, even before it gets into a journal, you know, people like me and the guys that, you know, high frequency trading, Renaissance technology and others, they're reading these papers, they're going to implement it. And the advantage goes, that's what makes the efficient market hypothesis, the most powerful of all thesis, it's that the very act of discovering these anomalies makes the market more efficient, because the act of exploiting the anomaly you discover, eliminates the anomaly.

Andrew Stotz:

So what I'm hearing you say is that maybe the only way that somebody could persistently outperform for a period of time, it won't last forever, is if they find something that the market hasn't yet recognized. And then or they've come up with some little advantage, and that their success will ultimately through their trades and their assets under management will ultimately feed that information into the market, even if it wasn't published through academic research. And the market will adjust to that. Yeah,

Larry Swedroe:

that's exactly what happens there. People work the Renaissance technology and then leave to go say, Well, I don't want to work for Simon's I want to make my own fortune. And they take their knowledge, and they go somewhere else and try to replicate. And the other problem is that there's no doubt there are a very strong diseconomies of scale in investment management. So if you're a successful, what happens, assets come in, very few managers are willing to turn away the fees. And now you have to look more either more and more like the market. And your higher fees make it difficult to overcome those expenses. Or you have to take bigger positions and those same few stocks, which means your market impact costs are going to go way up. That's why the phrase I use and I've written in my books is that successful active management contains the seeds of its own destruction. And that's why you one of the reasons why you don't see persistence, besides the other things that we have talked about.

Andrew Stotz:

And so one other question I had about that was, I have a friend of mine, and he invests in the Thai stock market. And what he looks for is because he's managing his family's money, he looks for relatively illiquid companies, that nobody's really, you know, trading in, he may try to get blocks of the companies. And he's got a super long time horizon. And he's not looking for price appreciation. He's trying to look for companies that are going to generate dividends and generate good returns over a long time. And maybe the price will go up, maybe it won't, but so he's built a position in, let's say, 10 companies and his argument to me, and I think it's a valid argument. But I may be wrong now that we're talking. But his argument is that I'm taking advantage of a anomaly in the market that most people will never take advantage of they can an institution can't do that in these types of small companies. And he's built a portfolio of let's say, 10, small, illiquid companies. It doesn't even have to be small. Let's just say illiquid companies that he's holding over a long period of time. Is it possible that he can outperform from that? Well,

Larry Swedroe:

one, I would expect him to outperform, because he outperform the market because he is accessing an illiquidity premium stocks that are less liquid, right, have a illiquidity premium, because the big people can't invest in it, or they're afraid to invest in it. Because if they want to get out, they'll move the market against themselves big time and when they're trying to buy, if they buy a few shares, the price runs up and runs away from them. So it's very difficult for them. So there is a well documented illiquidity premium in stocks, a problem that I have with his strategy is concentration of risk. We know as we've talked about, and prior episodes, most stock returned, or the excess returns to the market come from a very tiny small percentage of stocks. So we know in the US it's 4% of all the stocks or Camfil 100% of the excess stock returns. So incredible. If I own in the US, say 500 of these illiquid stocks, I've got a pretty good chance of capturing that illiquidity premium. And if I also use the investment knowledge, from my books, that academic research, you not only buy small illiquid, but profitable companies with low financial leverage, low operating leverage higher lower prices, the cashflow, which sounds like he's doing, then I'm accessing those premiums. And I'm likely to outperform the market, maybe not on a risk adjusted basis, but I'm likely to get higher returns. So my way of investing is I do what your friend is doing. But I'm investing in mutual funds that own anywhere from maybe three to 600 of these companies or more, because the US market is deeper than Thailand. So my only concern about the strategy of your friend is he's taking a lot of concentration risk, which I would prefer not to see it increases your chance of hitting a homerun, it also increases the chance that you're buying a company where somebody's going to commit fraud and steal. And this, you can have negative effects, you get lawsuits. I mean, lots of bad things can happen. And the different jobs would be the problem.

Andrew Stotz:

And the difference in Thailand and said we don't have a fund or an ETF that can really access that part of the market. But I noticed in the back of the book in your appendix, you've highlighted things like small plus value plus momentum plus profitability and quality. And for us, you know, there's there's different funds out there like the AQR small cap, multi style, the iShares, Edge MSCI multifactor, or to that you list, and I mentioned that only because for the listeners out there, you know, the resources in the back of the book are fantastic. But is that it's fair to say that in the US, you can get closer to replicating or capturing that potential risk premium? Because there are instruments available that really in somewhat smaller markets like Thailand, you just never gonna get? Yeah,

Larry Swedroe:

and I wouldn't add this. There's some trade offs here, the more you concentrate, the greater access to these premiums you have because the premiums are greatest in the smallest of stocks. So the more you diversify, the more you reduce the tail risk. So the question is, where's that medium, and US stocks, you know, I probably want to own as at least two or 300. And probably not much more than I don't think you need to own much more than 600. If you're owning having to own more than that, maybe your funds getting so big, you need to own more of it. Otherwise, you have those market impact costs. So Bridgeway small value fund has fewer stocks than dimensional small value fund. They're both very good vehicles, but Bridgeway gets you more exposure to those factors, deeper exposure to the factors, and you're gonna have more volatility and wider dispersion of returns, but a higher expected return, but not necessarily a higher risk adjusted return. You have to pick your poison, if you will. Do you want more diversification? And less tail risk? Or do you want higher expected returns, but more tail risk? And why did dispersion

Andrew Stotz:

are, so there truly is no free lunch, while

Larry Swedroe:

there is a free lunch, and that's diversification. But only if you do it properly, owning 10 Different tech stocks is not diversification.

Andrew Stotz:

I want to end this by talking about visualization for those people who are not familiar with American baseball. You know, when batters are warming up, they're swinging their bat and they're getting ready, they're loosening up. And then we have something called a donut that they put on the bat that adds weight to the bat, you know, and that's good for when you're warming up the bats pretty heavy. But could you imagine if a batter had to go up to bat with an extra weight on that bat, and I think what you talked about in the book was that that extra weight is the weight of all the costs of an active manager versus a passive manager that walks up without a doughnut on his back, but maybe you can explain them. Yeah,

Larry Swedroe:

I'm so proud and drew of that analogy. That's great. I wish I had thought of that. Right? That's exactly right. You know, you just have these extra hurdle to overcome. Imagine if Barry Bonds how to swing his bat against 100 mile an hour fastball with a five pound weight on his back. He wouldn't hit 150 Let alone 250. So that's that One of the disadvantage and the reality is active managers fail with great persistence not because they're dumb, they're very smart. In general, it's just that they have a burden of costs, which makes it very difficult for them to outperform, and overcome those costs. Even though there are some anomalies in the market. It's just that there aren't enough dummies like you or me to exploit. Right? You know, who are trading based on you know, who knows what, but it's not good research, something they read in Barron's or something, or hear Jim Cramer say, right, where they think they know more than the Mako without ever asking, Gee, I wonder if Warren Buffett knows that right? Yeah.

Andrew Stotz:

And to summarize the reason that the cost that an active fund manager faces you highlight, there's costs related to kind of operating the fund, which is research expenses, and just fun operation costs, then there's market impact type of funds, cost like bid offer spreads, commissions, market impact costs, and then there's listeners

Larry Swedroe:

just so if they're not familiar with market impact costs, let's say a stock is trading a small cap stock is trading, it can bid 10 and a quarter ass. Now you could buy 100 shares, or maybe even 1000 shares at 10 and a quarter, go try to buy 50,000 shares, maybe you get the first two or 3000 attended a quarter. Now the market sees you're trying to buy a lot and the next 5000 shares, you get a 10 and a half and the next 5011 and your drives the price up. And when you're finished buying your 50,000 shares, the stock drops back to 10 bit 10 and a quarter s that's market impact costs.

Andrew Stotz:

Yes. And some of us aren't so rich to have market impact. But the big institutions definitely have it.

Larry Swedroe:

Yeah, that's a big advantage that individual investors have is they don't have typically the average individual investor doesn't have market impact costs, but they don't have the knowledge and the information that the big institutions that so they, their winning strategy is just don't play, just take advantage of these well documented factor premiums that Andrew Birkin. And I wrote about in our book, your complete guide to factor Based Investing.

Andrew Stotz:

Yeah, and it's one last thing I would say about Asia, in particular, Thailand, but I know it's happened around Asia is that there's one case within the market that's been competed down to very narrow cost. And that is the cost of trading through brokers. It used to be very high, and now it's miniscule. So for the average, if someone was a knowledgeable person, they can access the market at a pretty low, you know, commission rate, what were you gonna say? Yeah, I

Larry Swedroe:

just want to add one other thing. I'm glad we I thought at this point, a lot of people think, for example, that small caps, the mock ups are less efficient than they are for large caps. Why? You know, there are, I don't know, 100 analysts following Google or Microsoft, or Tesla or whatever. And maybe you got XYZ fried chicken franchise that's in three states and whatever, and there's one animal is falling. So there's less information out there. Well, yes, that's true. And maybe that allows you to capture information the market does not have. The problem is the bid offer. spreads are much wider. And the market impact costs are much greater, because it's illiquid stock. And that's how you get this balance. Right. the more efficient the market gets, the harder it is to win. But the trading costs are lower because the markets efficient. Well, the evidence is in small cap stocks where people think it's less information than efficient, active managers do justice poorly. The same thing is true about your friend in Thailand and emerging markets. People think emerging markets are highly inefficient because there aren't as many people following them. But after managers fail with great persistence in emerging markets, as well, proving the point, that it's not, you know, that markets are informationally so efficient, that active managers can't win. It's that there are costs to exploit those inefficiencies, and the more inefficient the market is The more of the implementation costs weigh you down. And that's the problem there. So you have to have an inefficiency and very low costs and exploiting those inefficiencies so much

Andrew Stotz:

in this tiny little chapter. I appreciate, Larry, I want to thank you for another great discussion about Craig grading, growing and protecting our wealth. For listeners out there who want to keep up with Larry and see what he's doing. Follow them on, on Twitter at Larry swedroe And also on LinkedIn. I know I follow everything he posts. This is your worst podcast hose Andrew Stotz saying. I'll see you on the upside.





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