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It's Not Easy, But the Right Approach Can Outperform the S&P

Robert Hagstrom, CFA
MoneyWatch blog wars give prominent experts a chance to debate big issues related to the economy, the stock market, and personal finance. In this round, Robert G. Hagstrom and Charles D. Ellis face off on whether you should invest with active managers who try to beat the market, or stick to low-cost index funds that deliver market returns.
The debate between those who believe the stock market is efficiently priced and those who maintain they can generate excess returns by identifying mispriced stocks has been spirited and sometimes vicious since 1970 - the year in which Eugene Fama wrote his seminal work, Efficient Capital Markets. For the past 40 years, it has been an intellectual tug-of-war between academics and practitioners.

Each side is unwilling to give an inch per chance it would wreck their profession.

The Efficient Market Theory (EMT) claims that all information is instantly priced in the market by rational profit seeking investors. This instantaneous adjustment of prices based on new information leaves little room for arbitrage between price and value. To prove their case, proponents of EMT simply count the number of mutual funds unable to beat the S&P 500 Index.

Charley Ellis rightly points out that over time only about 30% to 40% of equity funds beat the S&P 500 Index. Once you adjust for survivorship bias, the actual number of funds that have out performed the S&P 500 Index over time is closer to 20%.

Let me first begin by saying it is an honor to engage in a conversation with Charley Ellis about stock market efficiency. Charley is a true pioneer in our industry. His many contributions have educated hundreds of thousands of young investment professionals. So, those of you expecting or wanting a knock-down and drag-out debate may be let down. However, I think even Charley would be disappointed if I did not challenge him on a few points laid out in his new book.

The S&P 500 is commonly perceived to be a passively managed index. Nothing could be further from the truth. In fact, the S&P 500 Index is an actively managed portfolio with an annual turnover ratio (yes that is right, there is turnover in the S&P 500 Index) of approximately 5% to 8%. A committee of nine analysts removes, on average, 25-40 companies each year and replaces them with companies that are financially sound, have sufficient trading liquidity and that are expected to be in business over the next 10 to 20 years.

Compare and contrast the portfolio management approach of the S&P 500 Index with most other active managers. One discerning difference is turnover ratios. According to Jack Bogle, the average annual turnover ratio of the average mutual fund has gone from 40% in the mid - 1960s to over 109% by 2009.

It is clear that the average mutual fund today is attempting some form of short horizon arbitrage while the S&P 500 Index is firmly focused on the long term.

I was reminded of the idea of long horizon arbitrage as I was writing Who's Afraid of a Sideways Market?. The last significant sideways market here in the U.S. occurred between 1975 and 1982. Despite a market that went nowhere for seven years, Warren Buffett and Bill Ruane generated cumulative total returns of 676% and 415% respectively, or average annual returns of 34% and 28%. How could two buy and hold money managers generate such outstanding performance results in a flat market? First, it is important to understand the difference between the trends of a system from the trends in a system. Stephen Jay Gould, in his book Full House, argued that individuals have a tendency to focus on the average without appreciating variance. Second, Buffett and Ruane pursued long horizon arbitrage.

To show the difference between what happens to a system and within a system, we calculated the performance of the five hundred largest stocks in the market between 1975-1982 over one-, three-, and five-year holding periods. We discovered that in any one year about 3% of the stocks in the 500 doubled on average. Over a three-year period, about 18% of the stocks doubled. When we extended the holding period to five-years, we discovered that an eye-popping 38% of the stocks had at least doubled in price. That almost four in 10 stocks went up at least 100% over five-year rolling periods when the broader market barely budged suggests to me the market mispriced these stocks.

The classic academic literature on market inefficiencies focuses in three main areas: size effects, momentum effects, and value effects. To this list I would add time horizon arbitrage.

First articulated by Andrei Shleifer and Robert Vishny in The New Theory of the Firm: Equilibrium Short Horizons of Investors and Firms, the authors compared the cost, risk and returns of short horizon arbitrage to long horizon arbitrage. The cost of arbitrage is the financing cost and the amount of time your capital is invested. Risk is the amount of uncertainty over the outcome of the arbitrage and return is the amount of money made on the investment.

Shleifer and Vishny note that "in equilibrium, the net expected return from arbitrage in each asset must be the same. Since arbitrage of long-term assets is more expensive than it is for short-term assets, the former must be more mispriced in equilibrium for net returns to be equal." What this means is the degree of inefficiency for long-term arbitrageurs, and as a consequence the investment returns, must be greater than the returns achieved by short-term arbitrageurs. All things being equal, investors who focus on the long-term investment opportunities are more likely to be rewarded with much greater excess returns. What we discovered in the 1975 to 1982 market was a basket of long horizon inefficiency not made available to short horizon arbitrageurs. You had to stick around for five years on average to get the returns.

Early in my career, I had the opportunity to write a book about Warren Buffett. Later I did my practical work with Bill Miller. Thus I was able to observe closely how these managers significantly outperformed the S&P 500 Index over time. I came to appreciate that the portfolio management approach that Warren and Bill use is highly unique. Both investors are concentrated low-turnover portfolio managers. They practice long horizon arbitrage.

When asked to comment on the fact that most active money managers fail to beat the S&P 500 Index, Bill responded that the observation "is not an argument against active management, [rather] it is an argument against the methods employed by most active managers." What passes for money management today is largely short horizon arbitrage with commensurate returns. Short horizon arbitrage costs less and has less risk than long-term arbitrage, but also has lower returns. When you subtract management fees and high transactions costs from the lower returns of short horizon arbitrage no wonder most mutual fund managers have difficulty beating the stock market.

On the other hand, even though long horizon arbitrage requires you to invest your capital longer and has a greater level of uncertainty over the outcome, the higher potential returns more than compensates you for the cost and risks assumed. After deducting fees and transactions costs, there is often plenty left over to beat the market.

I argue the market's inefficiency is a matter of degrees that varies over the investment horizon.

Thus the question becomes - "Are markets efficient or is the investment approach necessary to beat the market difficult to apply?"

Robert G. Hagstrom, CFA

Robert G. Hagstrom is a senior vice president at Legg Mason Capital Management and portfolio manager of the Legg Mason Growth Trust mutual fund and he manages the growth equity strategy for the company's institutional clients. Previously, Robert served as president and chief investment officer of Legg Mason Focus Capital. Prior to working with Focus Capital, he was a Principal at investment counseling firm Lloyd, Leith and Sawin. Robert has also been a portfolio manager with First Fidelity Bank a Financial Advisor for Legg Mason Wood Walker, Inc. Robert earned a B.A. and M.A. from Villanova University. He is the author of six books, including The Warren Buffett Way: Investment Strategies of the World's Greatest Investor.