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The Moment I Realized Manager Alpha Was Nothing More Than Smart Beta

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Posted on: 14.09.2017

My interest in stocks started when I was teenager, before I had cash to invest. I recognized a few things in the equity markets.  First, when stocks are going up they seem to go up for a long time, so in an economics class essay I proposed buying whatever stocks had gone up the most in the last 6 months; I was on to momentum.  I even attempted to implement my momentum strategy in a paper stock market simulator online, by look at 6 month returns in the newspaper – that wore me out quick.  I had also studied Buffet and his tendency to buy quality stocks that were underpriced. Unfortunately, I lacked the resources and mentorship to really do any in depth analysis or testing so these observations were shuffled to the back of my mind.

When  time came a few years ago to get started investing I wanted to know EVERYTHING about how the market worked, didn’t work, and how my returns were going to come about.  My research quickly led me to passive market cap investing and the Boglehead mentality.  The theory of buying into the market cap weighted indexes, which ultimately means buying the most expensive stocks, didn’t sit well with me.  It went against basic economic principles.  Nor did the idea that ‘no one can beat the market’.  Warrant Buffet has done it.  So has George Soros, the Bridgewater Hedgefund manager.  The list could go on, but there is a whole slew of fund managers and wall street guys who have beat the market (Important to note, that more have failed in beating the market than have succeeded).  Not to mention, the returns of various ‘passive’ portfolios, and asset classes have varied greatly over different time periods.  This had me wondering what was ‘passive’ anyways?  Every portfolio touted by the buy & hold crowd, other than the Global Market Portfolio, was taking some type of ‘active’ bet.  No one was truly passive, and many were beating the global market portfolio simply by tilting toward at minimum, an equity premium.

Many Mutual Funds Have Been Very Susscesful

I began looking into mutual funds.  I found some with long track records of out performance and some with higher sharpe ratio’s and lower drawdowns.  You know the names.  Vanguard Wellington (VWELX;  the legendary mutual fund that has been around since before the great depression and put the 60/40 portfolio to shame in both total returns and sharpe ratio.     Fidelity Contrafund (FCNTX) ran by Will Danoff has

fcntx-smart-beta-30-yr-returns

Fidelity Contrafund total returns compared to S&P 500

returned 13.16% annually over the last 30 years compared to just 9.83% for the S&P 500.  First Eagle Global Fund SGENX cruised through the lost decade of the 2000’s with wowing 12.36% returns and 33% max drawdown – over the last 30 years it beat world allocation benchmark by 3.43% annually.  The funds and others, along with successful fund managers, have long track records of success.  I found it hard to believe any stock picker could be that lucky, and patient (for those with low turnover), over a duration of time, so I kept searching for what was behind that alpha and was reminded of my initial observations as a high schooler.

 

Smart Beta Factors Explain The Success

I began writing algorithms looking for value and momentum on Quantopian.  Being in the quant environment I quickly found Fama & French’s research, and factor investing.  Suddenly it all became clear.    There was momentum and value, which I had recognized 10 years earlier.  Then there was Quality/Profitability, size, and low volatility.  All of which were based on systematic investing, statistical significance, and returned a premium over the market.  Factors could be controlled and backtested.  No luck required.

I started looking at my favorite mutual funds and trying to recreate them with smart beta strategies – I was successful.  The first mutual fund I analyzed was Vanguard Wellington which I

Investment approach of Vanguard Wellington Fund. Source: Vanguard

Investment approach of Vanguard Wellington Fund. Source: Vanguard

mentioned earlier.  Here’s what me know about it.

  • Holds 60-70% stocks, 30-40% bonds
  • Large and mid-cap value stocks
  • A mix of bonds
  • Uses fundamental risk controls

In other words, it is going with quality (likely using ROE), value stocks, and a bunch of bonds.  Simple enough. We could get exposure to these types of equities through a systematic index like the Morningstar Wide Moat Focus Index and Elements Morningstar WideMoat Focus ETF (WMW).  For the bonds, Vanguards’s total bond market mutual fund (VBMFX) would do the trick.  Lets do a test allocation of 65% WMW and 35% Bond (Portfolio 1) and compare it to VWELX.

Portfolio 1, Using a factor based ETF generate returns and characteristics of Vanguard Wellington mutual fun.

Portfolio 1, Using a factor based ETF generate returns and characteristics of Vanguard Wellington mutual fun.


Here we can see that Portfolio 1 has similar properties; draw down and sharpe ratio, to Wellington and out performs in total return.  +1 for smart beta.  Now I’m not at all saying that wellington is a bad fund, in fact with its 0.25% expense ratio it’s a great fund, rather I’m just illustrating how the alpha explained by Smart Beta.  You can find this across all mutual funds that have shown return consistency.  Duplicating the strategies of susccessful fund managers with Smart Beta ETFs gives can give you the option to lower fee’s, avoid sales loads, avoid style drift of the mutual fund managers, and tax efficiency.

I came to this realization the hard way, so don’t take my word for it.  Here’s some other research:

On Persistence In Mutual Fund Performance (Carhart 1997 – four factor model)

Persistence in Mutual Fund Performance: Analysis of Holdings Returns

Performance Evaluation Of Active Managers

Simple Tools To Understand What Drives Performance.

Interactive Brokers ‘Mutual Fund Replicator’ (I haven’t tried this yet)

Corey Philip

Corey Philip is the founder of RealSmartBeta.com. His focus is on expanding investor knowledge of Smart Beta ETFs and quantitative investing. Learn more about Corey in the 'ABOUT' section of this website.

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