It’s Easy to Beat the Market

I love Robert Shiller.  He’s a Yale professor that’s really shaped my thinking on how to value the stock market with the Shiller PE, he wrote a book called Irrational Exuberance at the peak of the technology bubble and he won the Nobel Prize in Economics last year for his efforts in showing that markets aren’t as efficient as the other Nobel Prize winner, Gene Fama, would suggest.

Last week, he was interviewed on Bloomberg Television and he made some interesting remarks, most notably that it’s ‘easy to beat the market.’

In the interview, the Bloomberg reporter asks him whether he thinks it is possible to beat the market and he says ‘It’s easy to beat the market, historically.  For example, one can just go into a value stock.  Over the long haul, value stocks have outperformed the market.  There’s a number of anomalies in the literature that … [show] it’s not that hard.’

This is a fascinating statement because it’s 100 percent true.  It’s also a bit perplexing on its face because we’ve all seen the studies that show that actively managed mutual funds generally fail to beat their benchmarks.  See the most recent S&P report here for more details.

What he’s referring to is something that we have written about extensively – what he calls an anomaly, we call a strategy, like the value premium.

Using data that goes back to 1926, the Fama French US Large Value Research index has earned 12.01 percent through February of this year, compared to the S&P 500 index of large cap stocks, which earned 10.14 percent over the same time frame.

When Shiller says it’s easy to beat the market, he’s saying that this known anomaly/strategy exists that simply involves buying the cheapest 30 percent of stocks each year, holding them for a year and repeating the process over and over again.

When a simple index can beat the market, does that really count?  Yes and no.

It counts in the sense that creating true value portfolios that actually capture the value premium is not as easy as you might think.  I wrote about this fairly extensively in January, and you can find the write up here.  In that regard, it counts.

But consider the five-year performance of a large, well known value mutual fund that I will call Fund X.  It has $19.5 billion in assets, a low fee for active management (0.88 percent), low turnover and for the five years ending yesterday, and it beat the S&P 500 by 2.39 percent per year.  Good deal right?

Well, I don’t think it’s anything special since over that period value performed well, earning 2.25 percent per year more than the market.

If you adjust for this fact, the large mutual fund in question didn’t really do anything special.  In our industry parlance, there was no alpha.  Some people mistakenly think that alpha refers to outperformance and they might say that the fund beat the S&P 500 by 2.39 percent and that’s alpha.

That’s false.  When alpha is calculated, it adjusts for a variety of factors, most famously for value and company size (the Fama-French Three Factor Model, the third being the overall market).  In the case of Fund X, the alpha over the past five years is basically zero because the outperformance is explained by exposure to value.

The mutual fund that we use for our large cap exposure outperformed Fund X, in large part because it costs 0.60 percent less than Fund x.

If Shiller’s statement was rephrased to say, ‘it’s easy to get alpha’ or market returns not associated with well-known strategies like value (or size, momentum, credit, etc.), the answer would be quite difference.

Of course, Shiller would agree.  I doubt he’s given it a second thought, but I wonder if he would regret his statement after realizing that the general public (and most of the investment community) would be able to parse his comments.

I also wish that he had included an important caveat, which is that to beat the market, you have to take some kind of additional risk.  In the case of value investing, you’re buying junky stocks that are going the problems.

Over time, most companies resolve the problems and their stock prices rebound.  Some companies fail, but most of the time the winners pay for the losers.

In the mean time, value is more volatile.  The Fama French research index that I referenced above was about a third more volatile than the overall market.  As always, risk and return go hand in hand.