Value in the Modern World

I like old-timers. They have terrific knowledge, perspective and, above all, experience. I love hearing the war stories about how decisions were made, what succeeded and what failed and the people who were in the room.

Over the weekend, I watched a rerun of WealthTrack on YouTube, a PBS show that features a reporter named Consuelo Mack interviewing many of the titans of finance. Most of them are from what I would call the ‘old guard,’ which is great, because I have a good sense of what the young turks are saying already.

In one episode, however, I was a little annoyed by one of the old-timers (who is 89, so that seems like a fair description). The guest, who I will leave unnamed out of respect, was basically saying that the people who believe in Modern Capital Theory ‘just don’t get it.’

Well, it’s actually Modern Portfolio Theory (MPT) and I think we do get it.

This particular fellow is a value investor, a disciple of Ben Graham, the father of value investing and Warren Buffet’s mentor. The theory described by Graham is right on the money in our view, we just prefer the approach developed by academia in the 1980s and implemented by some firms over the last 20 years.

The WealthTrack guest has five mutual funds with publically available information that we can evaluate: a value fund, an international value fund, a small cap value fund, a real estate fund and a corporate bond fund.

The oldest fund that invests primarily in US stocks, has a track record back to 1990. The performance through August was quite good – 11.94 percent annualized compared to 10.52 percent for the S&P 500.

To the untrained eye, that looks pretty good! Those pesky academics, however, have come up with a way to evaluate the performance that controls for factors besides the market performance, like an overweight to small cap stocks or value stocks.

Once you adjust for these overweights, the performance that you can attribute to manager skill, or alpha, is zero.

If there is no manager skill, then you can create a portfolio of indexes with the same biases and earn similar results.

In fact, I created a portfolio using three index funds (the S&P 500, the Russell 2000 and a small cap value index) with size and value tilts that approximate the value fund in question and it turns out that the index fund portfolio earned more than one percent annually more than the fund.

Essentially, I found the same thing across the four other funds that Mr. Old Time Value offers. In every case, a comparable fund from Dimensional Fund Advisors actually beat actively managed fund, except in junk bonds, where DFA doesn’t offer a fund (although this fund doesn’t beat the Barclays junk bond index either).

Importantly, DFA doesn’t win by adding alpha, or manager skill. They simply provide exposure to risk factors like small cap and value in a systematic way – a process that appears to provide better results for clients.

Now, I do want to say that Mr. Old Time Value investor does get heaps of credit because he started doing this decades ago – long before the academics were even looking at it. I’m mad at this fellow for badmouthing a modern adaptation of what he’s doing, but I still have a lot of respect for him.

I wish he would take a more circumspect view: rather than disparaging Modern Portfolio Theory, I wish he would say something like: ‘You know, it’s not how we did it in my day and some of it doesn’t make sense to me, but I can see that the results are good and this town is big enough for the two of us.’

Years ago, a different legendary active manager said, ‘there are many paths up the mountain, this is the one where we feel best about our footing.’

That’s a great approach and you can be sure that if and when we see better strategies out there, we won’t pooh-pooh it out of hand and will instead take a long, measured look and see what makes the most sense.