Our mission is to empower investors through education. This mission is our passion and what drives us to go to work everyday. But this mission is not our product. Our product is Affordable Alpha: We seek to deliver “alpha” (highly differentiated risk/reward profiles) at low costs, thereby giving sophisticated investors a higher chance of winning, net of fees and taxes. Note: Here are some high-level background documents on our firm
Why Affordable Alpha?We are based outside of Philadelphia, roughly 15 minutes from Vanguard’s campus. Vanguard is the gentle giant of the region and we welcome their business model and vision for financial services: transparency, affordability, and disintermediation. We also know competing against Vanguard in cheap non-differentiated, “commodity” products is a fool’s errand. Firms we greatly respect, such as DFA, AQR, and Blackrock, are learning this lesson the hard way. To us, Vanguard is like Costco. And when you need 5 gallons of Mayonnaise, there’s no better place. But we also know that Vanguard can’t effectively compete in all areas — especially when it comes to highly differentiated, limited capacity, concentrated investments. Because of our limited size and extensive research capabilities, we feel confident in our ability to compete. Eureka! Let Costco be Costco, and we will thrive where Vanguard can’t. But who is actually playing in this space and what are they doing? Note: if you are a hedge fund manager charging 2/20 from your yacht in the Maldives, you are not going to like the next section. Welcome to the land of “active” managers. When we looked at the active management industry we observe two key trends:
- Costs are too high.
- Not everyone is truly “active,” or genuinely different than a passive index fund. They’re essentially posers.
- Affordable: Non-scalable active strategies are scarce and expensive to produce. These products can never be priced like a Vanguard fund, but they also don’t need to be “two and twenty.”
- Alpha: Portfolios need to be different to be differentiated. We are not closet-indexers (e.g., “smart beta”) and we build portfolios that seek to deliver unique risk and reward profiles.
Understanding the Asset Management LandscapeOur hope is that the framework we outline below will allow investors to differentiate among investment management products based on a few key characteristics. First, let’s define a few concepts that are central to understanding the investments industry:
- Alpha: Formally, alpha represents the intercept estimate from a regression of an investment strategy against various risk-factors. In English, alpha is exposure to a different risk/return profile that may not be in your current portfolio (which is highly valuable).
- Tracking Error: The standard deviation between a strategy’s returns and a benchmark’s returns. In other words, how closely a portfolio follows, or “tracks,” an index. To the extent one cares about being close to a benchmark, tracking error is important. P.S. If you want to be vastly different than the market, tracking error is a positive indicator.
- Active Share: This measure quantifies how different a manager invests compared to a benchmark. A good proxy for active share is simply the number of securities in a portfolio. For example, a manager that holds 50 equally-weighted stocks will likely have a much higher Active Share than a manager that holds 500 market-weighted stocks. High Active typically means High Tracking Error and vice versa (not always). 1
- Passive Index: By construction, passive index portfolios are designed to have no differentiation from the broad market. A good example of an index strategy is the Vanguard S&P 500 Index Fund. This fund does not attempt to add Alpha, but seeks to match the performance of the S&P 500 index with minimal tracking error. Here is a post on the subject.
- Passive Index Products: Index (“Passive”) products offer no alpha, no tracking error, and no Active Share.
- These funds, typified by Vanguard’s products, have a high number of securities, low expense ratios (<20bps), and low marketing costs. (Think about the Costco example).
- “Closet Index” or “Smart Beta” Products: Closet Index products, sometimes referred to as “smart beta,” offer little differentiation, little tracking error, and little Active Share.
- These funds typically have a large number of securities, low to high-level expense ratios (25-100bps), and high marketing costs. (Think Sales Rep marketing fancy mayo, but spooning Costco mayo into tiny bottles).
- Active Products: Active products, often delivered via mutual fund or hedge fund vehicles, are characterized by high expected alpha, high tracking error, and high Active Share.
- These funds have a low number of securities (<50), high expense ratios (75bps – 200bps+), and extremely high marketing costs.
- Affordable Alpha Products: Alpha Architect products are characterized by limited scalability (a limited amount of $ can invest), high expected alpha (different), high tracking error and Active Share (don’t track a passive index).
- These funds are backed by intense research efforts, mid-level expense ratios, and limited marketing costs.
What We Seek to Deliver: Affordable AlphaTwo words define what we seek to deliver: Affordable, Alpha. We will briefly describe what we mean by each of these terms. First we discuss the most important aspect of what we do: generate alpha. Next we will discuss affordability and why costs matter. Our goal is to highlight Alpha Architect’s product goal, which is to deliver higher net returns for long-term investors in active products.
Condition #1: Be DifferentCharlie Munger, at the 2004 Berkshire Hathaway Annual Meeting, is quoted as saying, “The idea of excessive diversification is madness…almost all good investments will involve relatively low diversification.” Of course, you still need to be a good investor, but the point remains: too much diversification laid on top of a good investment strategy is a bad thing. Munger calls it: “diworsification.” Diversification is a dual-edged sword:
- Owning more stocks can lower a portfolio’s risk profile (i.e. good!).
- Owning more stocks than necessary can dilute performance (i.e. bad!).
- EBIT Cheap Decile = Value-Weight, monthly re-balanced portfolio of cheapest 10% of EBIT/TEV stocks
- EBIT Cheap Quintile = Value-Weight, monthly re-balanced portfolio of cheapest 20% of EBIT/TEV stocks
- EBIT Cheap Tercile = Value-Weight, monthly re-balanced portfolio of cheapest 33% of EBIT/TEV stocks
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. The results are clear: more concentration increases returns (but also increases volatility). The increase in volatility is expected (remember our ski slope graph still has lower volatility at 1000 not 50). But what should an investor choose? What is the tradeoff between returns and volatility? Answer: The Sharpe ratio. The Sharpe Ratio is one commonly used measure to calculate the tradeoff between returns and volatility. More Sharpe = Better tradeoff between risk and return. Based on Sharpe ratios, the evidence above suggests that concentration is a better, risk-adjusted bet. You get a net performance boost by concentrating your holdings. Munger is right: to the extent you believe you have an edge, less diversification is desirable and often cheaper.
|Summary Statistics||Cheap Decile||Cheap Quintile||Cheap Tercile|
|Sharpe Ratio (RF = T-Bills)||0.64||0.610||0.58|
Condition #2: Have an EdgeGreat, so all we need is a good strategy that works. Easy, right? Formally, alpha, or “edge,” is the intercept estimate associated with a factor regression using an investor’s favorite factor model (see here for an in-depth discussion). Informally, “alpha” can be interpreted as skill, luck, and everything in between. To some, alpha represents brains, to others, luck. To us, alpha represents an attractive investment opportunity, rooted in evidence, that is difficult to exploit for behavioral reasons. Humans are imperfect creatures. We eat cheeseburgers even though we know kale is better for us. We buy the Baywatch Collectors Edition box set rather than save for retirement. We do stupid things. For investing, we believe extreme investor education and following a structured process can save us from ourselves. And we must. Human behavior can influence investment decisions, sometimes in ways that hurt investors. This is the central premise in behavioral finance. Warren Buffett is attributed as saying that investing is simple, but not easy. Similarly, integrating our understanding of human behavior into an investment process is simple, but not easy. How, specifically, does our behavior impact stock prices? Despite our best intentions, our investing approach is not always governed by rationality. In particular, our judgment and decision-making can be significantly affected by intuition, a form of abstract, automatic thinking that can override our reason. Faulty intuition and other forms of irrationality can cause us to do the wrong thing and can also create mispricings in the market. We call this behavioral bias. One example of behavioral bias affecting stock prices is the human tendency to extrapolate short-term patterns and ignore long-term trends (representative bias). Academic research shows that representative bias likely explains part of the “value premium,” which describes the large spread in realized returns between value stocks and growth stocks. 3 But this phenomena only confirms that there are bad investors in the marketplace. Surprise. That alone, however, will not drive stock prices out of whack. Surely there are smart people, with supercomputers, that will send these Baywatch watching, cheeseburger eating cavemen back to their basements where they belong, right? The second building block of behavioral finance requires an understanding of market frictions, often referred to as the “Limits of Arbitrage.” 4 To understand the two components of behavioral finance (behavior and limits of arbitrage), let’s play a simple game of poker using the diagram below: On one end of the table, we have our irrational investors. They drop their cards, they giggle when they get an Ace, and they ask people next to them “Is it a good thing if all of my cards have the people’s faces on them?” On the other side of the table is an institutional poker player, hired by wealthy investors, to play poker as best as possible. This poker player is a pure genius, mathematically calculates all probabilities in her head, and knows her odds better than anyone. Now imagine that our super player, as a hired gun, has a few limits. “We need you to maintain good diversification across low numbers and high numbers. We also want to see a sector rotation between spades, aces, and clubs. Don’t take on too much risk with straights and flushes, stick to pairs like the market does…” No one would ever play poker like this. But in finance, this is how people play. Now the cards are dealt. Super Player sees a great opportunity with a high chance of success, but it violates all the requirements of her investors. She doesn’t bet, and sure enough, she could have won big. The two building blocks of behavioral finance–understanding bias (bad poker players) and arbitrage restrictions (great poker player restrictions)–combine to create opportunities for savvy long-term investors. The Efficient Market Hypothesis (the “EMH”) claims this phenomena can’t exist. EMH claims that market prices reflect all publicly available information about securities. In our poker example, the Super Player will gobble up every opportunity perfectly and efficiently as they are revealed by the bad poker players. In the EMH view, prices will always reflect fundamental value–even when some market participants suffer from extreme behavioral bias. But we feel a strict interpretation of EMH is flawed, since it assumes the costs of chasing the bad poker players’ mistakes are zero. In reality, exploiting investment opportunities created by bad poker players can be very costly (e.g., if you fail to maintain diversification across spades and clubs, we will fire you and get a different player). In our poker example, the real path to doing well in the game is to find the right clients that will stick to a strategy. No need to sector rotate across suits, diversify away a good hand, etc. The arbitrage opportunity is marrying a good investment strategy with a good investment partner. Our investment strategies systematically exploit these opportunities because “smart money,” will typically get fired if they are given free reign to really pursue a winning strategy over the long-term. We explain this philosophy in great detail in our sustainable active investing piece. We also like to emphasize why our two biggest focus areas — concentrated value and momentum — can have terrible bouts of relative underperformance. 5
AffordabilityWarren Buffett obliquely references the concept of affordability in the context of stock-picking:
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. 6Most people understand the concept of affordability when they shop at the grocery store, but lose sight of it when they shop for financial services. Let’s look at an example below with three shopping types. Our Expensive Shopper (green line) really likes Goldman Sachs because it’s awesome to tell the ladies at the cocktail party that you bank with Goldman Sachs. Let’s even give them the benefit of the doubt that they outperform, but they pay 1.5% all in. A cheap shopper (blue line) only focuses on price. Finance is intimidating, we don’t want to invest all of this time in learning the nuance and methods, let’s just go to CostCo and get the cheap stuff. Perfectly reasonable. Now let’s examine an “affordable” shopper that can follow a disciplined strategy, but pays a little more. The figure below highlights why being an affordable-minded consumer of financial services can be a good financial decision for those that want to learn the difference in what they are investing in. Our Goldman Sachs shopper fared poorest in his portfolio over time. Our cheap shopper did better, but our affordable investor, who weighed costs AND benefits, came out on top. 7 This all sounds great, but one question remains: How can we deliver high value services at lower costs than the competition? We deliver affordability by reinventing the way business is done in financial services:
- We seek to minimize distribution costs. Intermediaries should add value, not extract it.
- We leverage technology to maximize efficiency. “Computers good, people bad.” 8
- We maintain a culture of doing more with less. 9 In other words, you’ll find us driving Honda Civics, not Ferraris.
ConclusionWe believe that financial services will be more competitive, transparent, and client-friendly in the future. We want to be on the forefront of this new normal in investment management. Our particular focus is on the active management sector and our desire is to create a new category: Affordable Alpha. Alpha Architect seeks to generate higher net returns for long-term buy-and-hold investors. In order to have confidence in our approach, which is unique and highly differentiated from others, one must understand our investment processes and the research behind them (our books and blog posts are a great place to get started). We believe our approach to the markets makes sense for sophisticated, long-term, disciplined investors. They don’t want the generic passive indexes or closet-indexing funds. We call these investors “sustainable clients.” The central belief behind our “edge” is that we can couple patient and disciplined capital with innovative strategies. It all boils down to educating clients and making them better investors. And we should all want that.
- Cremers, K.J. Martijn, and Antii Petajisto, 2009, How Active Is Your Fund Manager? A New Measure That Predicts Performance, Review of Financial Studies 22, p 3329–3365. ↩
- Elton and Gruber have multiple papers and books on the subject. Elton, E. and Martin Gruber, 1977, Risk Reduction and Portfolio Size: An Analytical Solution, The Journal of Business 50, p 415-437. ↩
- Lakonishok, J., A. Shleifer, and R. Vishny. 1994. Contrarian Investment, Extrapolation, and Risk. Journal of Finance 44:1541–78. ↩
- Schleifer, A. and R. Vishny, 1997, “The Limits of Arbitrage,” The Journal of Finance 52, p. 35-55. ↩
- Here is the value version of the same story. ↩
- Buffett, W., “Chairman’s Letter,” Berkshire Hathaway Inc. Annual Report, 1989. ↩
- see this Vanguard report on making active management work ↩
- Quote from an old friend and early client of Alpha Architect. ↩
- Full credit to the United States Marine Corps for teaching me this. ↩