A recent New York Times article examines the story of Joel Greenblatt, author of “The Little Books That Beats the Market.” Joel has leveraged this book and is now managing money using a similar strategy for Gotham Asset Management. Joel is, of course, an investment legend at this point. We have been fans of Joel because he follows the goals of our firm, which is to empower investors through education. All that said, at Alpha Architect there ARE NO SACRED COWS. Some of his newer mutual funds involve a hedge-fund investment strategy that goes long cheap stocks and short expensive stocks. Here is the quote from the article:
At a meeting on Oct. 1, with 10 brokers in a cramped conference room in his Madison Avenue office and 40 more listeners on the phone, a tanned and confident Mr. Greenblatt told them, “We buy the cheapest we can find and short the most expensive.” With copies of his book stacked behind him, he said the general methodology had been “back-tested back to 1990” and “has worked for 30 to 40 years, no question.”While not taking a beta-neutral bet, the largest fund (Gotham Absolute Return Fund) involves having a long exposure of 120%, and a short exposure of 60%.
So how has this fund done?Here are the results: By any estimation, on a market-exposure adjusted basis this fund has done a great job since its inception. In expectation, a fund with a 60% net long exposure would expect to return 60% times the market return plus the risk free rate. During this time period (with the market return = 20.15% and risk-free rate essentially equal to 0%), the expected return would have been (60%)(20.15%) + 0% = 12.09%. Gotham Absolute’s 18.85% has after-fee out-performance of over 6.75% on an annualized basis–not bad! So even after the large management fee (2.00%) in the prospectus, and a 1% redemption fee (within 90 days), is this a free lunch?
Investigating long cheap, short expensive strategiesWe decided to do a simple analysis of Mr. Greenblatt’s “magic formula.”
- Variable 1: EBIT/TEV (Total enterprise value)
- Variable 2: EBIT/Total capital