Focus on What You Can Get for Free: Part 1/2
Milton Friedman famously opined that “There is no such thing as a free lunch.”
We beg to disagree.
For all of us trying to compound our capital, we think that in investing there are certain things that can be had at such a low cost that they are effectively free.
In this Part 1, we will discuss some simple ways to think about some things you get for free in the investment marketplace; Part 2, we will discuss some more sophisticated applications.
Consider the “fact” that 90% of us are better looking than average
Let’s start with a simple example: Consider the Vanguard S&P 500 ETF (ticker: VOO). This ETF invests in stocks in the S&P 500 Index, has an expense ratio of 0.05%, and thus represents a very inexpensive (and tax efficient) way to get exposure to the performance of the 500 of the largest companies in the U.S. Buying such an ETF is a solid strategy for most investors.
Now, what if I told you that you could get Slick Rick, LP to invest in those same S&P 500 stocks on your behalf, and you could do so for the “low low” cost of 1.05% on any assets invested. Would you be interested?
Of course not. And not just because you don’t like the cut of Slick Rick’s leisure suit. More specifically, as discussed above, you already have the opportunity to invest in the S&P 500 “for free,” (or essentially free) so there is no reason for you to pay that incremental 1.00% in Slick Rick fees. Put another way, your opportunity cost of investing with Slick Rick, LP is 1.00%. This represents fees you probably don’t need to pay.
The Slick Ricks of the world know that you’re too smart to pay him to invest in his brain dead S&P 500 closet index product, so he needs to find another way to fleece you. How can he do that?
Here’s a thought experiment…
Say that our anti-hero, Slick Rick, starts trading his imaginary fund on 10/1/12, charging traditional 1.0% plus a 20% carried interest fees, and hires a bunch of analysts to “research” stocks. He says he intends to beat the total return of the S&P 500. Slick Rick, however, has a couple of cardinal rules for his team that he will never break:
- He will only purchase stocks that are above the median for NYSE market equity.
- He will only purchase stocks with book equity to market equity ratios that place them in the top 20% of the NYSE for cheapness.
- He will rebalance quarterly.
Let’s say Slick Rick manages money for a year and on 9/30/13, we review his performance and find that he has returned 25%, dramatically outperforming the total return of the S&P 500, which was 19.02% over the period. “I’m a genius!” he crows. “I beat the benchmark by 6.0%!!”
Interesting. So what accounts for this outperformance of the so-called “benchmark?” Was it because his analysts made good stock picks? Perhaps. Or perhaps was it was somehow related to the effects of his cardinal rules?
Under these new conditions, it’s not as easy as it was in the S&P 500 index example above to assess your opportunity cost. After all, Slick Rick is not really investing in the S&P 500 at all. That’s not really an appropriate benchmark, since he’s only investing in the large, cheap companies. So we shouldn’t really be focused on whether he outperformed the S&P 500 in the aggregate. It’s only partly relevant since he has constructed his portfolio with exposure to only a part of it. Again, how do we assess his performance?
What we want is a way to control for the application of his cardinal rules. We want to control for the constraints we know are a part of his investment process. If we can find a way to do that, then we can begin to make some observations about whether he and his analysts have actually added any value above and beyond what you could get “for free,” by mindlessly buying a portfolio of large, cheap companies, following his rules. How can we do this?
Fama and French to the rescue!
It just so happens, by happy coincidence, that we can use insights from two of our favorite academics (the guy on the left actually won a Nobel Prize last week) who can provide the appropriate benchmark and thus a clearer view of how Slick Rick actually fared. We can head over to Ken French’s web site (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html), where he has conveniently compiled returns over the relevant period, and more important, has sliced and diced them in a way that will be helpful. Here is the output:
For our purposes, we want to look at the Benchmark Portfolios, and then see what Big Value returned over the Last 12 Months. The return was 33.13%. Recall that Slick Rick returned 25%. So now we can see that, controlling for Slick Rick’s cardinal rules, we could have bought all of the stocks matching those criteria, and gotten a 33.13% return “for free.” How would you feel now about paying Slick Rick his 1%, plus 20% carried interest? Not so good we hope. As with the ETF example above, Slick Rick is charging you for something you can get for free, and not only that, he is underperforming what you could get for free! And to make matters worse, Slick Rick probably doesn’t even understand what he can get for free–the blind leading the blind!
If you want to take your benchmarking to an even higher level, you can also control for momentum exposures. We’ve talked about identifying your size/value/momentum benchmark in a previous post: http://blog.alphaarchitect.com/2013/09/24/identify-your-size-value-and-momentum-benchmark/
What’s the point?
When you make an investment, you want to understand what kind of exposure you have to certain broad asset classes, including Value and Size. Slick Rick may tell you he is trying to beat the S&P 500, but he’s really giving you a different exposure. If you are anchored on comparisons to S&P 500 returns, while investing with Slick Rick, then you are making a mistake.
We have discussed here a simple approach to thinking about Size and Value factors, and in Part 2 of “Focus on What You Can Get for Free” we will discuss additional considerations for evaluating exposures, and thinking about things you shouldn’t have to pay for (or at least pay that much). You only want to pay up for managers that generate value above and beyond “what you can get for free.”
Note: This site provides NO information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.
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Definitions of common statistics used in our analysis are available here (towards the bottom)