The Future Isn't What It Used to Be

One of the most important bodies of work to influence the investment industry is Security Analysis written by Benjamin Graham and David L. Dodd. Among a variety of other topics, it suggested that the selection of a security should be based upon analysis of the business to gauge a fair value and if the stock price is below that value, it should be purchased. A portfolio built from such stocks should, in theory, outperform the market as a whole.

When the book was published in 1934, it was nothing short of revolutionary and has gone on to serve as a foundational tome for anyone who picks stocks. A later edition titled The Intelligent Investor has been described by Warren Buffett as “by far the best book on investing ever written.”

The “fundamental analysis” that spawned from Graham and Dodd’s early work represents the most common approach utilized by investment professionals who seek market outperformance through stock selection. Years ago, young analysts who studied Graham and Dodd and applied their wisdom to stock selection stood a reasonable chance of enjoying a professional future filled with market outperformance. But those days have passed. The future, it seems, isn’t what it used to be.

In 1976, something interesting and highly unexpected happened. Just be for he passed away, Benjamin Graham was interviewed by Charles Ellis for the Financial Analyst Journal and the following exchange ensued:

Ellis: In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?

Graham: In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was in its first days, any well-trained security analyst could do a good, professional job of selecting undervalued issues through detailed studies, but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

Let’s first marvel at Graham’s amazing willingness to go against natural cognitive biases and adjust his thinking to new information. That’s really difficult for most of us to do, particularly if it affects how a person is forced to re-consider their life’s work.

Second, let’s think about why he said what he did. Perhaps the most important term in Graham’s response was “efficient market.” The mid-to-late 1970s saw the early work on the concept of market efficiency, a theory that implied that achieving outperformance through security selection was difficult if not impossible to do so consistently over time.

Years before, consistent outperformance was achievable for those who applied fundamental analysis, so what happened? Did Graham’s philosophy have some fatal flaw that had not yet been uncovered? Actually, the opposite was true. It’s brilliant and it works, it just works too well. When the overwhelming majority of stock pickers started applying the same philosophy, it became diluted and far less effective. Recall that Graham mentioned “the enormous amount of research now being carried on” as support for his changed view. This led to the market efficiency Graham observed then and still exists today.

More recently, opportunities for outperformance have become even more elusive for the stock picker. New regulations in just the past 2 decades, for example, have flattened the playing field for everyone. Additionally, the advent of technology and the speed with which information is disseminated have made markets even more efficient. And perhaps most importantly, smart, motivated, hard-working people with access to best-in-class resources are all fighting tooth and nail against one another for even a small morsel of actionable information and when it's found, prices adjust instantaneously.

Despite the fact that most large capitalization stock-picking mutual funds in the U.S. fail to outperform the S&P 500, only recently have we seen the amount of assets in passive/smart beta strategies grow to a level greater than their actively-managed counterparts. We might ask why it took so long? While the trend in asset flows from active to structured/passive has been substantial and shows no sign of slowing, one wonders why the amount of assets in passive vehicles is not higher given the failures exhibited by the average stock-picking fund.

One explanation could be a personal bias where the investor may recognize that the average fund will underperform but believes their own manager possesses superior skill. Another explanation could be more primal – a human need to outperform. Simply buying a capitalization-weighted, market-matching index fund forfeits any opportunity to outperform and that can feel like giving up. So even though the probability is low and that may be well understood, many investors allocate to stock-picking active managers because the tug of hope for outperformance is strong.

But stock picking is not the only way in which outperformance can be sought. Smart beta strategies and those that tilt to certain factors in a systematic fashion can add value relative to traditional cap-weighted indexing. The proliferation of such strategies gives investors a wide variety of opportunities to beat the market without picking stocks.

Additionally, research indicates that high active share managers, those that position their portfolios differently than the benchmark, may have a greater probability of success than those that hug the index yet charge active-management fees.

But perhaps the most interesting means by which outperformance may be had in the future is the monetization of the volatility risk premium (VRP). The VRP is the persistent overpricing of options relative to fair value, a phenomenon particularly prevalent in put options associated with indexes. When monetized effectively, the VRP represents a powerful means by which market outperformance can potentially be attained.

It stands to reason that stock market returns in the future may not prove as favorable as those enjoyed in the recent past. In such an environment, outperformance will be either highly desirable or for some, a critical goal. But the U.S. stock market is highly efficient and consistently outperforming it by picking stocks is virtually impossible.

That said, passive, cap-weighted indexing is not an investor’s only recourse. Smart beta, high active share and the monetization of the VRP all stand as powerful means by which outperformance may be achieved – an important aspiration if over the coming years we find ourselves in a lower-return world.