Written by Krisna Patel, CFA
Ted Williams was the last MLB player to hit 0.400, back in 1941. To most this is a useless stat relegated to diehard baseball fans, to others it describes a game of the bygone era. An era of greatness in America’s pastime, when players cared more about the game and their craft than their paychecks.
Author Stephen Jay Gould, in his book Full House, tries to identify why there has been a long drought in achieving the monumental 0.400 batting average. He begins by recognizing that batting average is not an absolute statistic but rather a relative one, hitter vs. pitcher. Using statistical analysis and intuition he concludes that hitters of today are not inferior to those of the great 0.400 hitters of the past, and that in fact, on average, are better than their predecessors. The disappearance of the 0.400 hitter is a by-product of more efficient “play” in the system.
Investing, to a great extent, is also a relative endeavor, pitting buyers vs. sellers. Legendary investors, such as Sir John Templeton, John Neff, and Peter Lynch, who exhibited consistent alpha (outperformance) generating track records, could be considered the 0.400 hitters of their day. Today, however, the “star” fund managers are much more difficult to identify. Most would point to Warren Buffet as the modern-day equivalent of the 0.400 hitter, but even Berkshire Hathaway’s stock performance BRK.A (his collection of investments) has trailed the S&P 500® over the last 15 years. In analyzing the demise of the 0.400 hitter, Gould has made certain arguments which could help explain the disappearance of the once famed “star” investment managers.
For his main argument Gould writes, “I have proposed that 0.400 hitting be reconceptualized as an inextricable segment in a full house of variation – as the right tail of the bell curve of batting averages – and not as a self-contained entity whose disappearance must record the degeneration of batting in some form or other. In this different model and picture, 0.400 hitting disappears as a consequence of shrinking variation around a stable mean batting average. The shrinkage is so exceptionless, so apparently lawlike in its regularity, that we must be discerning something general about the behavior of systems through time.”i
His thesis is premised on two central arguments:
These principles have parallels to the investment world and may help explain the disappearance of “star” fund managers. Professional investors are always looking for a legitimate edge, retooling prior investment methods or discovering more robust investment frameworks. One such investment method that has pervaded the investment universe is factor (value, quality, low vol, etc.) investing. As factor investing becomes more utilized through the system the alpha generated deteriorates. Research Affiliates studied 8 different factors and showed that on average the annualized return decreased by 3.3% after publication.ii Professional investors are continually learning to achieve better outcomes, trying to find alpha against one another. Often, these small edges or discoveries leak into the investor universe, gets copied and diminishes the edge.
One tenet of Gould’s argument is that the variation of batting averages has contracted through time. His research showed that the average top 5 and bottom 5 batting averages has converged towards the mean batting average through time, which remarkably has stayed stable, around .260ish. This is indicative of a system reaching peak performance, where the best and weakest performers converge towards a mean. One way to look at variation of performance in investing is through the lens of tracking error. Tracking error gives us an indication of how closely an investment method is “tracking” its stated benchmark. The higher the tracking error the greater the dispersion of return from the stated benchmark (greater variation), translating to the opportunity for significant out or under-performance.
Jeffrey Ptak, of Morningstar Research Services, was able to provide me with a graphical representation of tracking error for Large Cap Blend mutual funds on a 3-year rolling basis. You can see that since 2003, the average tracking error has a downward sloping bent, which means that the dispersion of returns around the S&P 500® over time has decreased. This could mean that large cap managers are managing more and more to an index (closet indexing) or, per Gould’s argument, that the system is becoming more efficient and that the relative performance of managers will skew more and more towards the mean outcome. My suspicion is that the declining tracking error is a function of both devices.
Argument two that Gould uses for assessing the demise of the 0.400 hitter also has some relevance to active management. Gould states “A flattening out of improvement signals approach to the right wall, as sports mature due to the promise of ever greater rewards, become accessible to all, and optimize methods of training. This flattening out must represent the approach of the best to the right wall. The longer a sport has endured with stable rules and maximal access, the closer the best should stand to the right wall, and the less we should therefore expect any sudden and massive breaking of records.”
Though the execution and practices have changed, investing itself is a mature field. The internet, platform accessibility, and reduced costs have allowed for entry of competitors from around the world. This larger pool of participants builds upon previous generations of investment methods and ideologies, with each participant becoming more informed and efficient in their trading methods. The system, therefore, becomes more and more optimized.
Gould’s overarching premise is that systems which have rules, stability, and maturity, tend to equilibrate, leading to a shrinkage in variation among its participants. Applied to investing, this framework helps explain why “star” fund managers are more difficult to find. As pointed out in our earlier blog, we don’t believe that active managers are worse or less talented than in the past, in fact, they are more talented, informed, and equipped. This leads us to believe that there are “star” fund managers, and will continue to be so, but creating alpha becomes ever more challenging with so many.
“Perhaps no giants inhabited the earth during baseball’s early days, but the best then soared so far above the norm that their numbers seemed truly heroic and otherworldly, while our current champions cannot rise nearly so far above the vastly improved average.” – Gould
Past performance is not a guarantee of future results. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of 02/11/2020, based on the information available at that time, and may change based on market and other conditions. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.
Krisna Patel is an Investment Advisor Representative at Engage Financial Group--11622 North Michigan Road, Zionsville, IN 46077.
Securities and investment advisory services offered through Woodbury Financial Services, Inc. (WFS), member FINRA/SIPC. WFS is separately owned and other entities and/or marketing names, products or services referenced here are independent of WFS.
[i] (Gould, Full House; The Spread of Excellence From Plato To Darwin 1996)
Active funds are not a one-man show. Management firms combine supercomputing capabilities with a multitude of field experts who have earned credentials like PhDs, MBAs, and CFA charterholders. Theoretically, then, these investment powerhouses have every advantage to produce funds that outperform benchmarks like the S&P 500®, yet they fail on a consistent basis[i]. I believe there are five major reasons why large-cap managers in particular fall short of the S&P 500®.
It comes as no surprise that investors expect financial advisors to be able to select profitable and suitable investments for client portfolios. There are three primary ways in which advisors approach this decision-making process. Some advisors rely on their home office or investment companies to perform the research and create a list of recommended investments. Others prefer to leave the investment decisions and asset management solely in the hands of a third party. Lastly, an advisor may prefer to perform their own research and analysis to determine suitable investments for their clients.
As an advisor who enjoys the research and analysis approach, I have begun to wonder if the time spent on choosing between active and passive management, especially with large-cap blend funds, is worth the trouble. Many different studies are available to argue the success of one over the other, and each strategy certainly has its pros and cons. I do not intend to elaborate on these differences; instead, I am presenting data I have gathered over the years for advisors and investors to bear in mind when deciding between active and passive investments.