Episode 130 – The Quest for Alpha with guest Larry Swedroe, MBA

Episode: 130
Originally Aired: June 15, 2015
Topic: The Quest for Alpha with guest Larry Swedroe, MBA

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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The Quest for Alpha
James Lange, CPA/Attorney
Guest: Larry Swedroe, MBA
Episode 130

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TOPICS COVERED:

1. Guest Introduction: Larry Swedroe
2. Defining “Alpha”
3. The Four Factors
4. Index Fund Recommendations
5. Reducing the Risk of the Black Swan

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1. Guest Introduction:  Larry Swedroe

David Bear:  Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks.  I’m David Bear, here in the studio with James Lange, CPA/Attorney, and author of Retire Secure!, The Roth Revolution: Pay Taxes Once and Never Again, and his new book, Retire Secure! For Same-Sex Couples.  Investors put a lot of time and effort into the alpha decision, of selecting investment funds or managers they hope will outperform the market.  But the hurdles to generating true alpha returns are getting higher.  For perspectives and insights on this issue, we’re pleased to welcome back investment advisor and author Larry Swedroe to this edition of The Lange Money Hour.  Principal and director of research at BAM ALLIANCE, a community of more than 130 independently registered investment advisors throughout the country, Larry’s the author of a dozen books on finance, including two recent works, Think, Act, and Invest Like Warren Buffett” and Reducing the Risk of Black Swans.  He also contributes regularly to CBS’s personal finance website MoneyWatch.  Over the years, Larry’s earned a reputation for evidence-based investing and exposing misleading information and flat-out lies spoken by Wall Street and too often echoed by mainstream financial media.  Larry and Jim will discuss the quest for the alpha and why it’s becoming increasingly harder for active managers to outperform their benchmarks.  Since the show is live, you can join the conversation.  Please call the KQV studios at (412) 333-9385.  And with that, I’ll say hello, Jim and welcome, Larry.

Jim Lange:  Welcome, Larry!

Larry Swedroe:  Thanks for having me!

Jim Lange:  You know, Larry, I always love having you on the show, and I love reading your books.  I really do.  And originally, my plan was I really wanted to talk about alpha, and, you know, I know that you wrote a book two years ago on it.  Now, you have another book on it.  But you also wrote Reducing the Risk of Black Swans, which I wasn’t planning on talking about at all.  And actually, in the e-mail promo, I don’t even mention it.  But I thought that you had so many good points there that if it’s okay with you, I’d like to expand the scope of the show to talk about not only alpha, but also some of the thoughts that you had on Reducing the Risk of Black Swans.  Is that okay with you?

Larry Swedroe:  Happy to do that, and if we can’t cover it all, happy to come back any time, Jim.

2. Defining “Alpha”

Jim Lange:  All right, I sure appreciate it.  All right, well first, let’s start out with the basics.  If we’re talking about the quest for alpha, what is alpha and what are we referring to when we’re talking about the quest for alpha?

Larry Swedroe:  Yeah, it’s a great question, Jim, because actually understanding that gives us the key to understand while my book, The Quest for Alpha, provides the evidence on mutual funds, individual investor’s pension plans, hedge funds and venture capital and how poor a job they do at generating alpha.  It’s actually getting to be harder and harder to generate alpha.  So, let me define it first for people.  Alpha is performance above the appropriate risk-adjusted benchmark.  So, I think, for example, people could agree that if you own stocks and claim to add alpha by outperforming a bank CD, they would laugh.  So, you have to have the appropriate benchmark, and similarly, what a lot of active managers do, and hedge funds and others, they invest in more risky types of stocks securities, and they propose their benchmark should be something that’s safer.  So, for example, if you invest in small value stocks, which have historically returned about 14% a year, and say you generated alpha because the S&P or the total stock market, like a Russell 3000 index, got about 10%, that’s just a big a lie as the prior one.  But that kind of conversation goes on all the time.  So, you have to make sure that when someone’s claiming alpha, it’s against an appropriate risk-adjusted benchmark.

Jim Lange:  All right, so basically though, what the essence of alpha is, it is outperforming the appropriate benchmark.

Larry Swedroe:  That’s exactly right.

Jim Lange:  So, let’s say that I said, “Oh, Larry, I have the fastest computers, and my analysts are really wonderful, and we have a large cap mutual fund that buys and sells large cap growth companies, and we performed 5% better than the S&P.”  If that was true (which, of course, it’s not), then that, in effect, is alpha: an apples to apples comparison to a legitimate benchmark.  Is that right?

Larry Swedroe:  Yeah, that’s exactly correct.  You could say that.  And, of course, it’s important to understand (as I explain in my book, The Quest for Alpha), active management is called the ‘loser’s game.’  Charles Ellis wrote a great book, Winning the Loser’s Game.  He was the one who coined that phrase.  It doesn’t mean that the people who are playing it are losers, and it doesn’t mean that it’s a game that it’s impossible to win.  It means that the odds of doing so are so low that it’s far more prudent to not try to play the game.  Just like you can win money going to the roulette table in Las Vegas, it’s prudent not to take your retirement account there because you’re not likely to win.

Jim Lange:  Well, by the way, a quick note: I think that that’s a very good book (Charles Ellis’ Winning The Loser’s Game), and also, if listeners are interested, Charles Ellis was actually a guest on this radio show, and if they go to www.paytaxeslater.com and they click on ‘listen now,’ they can go into the archives of the show and they can actually hear the radio show where I interview Charles Ellis, as well as, by the way, prior shows with you, because we’ve done, I believe, two other shows where I think you gave wonderful information.

Larry Swedroe:  I would recommend anything Charles Ellis writes to people.  He’s one of the best thinkers in finance.

Jim Lange:  All right.  So, anyway, alpha is basically outperforming the appropriate index, and what you said, I think, was very appropriate, which is that it is assuming an apples to apples comparison, and if you have, let’s say, somebody who has perhaps a better diversified portfolio that would include small cap, and it would include value, and it would include emerging markets, that you would expect a fund like that to do better than the S&P 500 because those individual asset classes have historically outperformed the S&P 500, and it’s not really a legitimate comparison to the S&P 500 unless you’re saying the reason we are doing better than the S&P 500 is because of diversification, not because we pick better stocks.  Is that a fair statement?

Larry Swedroe:  That’s a fair statement, the right way to think about it.  I would just make one slight correction to your comment.  Alpha isn’t necessarily outperformance against any particular index because, as you said, you could run a fund that owns small cap and value stocks and even emerging market stocks.  There are all kinds of things.  So, what you have to do is a more technical analysis called a regression analysis, and then you figure out how much exposure that fund had to these various asset classes, and then you adjust the performance for how an index of those stocks would have done.  So, if you had 20% small stocks, then you would weight it to 20% small cap index, if you will, and 40% to some value index.  So, in effect, each fund has to be benchmarked appropriately against the type of assets it’s holding, not necessarily some individual index, and that’s how the active managers often “lie” and say they created alpha, because maybe you’re a large cap fund and 80% of your stocks are large cap, but then 20% are small value, and those stocks are the ones that cause you to outperform the S&P.  An index would show that you outperform, but a regression analysis would fully explain it, and your alpha would disappear.

Jim Lange:  Okay, that’s a good correction.  One of the things that I liked in your book about how the hurdles are getting higher, is you had a great analogy, kind of like a story of the quest for alpha, and you talk about finding a twenty dollar bill on the street.  Can you explain what you meant by that, and could you, kind of, go through that example?  Because I thought it was terrific, by the way.

Larry Swedroe:  There are actually three versions of that story.  The one that active managers, or those who want you to believe in active management, tell is a joke that goes like this: there’s a financial economist and their friend and they’re walking down the street, and the friend stops and says, “Look! There’s a twenty dollar bill on the floor.”  And the economist, of course, says, “That can’t be.  If there’s a twenty dollar bill on the ground, somebody would’ve picked it up,” and he walks away.

Now, that’s a joke that’s convenient, but I think a better, more articulate and more accurate version of the efficient market is this version, where the same economist and friend are walking down the street.  The friend again says, “Look!  There’s a twenty dollar bill.”  And the economist turns to him and starts to lecture.  He says, “Boy, this must be our lucky day.  We’d better pick that up quick because the market’s so efficient, it won’t be there long.  Finding a twenty dollar bill doesn’t happen every day.  We’d be foolish to spend time looking for them because you’re not likely to find them, and if you assign value to our time, it’s not worth the investment.  You don’t see many people who get rich mining beaches with metal detectors.”  And of course, by the time he finishes his long explanation, they both look down and the twenty dollar bill was gone.

However, I like the Hollywood version, I call it, which goes like this (and I think this is a much more accurate depiction), which is that the same two people are there and they see the twenty dollar bill and the economist turns and says, “Can’t be!  If there’s a twenty dollar bill on the ground, somebody would’ve picked it up.”  So, the friend bends down, he picks up the twenty dollar bill, dashes off and decides, “Hey, this is an easy way to make a living!”  He quits his job and he begins to search the world for twenty dollar bills lying on the ground waiting to be picked up.  Of course, a year later, the economist is walking down the same street, he sees his long lost friend, he’s lying on the ground wearing torn clothing, he’s filthy, and he asks him what happened.  He says, “Well, I never again found another twenty dollar bill.”

Jim Lange:  So, I guess the moral of that story is you can be an active manager, and if you run into a twenty dollar bill, great, but that the time and expense of looking for the twenty dollar bill, that is, of outperforming the indexes, is not worth the time and trouble that it takes to do that.  Is that fair?

Larry Swedroe:  That’s exactly right, but I would add this to give further clarity to the picture: think about all these high frequency traders and hedge funds who have wired their computers to be a tenth of a second faster so they can find that twenty dollar bill before you.  Think about all the resources they’re deploying.  What are the odds that you are going to find it?  And by the way, what are the odds that you’re going to find many of them, because the competition to find these twenty dollar bills is so great that they’re disappearing rapidly.  Just think about if a rumor spread that there were twenty dollar bills at some section of a beach off of New York City.  How fast would everybody be there with their…you know, people trying to find these twenty dollar bills that it would be effectively…if there were a few, they’d be gone very quickly.  By the time you could get there, it’d be too late.

David Bear:  Well, and also, when an investment manager finds that twenty dollar bill for you, how much does he charge you for finding it?

Larry Swedroe:  Yeah.  I would add this: recently, a good paper was published that looked at the academic research and looked at what happens when economists publish this data, finding these twenty dollar bills that show that there are better, smarter ways maybe to invest, or at least, there are areas of the market, like small caps and value stocks and some other factors that have higher returns.  Well, once the research is published…and by the way, it’s economists usually looking at the great investors who have great track records, people like Graham & Dodd and Warren Buffett and others, trying to figure out how exactly did they get these great returns?  And the research then often discovers it, they publish the research, and we can talk about that, and then once it’s published, their evidence is that much of those excess returns tend to disappear because everyone’s competing, and the undervalued securities that Warren Buffett was buying tend to get bid up, and they’re no longer so undervalued, and the overvalued stocks tend to get pushed down because people are now avoiding them, and the market becomes ever more efficient.  In fact, I like to say that it’s the very people like Buffett and others who attack the efficient markets theory.  In the end, they’re really the strongest defenders because when they find this anomaly, they’re very active exploiting it and the research that’s published tends to make it go away.

Jim Lange:  And the other thing that’s interesting about Warren Buffett is, he has a famous quote that basically says, “For the average investor, the smartest way to invest in money is in a well-diversified set of index funds.”

Larry Swedroe:  Well, you know, it’s, I think, one of the great tragedies and anomalies in all of finance, which I wrote about in my book Think, Act and Invest Like Buffett.  Investors worship Buffett, they idolize him, and yet they tend to not only ignore his advice, they tend to do exactly the opposite.  As you point out, Buffett advises investors to invest in index funds.  Unfortunately, the vast majority of individuals (about 85%) invest active.  He tells people he hasn’t looked at an economic forecast or a market forecast in twenty-five years, and he urges you to ignore them because they tell you nothing about where the market’s going.  Yet most people pay attention to people like Jim Cramer and Nouriel Roubini and others on CNBC who make these forecasts, and he tells people to not be a market timer, and his favorite horizon is forever, and yet, most people try to time the markets.  So, they not only ignore his advice, they tend to do exactly the opposite, which is why most people, the evidence shows, actually underperform the very investments, meaning the very mutual funds they invest in.

Jim Lange:  Now, hang on a second.  You’re talking about Jim Cramer, and I have it on good word that if you listen to Jim Cramer and you took all his advice, today you would have a million dollars if you started with…

Larry Swedroe:  If you really started out with ten, maybe!

Jim Lange:  Well, I was going to say two!  Okay.

Larry Swedroe:  Okay.

Jim Lange:  So, you’ve heard that joke too!  Alrighty.

Larry Swedroe:  Right, but let me point out, this is worth a mention quickly.  Jim Cramer, there were two academics independently who studied his advice.  Remember his show tended to appear, it was after five o’clock.  You know, markets were closed, and they tracked every one of his recommendations.  Now, just as you would expect, people watched the show, and now you can’t buy at the price he’s recommending because the market’s closed.  So, what happens?  The very next morning, the prices tended to jump up at the first price because individuals listened to Cramer and think he actually knows something.  The market would jump up, the professionals would then come in knowing these individuals got it wrong, they know Cramer doesn’t know anything, they would go in and short the stock, and within a day or two, the prices went right back to where they started from, relative to the market, the individuals lost money and the institutions made money.

3. The Four Factors

Jim Lange:  I didn’t know that!  So basically, I know you’re a classic index guy, and of course, we always think of the most famous index, which is the Vanguard S&P 500 index, but there are other indexes.  And we’ll get to the Black Swan book, but there are competing indexes, and there are factors that have been identified that have a significant impact on return, and you talk about that in your book.  Could you talk about the four factors that our listeners should probably be aware of, and the implications of them, and why, for example, it doesn’t necessarily make sense to have, let’s even say in a classic 50/50 portfolio (50% stocks and 50% bonds), why your 50% in stocks should not be, for example, even if you’re an index investor, let’s say the S&P 500, or any 500 or 1,000 large company stocks?

Larry Swedroe:  Okay.  Well, there’s a lot in that question.  Let’s see if we could address them.  The four factors that you talk about relate to equities, or what is called beta, which is the risk of your portfolio or mutual fund relative to the overall risk of the stock market.  Now, that doesn’t mean your equity allocation.  So, you could be 100% stocks, but if all your stocks are high flying tech stocks that tend to be much more volatile in the market, you might have a beta of 1.4.  So, you have a much more risky portfolio, and at least theory would say you shouldn’t get higher returns for that risk.  Or you could be 100% stocks, but you own a lot of staid utilities and grocery stores, and they’re only going to be 70% maybe as volatile as the market.  So, you don’t have the same, or shouldn’t have the same, expected returns.  But if your portfolio is pretty well diversified, like an S&P 500 index fund or a Russell 1,000 or 3,000 fund, most pretty well diversified portfolios have betas of about one.  So, they’re going to look like the market.  And beta historically has provided about 8% a year higher average annual return than riskless one month treasury bills.  So, that’s the first factor that we want to talk about.

Jim Lange:  In other words, owning companies in the long run, historically, has been significantly more profitable than lending money to companies, which is basically what a bond or a fixed income fund is?

Larry Swedroe:  Well, that’s true, but beta people don’t need to understand it is measured against the riskless treasury bills, so stocks have gotten annual average returns, and that’s the way factors are defined, not in compound returns.  So, if stocks have gotten, let’s call it (I’m going to just round things for the audience), roughly 12% a year, if you add the last eighty-seven years up individually, divide them by eighty-seven, you got 12%.  Now, compound returns were less.  They were about 10%.  That’s because their annual volatility of stocks was pretty close to 20%, and volatility destroys compound returns.  Treasury bills got roughly 4%, so the difference is roughly 8%, and that’s what’s called the equity risk premium.  So, that’s the first one.

The second premium is the size premium, which was discovered by a fellow named Ralph Bans in the early eighties, and he found that small stocks outperform large stocks.  So, if you owned a portfolio of small stocks, on average, they earned about an extra 3% a year.  Then, research showed that Benjamin Graham and Dodd and Buffett were right that value stocks had outperformed growth stocks roughly by 5% a year.  And more recently, in 1998, Mark Carhart put together the research on what’s called momentum, which means stocks that have done relatively well over the last year continue to outperform stocks that have done relatively poorly over the last year, on average for about another five months or so, and that average premium has been about as big, actually, as the equity risk premium.  That’s pretty large.  So, those are the four factors.

Now, here’s what’s really important for people to understand: up until 1992, we lived in what was called the CAPM World.  The only models we had to explain asset prices was the CAPM model, which is Capital Asset Pricing model, and that said everything was explained by the beta of your portfolio.  So, along comes people like Graham & Dodd and Warren Buffett, and they figured out that the model was wrong, like all models are wrong.  They’re not called laws like we have in Physics.  They are meant to give us the best understanding of the markets we have at the time.  And so, they were able to generate alpha simply by investing, say, in value stocks.  Well, by 1992, when Fama and French, two professors, published their paper on these factors, adding size and value, you know, if you beat the market by adding small cap stocks, which Peter Lynch did for much of the early part of his career, or Warren Buffett did by buying value stocks, legitimately, you could claim alpha.  After 1992, you couldn’t because it could be explained simply by your exposure to an index of these stocks.

Now, it’s very important for people to understand, I’m not taking anything away from Warren Buffett, Graham & Dodd or people who bought small stocks.  They discovered this before the academics did.  But after 1992, you didn’t have to pay some hedge fund or active fund to get exposure to these factors.  Vanguard, iShares now, WisdomTree, Dimensional Fund Advisors, many other firms have funds that you can invest in that get you those exposures for very low cost.  In other words, alpha (which is expensive to buy because it’s very scarce, very few people could generate it) became beta, or simply, what I would call, loading on these well-known factors, and then when we added momentum, you could buy momentum stocks, and mutual funds began incorporating the momentum into their strategies.  Dimensional Fund Advisors and Bridgeway have done that in their value funds, and firms like AQR, and there are now ETFs that focus on momentum.  So, if you bought momentum stocks before ’98, you could claim alpha.  Now, we know that you can get that same exposure without paying some active manager.  And so, alpha was disappearing because we simply now understood the sources of it, and it wasn’t stock picking.   It was owning exposure to these factors.  So, that’s one of the three big reasons why alpha is getting harder to generate.  If you want, we can touch on the other two.

David Bear:  Well, why don’t we take a quick break first?  And when we return, you can continue the conversation, and listeners, again, we’re live, so you can call with questions at (412) 333-9385.

BREAK ONE

David Bear:  And welcome back to The Lange Money Hour.  I’m David Bear, here with Jim Lange and Larry Swedroe.  If you have a question for either of them, call (412) 333-9385.

Jim Lange:  Larry, we didn’t get a chance to give our listeners an opportunity, assuming that they like what you say, to access your books, and I know that you’ve written many books.  By the way, the one I’m most excited about is actually Reducing the Risk of Black Swans.  But if our listeners were interested in…let’s just say you had to limit it to one book.  And by the way, if I were the listeners, I would actually go to Amazon and look at some of the different ones and pick the one that they think is most appropriate.  But if you were to limit it to one, which book would you recommend our listeners read, and where do you think they should go to get that?

Larry Swedroe:  Well, given there are almost no book stores left, I think Amazon or BarnesandNoble.com are the places to go, but I actually think there isn’t a one ‘right’ book.  I think it depends on what people are looking for.  So, if you want a real simple book and want to learn about investing, I would urge people to check out Think, Act and Invest Like Warren Buffett.  It’s probably a few-hour read, and I think it’ll be the best investment of a few hours of your time that most people would make.  If you want to learn the insights into modern portfolio theory, and how markets really work instead of how Wall Street wants you to believe, I’d recommend getting Wise Investing Made Simple.  I use twenty-seven stories that help people understand these very difficult concepts, using analogies to sports betting, cooking, Greek mythology, etc.  So, that would be the book I would recommend people read.  If you want to look at the evidence on active versus passive, then the one we’re discussing, The Quest for Alpha.  And for your most sophisticated investors, they may want to pick up Reducing the Risk of Black Swans.  But I would say, it is definitely a book more for people who are well experienced.  Maybe engineers who love the math of investing would want to pick it up.

Jim Lange:  Well, for whatever it’s worth, I actually got a lot out of it, and I actually skipped some of the math stuff for the conclusions of it.  And the other thing that I’m going to do is I’m going to also put in a plug for your…and I forget the exact name, but it’s something like Twenty-One Mistakes That Investors Make…

Larry Swedroe:  Investment Mistakes Even Smart People Make.

Jim Lange:  Yeah, that’s it.

Larry Swedroe:  It covers seventy-seven of them.

Jim Lange:  Just seventy-seven!

Larry Swedroe:  And yes, that’s the one I tell people, if you want to laugh at yourself, read them.  You’ll find yourself in many of those.  I know I made most of the behavioral errors early in my career, but like most smart people, once I make a mistake, I don’t repeat the same behavior.

Jim Lange:  Hopefully!  All right.  So, I want to go on to new material, but the quest for alpha, the hurdles are getting higher.  If you could, let’s say somebody says, “I’m too lazy to read the book.  Larry, just tell me the essence of the book.”  Could you give people, let’s say, the couple minute summary of that book?

Larry Swedroe:  Well, it presents the evidence on mutual funds, hedge funds, Venture capital, individual investors, summarizing all the academic research and shows in every case.  Now, obviously, while it’s not impossible to beat the market, the vast majority of people fail to do so, and this is especially true in the hedge fund world where the results have been disastrous for investors.  We touched on some of the reasons why it’s getting harder, but let me focus on two things quickly that I think we can do.  One is, investing in the market is a winner’s game if you play it the right way, because everyone can earn the returns of the market using low-cost index funds.  So, if you invested in Vanguard’s S&P 500 fund for life, you got a great experience if you stayed the course.  But alpha is a zero sum game before cost because if somebody, when the market earns 10%, gets 12%, even before expenses, somebody else must get 8%, let’s say.  So, it’s a zero sum game before the expenses, but, of course, negative after the expenses because it does cost money to play.  So, you need a victim to be able to exploit.  So, here’s a summary of the evidence: retail investors are what we would call ‘dumb’ money.  It doesn’t mean the people are dumb, but they get exploited.  On average, the research shows, the stocks they buy go on to underperform after they buy them (of course, this never happens to any of your listeners), and the stocks they sell go on to outperform after they sell them.  Well, somebody has to be on the other side of the trade.  It turns out, on average, it is the institutional investors, pension plans, mutual funds, etc.  But their outperformance, on average, is so small that after expenses, they lose in the game.  But here’s the problem: Jim, you’re a very knowledgeable investor.  What percentage of all the stocks were owned directly by U.S. households in 1950 coming out of World War II?  What would you guess?  That means directly held.

Jim Lange:  I would think that that’s much higher than it would be today, because I would imagine that today that those stocks are owned much more by individual institutions rather than individual investors.

Larry Swedroe:  Right.  So, that’s exactly right.  In 1950, over 90% of the stocks were owned directly by individuals.  The mutual fund world was very small.  There was pretty much no such thing even as a hedge fund, Venture capital, all these kinds of things didn’t exist.  So, there were lots of victims to exploit, and yet the evidence shows that over the next forty-fifty years, active managers still did very poorly in trying to exploit them.  But today, as you pointed out, that number is about 20% and continues to shrink.  So, the pool of victims that these active managers have to exploit is shrinking very quickly.  So, that’s one point.

The other side of the coin is that the amount of profits you can generate also depends upon the amount of competition you have.  So, just think about the mutual fund world.  We now have ten thousand mutual funds and trillions and trillions of dollars, when fifty years ago, it was a tiny industry with less than a hundred funds.  Twenty years ago, there were only three hundred billion invested in hedge funds.  Today, there’s three trillion.  Turns out, twenty years ago, hedge funds actually did fairly well, leading a lot of people and institutions to put a lot of money into them.  For the last ten years, with three trillion trying to exploit alpha, they’ve actually earned just one percent a year, underperforming every major equity asset class around the world, and even underperforming every major bond asset class, including virtually riskless one month treasury bills.  So, you have academics publishing how the secret sauce was being cooked, so you didn’t need to hire these people, and you could buy cheap index funds.  You have fewer and fewer victims to exploit, and more and more competition trying to exploit those fewer victims.  I think the quest for alpha, which was always a loser’s game, the evidence shows, is becoming harder and harder and harder to win.

4. Index Fund Recommendations

Jim Lange:  Okay.  Well, let’s say that somebody says, “Okay.  I get it, Larry.  Going to an active money manager who is trying to beat the market, mainly using large cap stocks, is a loser’s game and that isn’t the way to go.”  And let’s assume, for discussion’s sake, and I kind of hate to pick on individual index funds, but probably I think it’s fair to say that Vanguard is one of the best, if not the best, very low-cost index fund for the do-it-yourselfer.  Are there other index funds that people should consider?  You had mentioned Dimensional Funds before, and, very frankly, I should, let’s say, warn listeners.  This is a potential conflict of interest because you do work for a company that does recommend a variety of index funds, and I think Dimensional Funds is part of that list.  Is that a viable alternative for somebody, and does Dimensional Funds, say, take into consideration some of the things that you have mentioned regarding getting a higher return using smaller companies and value companies?

Larry Swedroe:  So, let’s first define things.  All index funds are passive investments by definition.  There’s no stock picking and market timing going on at all.  And index funds, as Warren Buffett again recommends, are a great way for most people to do it.  However, indexes actually have some negatives that can be improved on, and there are fund families like Dimensional Fund Advisors, we don’t use them exclusively.  We also recommend Bridgeway’s funds, some funds by a company called AQR Capital management, all of them base their fund construction on peer reviewed academic evidence, and again, there’s no stock picking per se or market timing.  They just define their indexes in slightly different way that can actually enhance the performance of an index fund.

So, let me give you an example.  Vanguard’s small cap index fund is benchmarked against what’s called the MSCI 1750, the smallest 1,750 stocks in that index.  Its average market capitalization for those stocks, a sign of how small they are, is about three billion dollars, or pretty close to it.  That’s for their small value fund.  Dimensional Fund Advisor’s small value fund, which is benchmarked against Fama-French, an academic index of small value stocks, has a much smaller market cap of about $1.2 billion, and the evidence is, the smaller the stocks, the higher the expected return.  The Bridgeway small value fund, which is actually the one we use now, is even smaller, less than $700 million.  And in terms of value, the PEs on the Vanguard fund are much higher.  They may be something like seventeen, and for Dimensional Funds, it might be fifteen, and Bridgeway’s may be thirteen or fourteen, I don’t remember.  In each case, each fund is doing exactly what it’s supposed to do.  It’s getting exposure to the asset class as its defined.  But the smaller and more value you go, you have higher expected returns.

So, most investors think that all small value index or passive funds are equal.  Well, the DFA fund has outperformed Vanguard’s small value fund over the last fifteen years, I think by something like 1.8% a year.  Now, it does some other things we don’t have time to go into, but slight things like screening out all stocks that have negative momentum, because that’s what the research shows, can add value.  Vanguard doesn’t do that because their index doesn’t do that.  So, there are funds that actually have shown that they’re a better construction, but you really need to understand the nature of their risks, and again, each one does exactly what they’re supposed to do.  So, I wouldn’t necessarily recommend one over the other unless you do the research and understand the differences and what extra risks that may create.  I would say most people would be better off simply sticking with Vanguard’s index funds, or iShare versions of the same types of indices.

David Bear:  Well, why don’t we take one more break?

BREAK TWO

David Bear:  And welcome back to The Lange Money Hour with Jim Lange and Larry Swedroe.

Jim Lange:  Hi Larry.  Before we go back to some of the issues that you brought up in Reducing the Risk of the Black Swan, if you could tell us one more time what some of your favorite books that readers could potentially purchase if they like what they’ve heard?  And by the way, I like them all.  I was going to really concentrate on alpha today, but when I read The Black Swan, I thought it was so good that I want to talk about that before we close out.

5. Reducing the Risk of the Black Swan

Larry Swedroe:  Yeah.  Well, The Black Swan book explains how we’ve been helping investors keep returns up while minimizing losses when you have those black swan events like 2008 or from 2000-2002 or the oil embargo in ’73-’74.  The benefit is that you do cut your losses dramatically in those periods, but the offset is you do give up some of the upside in the good years.  But it turns out, because of how the math works here and how assets correlate with each other (which is an important part of the discussion), the left tail, the bad side, gets cut much more.  So, you have much smaller losses.  While the upside, while being cut, gets cut much less.  So, you still can capture maybe half of the gains in the best years, but you get rid of maybe 75% of the losses, or maybe even more, in the bad years.  So, that’s why, I think, most people, when they read that book, I’ve had a lot of people tell me, “Boy, that was an eye opening, a wow experience, an ‘ah ha’ moment that maybe there is a better way to invest.”

Jim Lange:  Well, it certainly was for me.  So, let’s talk about some of the conclusions there.  Is it fair to say that what you are saying in that book is not necessarily…I think the biggest mistake that I see for the average investor that comes to my office, and this is before they work with me, is I see a very heavy concentration in large cap stocks, and sometimes people don’t even know it.

Larry Swedroe:  Large cap U.S. stocks.

Jim Lange:  That’s correct.  Fair enough.  So, they might even have money in Vanguard and CREF and T. Rowe Price, and if you kind of look under the hood of what investment they have within each one of those companies, maybe some money at Schwab, a lot of times, it is large U.S. stocks, and then maybe some bond funds.  And I think what you are saying in Reducing the Risk of the Black Swan is no, maybe consider having a higher percentage of smaller companies.  And again, as you just said, not necessarily three billion, but maybe closer to a billion.  Have some money in value companies, that is, not companies with a very high price earnings ratio, but a lower ratio, have some money in some of the international and even international value companies.  And then, to offset the additional risk of those particular types of investments, you could afford a higher percentage of fixed income.  Is that a fair summary?

Larry Swedroe:  State fixed income, yeah.  So, let me touch on a few things.  First, I’ve seen, and I know you have seen the same thing, I’ve seen people come in with as many as twenty different mutual funds, and they’re all basically U.S. large cap stocks.  So, they think they’re well diversified.  They would have been far better off having all their money in a Vanguard total stock market fund or the S&P 500 fund that have much lower expenses and better returns.  So, that’s one thing.  Diversification is not determined by the number of things you own, but by the types of different stocks, different asset classes that you own.  So, U.S., domestic, foreign (meaning developed) and emerging markets.  And then also small and value stocks, and real estate and maybe commodities.  That’s how you determine diversification.  So, that’s the first point I wanted to make.

The second point is, I don’t think there is really a ‘right’ portfolio, Jim, because unless somebody really understands the pros and cons of a strategy, when that strategy appears to be doing poorly (and all strategies will have bad years), then people will abandon it because they don’t understand.  So, let me see if I can do this fairly quickly, this complex subject.  Small value stocks are the riskiest in economic theory, and they’ve had the best returns, as the theory would expect.  They’ve roughly gotten you 14% a year.  In the long term, to make the math easy, I’m going to say that large cap U.S. stocks, or the total market, got 10%.  And again, not exactly accurate but close enough for our example.  Say bonds got 6%.  Now, if you needed to get 10% looking backwards, you could’ve gotten there by owning 100% of your money and putting it in an S&P 500 fund, right?  Because the market got 10% if you stayed the course.  Another way looking backwards that you could’ve gotten 10% was put 50% of your money in small value stocks and 50% in bonds.  Half gets 14%, half of that is 7%, half gets 6%, half of that is 3%, 7% and 3%, you get the same: 10%.

Now, if you buy only the kinds of bonds that I recommend, which are very safe, no high yield bonds, no even corporate bonds, but government bonds or CDs or things like that, here’s what tends to happen: in a very good year, let’s say like 2013, the S&P goes up 32%.  Small value does much better.  The fund we use, the Bridgeway fund I mentioned, was up something like 45%.  But I can’t do as well because I’ve only got 50%.  So, weighting it is 22%, bonds about broke even, so let’s say my portfolio is up 22%, you’re up 32%.  So, you’re better.  But here’s the offset: in 2008, you go down 37%.  Now, small value does worse.  Let’s say it goes down 45% that year.  But I only own half, so I’m down 22%.  But very importantly, if you bought safe bonds, not risky bonds, they actually went up because they tend to do very well in crises when stocks get killed.  So, let’s say they went up 10%.  So, 10%, I own half, that’s 5%.  So, now I lose, say, 22% from my stocks on a weighted basis.  I make 5% on my bonds.  I’m only down 17%.  You’re down 37%.  So, you can see how you cut the bad tail much more than you cut the good tail because the safe bonds tend to do well just when you need them most.

That’s how this works in shorthand.  But you have to be prepared for years like 2013 where you’re going to underperform your friends who own large cap stocks.  Another example I showed, in 1998, the S&P was up 29% and small value stocks were actually down 10%.  So, you’re underperforming at least the equity portion by 40%.  But of course, there are periods like 2001 when the S&P was down 12%, I think, or something like that, and small value stocks were up 40%.  So, the reverse can also happen.  I show people how by building a portfolio with only about 30%, 35% stocks, if they are small value stocks, and then they buy five-year bonds, treasuries even, you would have outperformed a hundred percent S&P portfolio over the last forty-plus years.  So, there’s far less risk.

Jim Lange:  Well, I think you have a lot of valuable information, and for listeners who are interested in more information, they could go to my website, www.paytaxeslater.com.  This show will re-air Sunday and will, as other shows, eventually be part of the archives.  And buy Larry’s books at www.amazon.com.  Larry Swedroe.

David Bear:  And thanks for listening to this edition of The Lange Money Hour, Where Smart Money Talks. Thanks also to Alex, our KQV in-studio producer, and Amanda Cassady-Schweinsberg, Lange Financial Group program coordinator.  As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can also call the Lange offices directly at (412) 521-2732.  Finally, please join us on Wednesday, September 3rd at 7:05, when we’ll welcome Paul Merriman, another nationally recognized authority on investing, for the next new edition of The Lange Money Hour.

END

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