For investors, the 2010s were a remarkable decade. Share prices roared back from the depths of the Great Recession, interest rates plunged to the lowest levels in 5,000 years, and the longest bull market in history propelled Wall Street to record highs.
One of the most surprising features of the decade, however, was a more subtle distinction. It was a period where it didn’t pay to be smart.
The dismal returns from high intelligence are apparent if you examine the 2009 to 2019 investing records of Ivy League universities. These eight schools – Brown, Columbia, Cornell, Dartmouth, Harvard, Pennsylvania, Princeton and Yale – are some of the top-ranked educational institutions in the world. They are also among the richest. With tens of billions of dollars in their collective endowments and platoons of world-class brains at their command, the Ivies have well-deserved reputations for being among the most sophisticated of long-term investors.
Over the past decade, however, most struggled to keep up with a simple investing strategy known as a 60/40 portfolio. People who follow this time-honoured approach plunk 60 per cent of their money into a plain-vanilla stock-market index fund and 40 per cent into an equally boring bond-market index fund.
During the 10 years ended June 30, the bare-bones 60/40 approach produced a 10.5 per cent annualized return, according to Markov Processes International, a market research and software company. By comparison, the brilliantly managed endowment funds of the Ivies returned, on average, only 10.3 per cent a year. This is not the best advertisement for higher education.
To be sure, the Ivies didn’t suffer a total wipeout. Princeton and Yale both managed to narrowly beat the 60/40 portfolio, according to Markov Processes. However, their results – 11.6 per cent for Princeton and 11.1 per cent for Yale – weren’t exactly table-thumping victories for high IQ investing.
For Yale, especially, the results were disappointing, given that it pioneered many of the complex strategies that university endowments and pension funds now count on to bump up returns. The Yale model, which emphasizes pouring money into private markets, as well as the vigorous use of sophisticated forms of active management, barely edged out the simple-minded 60/40 indexing approach.
Academia’s big brains shouldn’t feel too bad, though. Just about everybody who tried to beat a red-hot U.S. stock market wound up falling short in recent years.
Private equity, for instance, has long been the great hope of many pension funds. Consultants claim this strategy, which consists of investing in companies that are not yet public, can reliably generate better returns than stocks and bonds.
But as researchers dig into the numbers behind the claims, the superiority of private-equity looks more and more questionable. In a landmark 2015 paper, a team of academics – Robert Harris of the University of Virginia, Tim Jenkinson of the University of Oxford and Steven Kaplan of the University of Chicago – looked at 1,800 buyout and venture-capital funds and concluded they beat public markets only in the pre-2005 period. After 2005, private equity performed roughly the same as public markets. More recent research by people such as Arpit Gupta at New York University has arrived at similar conclusions.
How about hedge funds? These exotic investment vehicles are managed by people who like to consider themselves the smartest people in the room. They charge whopping fees for access to their esoteric strategies. However, based on their lacklustre results since the financial crisis, hedge fund managers aren’t doing a lot to justify their notoriously inflated paycheques.
Warren Buffett provided a dramatic demonstration of this back in 2008 when he bet US$1-million that a team of hedge fund geniuses hand-picked by a noted adviser could not beat a simple, cheap S&P 500 index fund over the next decade, once all fees were deducted. Mr. Buffett won that bet decisively: The index fund returned 125.8 per cent over the decade, while the all-star hedge funds produced a payoff of only 36 per cent after fees.
The huge disparity in results was a sweet victory for low-cost indexing approaches. But one additional twist should be pointed out: Mr. Buffett, perhaps the greatest investor in history, could have prospered by taking his own advice. Not only did the S&P 500 index fund thump the hedge funds over the decade. It also narrowly edged out the returns from Mr. Buffett’s own flagship, Berkshire Hathaway Inc.
If neither Mr. Buffett, nor hedge funds, nor Ivy League endowments, nor private equity masterminds can outpace market benchmarks, it’s time to ask what is going on. Why are such icons of intelligence failing to produce superior results?
One possibility is that this has simply been an historical aberration, a period when several normally reliable strategies have gone on holiday for reasons we don’t fully understand.
Consider value investing – the practice of buying stocks that are selling at cheap prices compared with their fundamentals. Value strategies have produced market-beating results during most patches of market history. Over the past 10 years, however, they have largely flopped.
The same holds true for international diversification. History shows that spreading your bets among different countries reduces risk and improves results over the long haul. During the past 10 years, however, diversification has been a loser. U.S. stocks have thumped their international peers.
Maybe this is all a matter of chance. Maybe value strategies and diversification will come back into their own and order will be restored to the investing universe. If so, smart investors may once again start to reap bigger rewards.
There are other possibilities, however. One is that the structure of the investment business has shifted in a way that reduces the payoff from intelligence.
For instance, it is possible that smart and well-informed investors are no longer able to take advantage of naive individual investors to the extent they once did. Dumb money may be becoming rarer as more and more people decide to give up individual stock picking and invest in more intelligent and diversified ways, through vehicles such as mutual funds and exchange-traded funds. These funds may not be perfect, but they do offer some level of professional management.
If the slow kids in the class have indeed narrowed the gap with the brainiacs, it would make sense that the rewards from high IQ investing might shrink.
There is some evidence in support of this notion. Bill Gross, the billionaire investor, said earlier this year that he doubts anyone will be able to beat the bond market to the degree he did in his heyday at Pacific Investment Management Co. (PIMCO) in the 1970s and 1980s.
Back then, he told Bloomberg, he was able to take advantage of several market inefficiencies, such as opportunities for riskless arbitrage in the futures market, that few people understood. Today, lots of other traders have caught on to how the game is played. High-speed, computer-based trading strategies have closed the door on easy profits.
A similar trend is evident in other areas. For instance, a recent paper on the “lost decade” for hedge funds argues that increased competition from mutual funds has been a key factor in pushing down hedge fund returns. Mutual funds are now employing many of the exotic strategies pioneered by the hedge fund geniuses, but offering them at lower cost, according to Tilburg University professor Joseph McCahery and Alexander de Roode, a researcher at Robeco Asset Management.
This levelling of the investment playing field sounds like good news. It suggests that many of the strategies once employed by the market’s smartest money managers are now being widely employed by less exalted investors.
A more disturbing possibility, though, is that something else has fundamentally shifted in the market, in ways that will not be sustainable.
Some noted pessimists – think John Hussman of Hussman Funds or Albert Edwards of Société Générale – argue the great bull run of the past decade was an artificial boom engineered by hyperactive central bankers.
They say central bankers ambushed smart investors with unconventional and unexpected policies, such as quantitative easing and radically low interest rates – the lowest in 5,000 years, according to Bank of England researchers. These policies papered over problems and prevented an even deeper recession, but did so by interfering with the normal working of the market.
So what happens now? If you buy the central-bankers-did-it-on-the-sly-with-unconventional-stimulus theory, you have to worry that the bull market of the past decade will crash when policy makers begin to back away from negative interest rates and other extreme policies.
Or maybe the bull market will end not with a bang, but with a whimper. Many observers argue the ultralow interest-rate policies of the past decade have pulled forward investors’ future profits. If so, we may not be headed for disaster, but simply for a long period in which most everyone suffers lacklustre results.
Strategists at Morgan Stanley are among those predicting a decade of meagre returns. By their reckoning, a 60/40 U.S. portfolio will return just 4.1 per cent annually over the next decade, while a European 60/40 portfolio will generate only 3.9 per cent a year. Forecasts from money managers GMO and AQR Capital Management vary in the details but are similarly pessimistic.
All these forecasters see similar challenges ahead – low bond yields and share prices that look fully valued. It is an environment where many people will be desperate for larger returns. Private equity, hedge funds and other forms of alternative investing will all tout their potential for beating the market.
Investors should proceed with caution. If the past decade demonstrates anything, it is that apparently brilliant plans to beat the market don’t always pay off.