Why Academic Research?
As most followers of this blog will know, we utilize an evidence-based investment strategy with our clients, and we think you should as well. The term “evidence-based” describes a practice that has been rigorously evaluated by objective experts, and shown to make a positive, statistically significant difference to important outcomes. In the case of investing, the relevant objective experts are academics, who test theories, publish papers, and have their peers (academics at other institutions) validate their findings. Once a theory has been validated by other academics, that theory becomes fact, and it is up to investment professionals to implement strategies that align with the facts discovered to improve investment outcomes. It is just as important for investment professionals to disregard half-baked investment theories or opinions that do not stand up to the scrutiny of the scientific method.
Not all ideas that come out of academia can be practically implemented, but those that can should be given very serious consideration in portfolio construction and management. It is also important to understand that using an evidence-based investment methodology does not mean that a portfolio will outperform other strategies in all periods, but it does give an investor the best odds of a superior outcome over long time periods. One of the biggest issues that individual investors have in selecting an investment strategy is separating the signal from the noise – there are a lot of convincing “expert” opinions out there that contradict evidence-based (academically verified) methodologies. The intent of this blog post, and several that will follow, is to take you through some of the leading academic literature, and help you understand the one or two key findings from each that you can use in your own portfolios. We will also do our best to help you identify ideas that are not based in evidence, and help you to avoid them.
Academic Research Review: Do Stocks Outperform Treasury Bills?
In our first White Paper review, we are going to provide you with a synopsis of a paper published in May 2018 by Henrick Bessembinder, from Arizona State University titled, “Do Stocks Outperform Treasury Bills?”. The title is purposefully attention grabbing, as even the most novice investors are likely inclined to think, yes, of course they do! It turns out that stocks have indeed generated returns that have exceeded treasury bills (T-bills), but there is a very important caveat that you must be aware of, which is best explained by the author: “The evidence that stock market returns exceed returns to government obligations in the long run is based on broadly diversified stock market portfolios”. The author goes on to highlight that the vast majority of stocks that were available to investors in the US since 1926, however, did not generate returns that exceeded those obtained by holding government obligations over the same time period. In other words, the relative outperformance of stocks over T-bills, was due to exceptional returns generated by a select few of the total stocks available for investment.
To come to this conclusion the author analyzed data from the Center for Research in Securities Prices (CRSP), which includes all common stocks listed on the NYSE, Amex and Nasdaq exchanges between 1926 and 2016. The author focused on US stocks in his study due to the vastly superior availability of data in the United States. Similar studies based on stock performance in other countries are also available, but are based on much more limited data sets and time series. Nevertheless, the conclusions of the studies based in other countries arrive at similar results. The synopsis that follows speaks directly to results of Dr. Bessembinder’s paper, and focuses solely on US stock market data.
Over the 90-year time period analyzed there were approximately 25,300 companies that issued common stocks in the US. Those 25,300 stocks generated total wealth creation of $35 trillion. But, only 1,092 stocks, or roughly 4% of the total, accounted for all of the net wealth creation. This means that the other 96% of stocks (approximately 24,200 companies) generated collective gains equal to the returns an investor would have received by being invested in T-bills.
Drilling down further, the author noted that the five top-performing companies (Exxon Mobile, Apple, Microsoft, General Electric, and IBM) accounted for a whopping 10% of the total wealth creation between 1926 and 2016. Further, the 90 best performing stocks of the 25,300 (approximately 1/3 of 1%) were responsible for over half of the total wealth creation. Only 42.6% of CRSP common stocks had lifetime buy-and-hold returns that exceeded T-bills, while the remaining 57.4% of stocks underperformed a buy-and-hold investment in treasuries.
To help put this into perspective, take a look at Figure 2, which is comprised of 25,300 (very small) individual squares. The squares represent the total number of individual stocks that were available from 1926 to 2016, the coloured squares represent the 1,092 (~4%) of stocks that generated returns in excess of T-bills.
Despite the challenges that picking individual stocks presents, the CRSP stocks generated compound annual returns, inclusive of reinvested dividends, of X% between 1926 and 2017. Treasury Bills, over the same time period, generated a compound annual return of Y%. Clearly, this data proves conclusively that investors in a broadly diversified portfolio of stocks in the US would have dramatically outperformed investors holding treasuries. What this data also highlights is how important it is to be invested in the select few stocks that are attributable for the majority of excess returns over T-bills.
A common strategy employed by many portfolio managers over the time period examined, was to actively select stocks that were thought to have the best prospects of a positive future return. At the same time, those same active managers hoped to avoid the stocks they thought had lower potential future returns. These strategies resulted in portfolios that outperformed the market benchmark returns 48.7% of the time when evaluated on a one-year basis, and before accounting for transaction costs and management fees. Over ten-year time horizons, actively managed portfolios outperformed their benchmark 45.7% of the time, and over the full 90 years, such strategies led to outperformance just 36.8% of the time. In other words, these active managers outperformed the comparable market benchmark index less than 50% of the time over all time periods in the study. After factoring in trading costs and management fees, their underperformance as compared to the benchmark index was even worse.
Imagine that the coloured squares from Figure 2 are randomly dispersed across the entire sample of stocks as shown in Figure 3 (below). Your job is to pick the winning stocks, the only problem is that you have no way of definitively knowing before buying a stock if it will be one of the 1,092 stocks that generates excess returns, so you are unable to see the colour of the squares ahead of time. To accomplish this, take out a fine tipped pen, look away from the image, close your eyes and place your pen on Figure 3. Next, open your eyes and record the colour of the stock you selected. Repeat this process 50 to100 times to simulate picking an entire portfolio. How does your portfolio look? How many of the top five stocks did you successfully pick? What percentage of your portfolio is invested in the top 90 or even the top 1,092? Of course, an active manager, or stock-picker, will tell you that they are able to "see" the winners before they buy them, but as discussed earlier, their track-records, on average, say otherwise.
The reason that concentrated portfolios tend to generate lower returns, on average, is attributable to a few common missteps. First, holding a concentrated portfolio of investments increases the likelihood of not being invested in one or more of the few key stocks (the 1,092 outperformers) that go on to generate the best performance. Such strategies are also more inclined toward “market timing”, meaning their managers will often enter and exit investments based on their perception of the likelihood of future near-term market events (i.e: whether the manager believes markets are positioned for a boom or bust). As Dr. Bessembinder states in his paper, market returns tend to be highly concentrated around brief time intervals and that the academic literature stresses “the importance of not being out of the market at key points in time… [as well as] the importance of not omitting key stocks from investment portfolios”. Finally, having concentrated positions in an investment portfolio also increases the risk associated with owning equities that have dramatic declines in value, or become delisted (investments that become worthless). Dr Bessembinder states, “just 36 stocks were present in the database for the full 90 years. median life of a common stock on CRSP, from the beginning of sample or first appearance to end of sample or delisting, is just 90 months or 7.5 years. 90th percentile life span is 334 months or just under 28 years”.
These missteps have important implications for long-term portfolio performance. Let’s assume an investor owns a concentrated portfolio that contains most, but not all of the key performing stocks. In a paper published by Kacperczyk, Sialm and Zheng (2005) the authors show that the average actively managed equity mutual fund held a median of only 65 stocks. By not holding even one of the key performers, such a portfolio is likely to generate returns that underperform the benchmark index. The returns can also be further negatively impacted by tactical timing decisions that result in missing a period of strong (often unforeseen) favourable returns.
Lastly, let’s consider the impact to the concentrated portfolio if one of the few holdings becomes delisted. Such an event results in a permanent loss of capital that represents a greater portion of a concentrated portfolio (i.e. a portfolio with 65 stocks as compared to a portfolio with 10,000 stocks). An investor who instead holds the entire market, in a buy-and-hold strategy is guaranteed to own all of the key performing stocks, and will not miss even a single day of returns due to attempts to “time markets”. That same investor will also be guaranteed to own all of the securities that become delisted, but the losses associated with those delisted securities will be more than offset, on average, by the gains associated with owning the key performing stocks over the same time period, as each delisted security will represented a much smaller percentage of a well-diversified market portfolio.
It is important to understand that with the benefit of hindsight, we are all tremendous investors. It is tempting to look at the “home run” performance of a select few stocks and imagine how well off we would be if we had just bought those key investments. Do not be fooled, however, into thinking that identifying those key few stocks ahead of time would have been easy or even possible. As markets continue to become ever more competitive, the likelihood of anticipating the select few key stocks of the future has become increasingly difficult. In another recent paper written by Noe and Parks (2004), the authors conclude that the internet economy will be associated with increasing “winner take all” outcomes – this means that the key companies or stocks that drive excess investment return in the future are likely to be attributable to an even smaller percentage of the stocks available in the broader market.
Investor psychology plays an important role in portfolio outcomes. It is tempting to be lured into strategies that promise outperformance, but the evidence overwhelmingly suggests that deviating from evidence-based, broad market strategies, most often leads to disappointment in the long run. While there will always be a few outlier portfolio strategies that outperform the broad market over different time intervals, very few, if any, are likely to result in superior performance over long time periods. More importantly, those strategies that experienced superior performance in one time period prove to be unlikely to continue to do so in future time periods. This means we cannot rely on the past superior performance of an outlier strategy to generate superior relative performance in the future. The research concludes that an investor’s best odds of generating a superior, risk-adjusted, rate of return is to follow an evidence-based investment strategy that incorporates a broad-market investment discipline in a buy and hold manner.