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The Sunday Times 05 March 2017


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Last weekend saw the release of Warren Buffett’s highly anticipated annual letter to shareholders. Such is Buffett’s success that I may be conditioned to think only positively towards him, but it’s a superb read. On my bucket list is to make the pilgrimage to Omaha to listen to Buffett at the annual shareholder meeting of Berkshire Hathaway. He is 86 years of age; I can’t afford to put this off much longer!

At last year’s gathering Buffett was quizzed about his large shareholding in Coca-Cola (9.3 per cent) and asked to explain why Berkshire Hathaway shareholders should be proud to own Coke.

The inimitable Mr Buffett responded saying he consumed 700 calories of Coke a day. He wished he had a twin who had eaten only broccoli his entire life. “I know I would have been happier and I think the odds are fairly good I would have lived longer.”

Unfortunately life isn’t a science experiment - we can’t test Buffett’s hypothesis. However, an interesting thought experiment would be if Buffett did have a twin (broccoli eating or not), would he have enjoyed the same investment success as his real-life sibling if he was also an investor?

Buffett has trounced the S&P500 in his fifty years at the helm of Berkshire (more than doubling the annual return, every year). It should be noted that the corporate structure of Berkshire and its investment in large insurance companies affords Buffett a large float from unpaid future claims that leverages the company’s own equity. Leverage adjusted, his track record is still stellar.

To the efficient market diehards, Buffett is the happy winner of a coin-flipping contest. If you start with enough people you’ll end up with a small number that flip a highly improbable ten heads in a row. Repeat success for Buffett’s twin, academics would argue, is akin to a lottery winner.

Buffett rips apart the academic view of his success in his seminal paper, The Superinvestors of Graham-and-Doddsville. 

I’m not interested in whether Buffett is lucky or skilled – he’d argue both. I’m more interested in whether a modern-day acolyte could repeat what Buffett has done in the next 50 years. And on that question I’m far less sanguine.

Markets in 2017 are very different to those in the 1960s. I suspect if Buffett had a twin, his (or indeed her) chances of success were far higher then, than they are today.

It could be argued that some pockets of opportunity existed in the 1970s and 1980s, when technology was cumbersome, access to data was both expensive and scarce and some agents were more informed than others. But in today’s world, those informational asymmetries are largely absent, and so are many of the easily exploitable opportunities.

Consistent with this, is the increasing frequency with which successful hedge funds are those that tend to rely on highly sophisticated mathematical algorithms, massive computing power and unfettered access to market data.

For many hedge funds, the last decade has been underwhelming, with years of subpar performance.

The HFRI Equity Hedge Index of U.S. equity hedge funds has an annualized return over the past 5 years of only 5.1%. This compares to a 14.1% annualized return for the S&P500 index over the same five-year period (ending January 2017).

And corporate clients of hedge funds are voting with their feet with large U.S. pension funds, reducing allocations to hedge funds, or in some cases exiting alternatives all together.

It doesn’t mean the more traditional style hedge fund approach is going the way of the stamp – on its last hurrah. But market circumstances today are such that merely swimming against the tide of the human crowd, is simply not enough. Now it’s a race against the machine.

The quantification of finance has its upside. The data now reveal that much of the return advantage of consistently successful stock pickers might actually boil down to simple bias for value, small caps, momentum or quality; factors which academics now concede offer a return premia to the overall market. Alpha — or at least a good deal of it — can be replicated by computers. And systematic solutions tend to be a fair deal cheaper than those requiring human intervention.

This paint by numbers or ‘cookie-cutter’ approach to investing is disparaged by some as hopelessly inadequate to capture the complexities of picking stocks. And they are correct. But these phenomena (value, momentum etc) work best at the aggregate level not the individual stock level. And so your approach is best achieved with a high degree of diversification.

So you can have your cake and eat it. The only likely obstacle in your way is human intervention in the process, i.e. you. So get some advice and try and stay out of your own way.
 

Warning: Past performance is not a reliable guide to future performance. The value of investments may go up and down. Returns on investments may increase or decrease as a result of currency fluctuations.
 

Gary Connolly is Managing Director of iCubed, promoting better investment outcomes through a collaborative approach to investing. He can be contacted at gary@icubed.ie or on twitter @gconno1.  iCubed Training, Research and Consulting, trading as iCubed, is regulated by the Central Bank of Ireland.

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