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“I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will”. That was one of the first epigrams from Warren Buffett that caught my attention twenty years ago when I was researching a thesis on the Sage of Omaha’s stockpicking methods at MIT. What belatedly dawned on me the other day was that something similar might just as easily these days be said about the fund management business: “Try to buy a fund whose investment style is so simple that your kid’s computer could run it. Because sooner or later, one will”.
The march of the algorithms is potentially one of the most profound and dramatic changes to have overtaken the fund management business in the 30 years that I have been following it. While it is fashionable in some quarters to deplore the advent of so much computerised trading, the ability to use algorithms to manage money strikes me as being potentially one of the most valuable innovations of our professional generation, the latest in a long line of life-changing technological advances that adds materially to the welfare of mankind.
Last week saw the 20th anniversary of the launch of the Spyder, the exchange-traded fund which in 20 years has grown from nothing to an astonishing $120 billion in assets, in the process becoming the single most traded security anywhere on the planet. Once you strip away the mechanics of how it is constructed, the Spyder, like its more humble cousin, the index-tracking mutual fund, is really not much more than a simple algorithmic trading vehicle, one which just happens to pursue a proven and highly successful investment strategy.
There are of course many far more sophisticated models around. The pioneering efforts of Jim Simons, David Harding and others have spawned a generation of ultra-fast artificially intelligent computer-driven investment machines. Hedge fund clones are busy seeking to replicate the results, if not the precise strategies, of their real world counterparts. The main reason that the average holding period on the New York Stock Exchange has fallen to 23 seconds, or whatever the figure now is, is that there are now so many computers chipping away all day long at identifying minute anomalies that were not even visible twenty years ago.
Now the computerised traders even have the master himself in their sights. The three authors of a recent academic paper at Yale have run the performance of Mr Buffett’s holding company Berkshire Hathaway between 1976 and 2011 through their computers and demonstrated convincingly that a relatively simple six-factor model could have replicated Mr Buffett’s exceptional returns over the same period, had the tools been available at the time.
The authors, two employees of AQR Capital Management, and a New York University academic, took care to adjust the performance data for the effective leverage that Mr Buffett obtains by deploying the low cost “float” produced by the disciplined underwriting of his insurance companies and the surplus cash flow generated by his portfolio of unquoted companies, which now make up 80% of Berkshire Hathaway’s assets. These have the effect of leveraging his returns by approximately 1.4 to 1, the authors estimate.
And what are the other secrets of his success? While conventional style analysis cannot explain his consistent alpha, what does make a difference, the authors conclude, are the specific style factors which stem from Mr Buffett’s oft-stated preference for picking “cheap, safe, quality stocks”. Critical too is his willingness to tolerate above average volatility and drawdown, something that is not in practice an option open to most other fund managers.
These results are, gratifyingly for any fan of the Buffett approach to investing, suitably impressive. No other mutual fund with a 30-year history has produced a better performance than Berkshire Hathaway’s 19.0% per annum compound excess return, the paper concludes. It is also the single best performing US quoted equity over the period 1976 to 2011. Nobody, in other words, has generated more genuine alpha over so many years. Mr Buffett is officially worthy of his reputation as the best investor of his generation (albeit that his margin of outperformance has fallen away quite sharply since the year 2000).
These findings will hardly come as a surprise to Buffett afficianados. Everything that the Yale paper identifies as being the keys to his success – the leverage, the tolerance for volatility, right down to the type of stocks he likes – are exactly what Mr Buffett himself has told us he does. What you get from an investment in Berkshire Hathaway, to quote a popular advertisement in the UK, is “exactly what it says on the tin”. The wonder, as he often points out, is that so few other professional investors even try to copy his approach, given how simple and successful it has been.
“Ben Graham taught me” he wrote in his 1994 Annual Report “that in investing it is not necessary to do extraordinary things to get extraordinary results”. For years you had to be peculiarly dedicated and emotionally disciplined to mimic the Sage of Omaha’s approach. But now, thanks to the onward march of the algorithm merchants, it may soon be open to anyone to follow his approach with just a few strokes on a keyboard. I find that rather a wonderful thought, though not perhaps a consoling one for the still over-rewarded fund management profession.
Jonathan Davis 