This week's Chartstorm is a special issue that puts together timeless charts with a focus on the biggest risks and opportunities in the coming years. You can check out the special pack here and subscribe:

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Actionable insights

• Stock prices of companies have consistently shown short-term fluctuations during unexpected deaths of CEOs and executives. This is increasing with time.

• Most of Warren Buffett’s consistent outperformance of the market can be systematically explained by a disciplined application of investment factors.

• Emerging markets have more “alpha” due to unexploited inefficiencies – despite higher transaction costs.

• Illiquidity is also a form of risk, and carries its own premium. Higher returns of value investing portfolios might be a result of their illiquidity, and it’s crucial to separate the illiquidity premium from the perceived value premium.

Keyman risk

While most people claim that they're long-term value investors, they are truly tested when unexpected events occur. Here's how the market reacted to some news events:

1. When Elon Musk appeared on Joe Rogan's podcast and took a puff of marijuana, two of his key executives resigned, and Tesla's stock crashed by 9% in a single day.

2. Papa Johns's founder John Schnatter resigned in 2018 following a controversy related to using a racial slur. The stock dropped by more than 13% from its all-time highs before bottoming out.

3. Apple shares fell by more than 5% following the death of Steve Jobs.

The reputation of many companies seems to be tied to the actions and fortunes of "star CEOs". An average of 7 CEOs of publicly traded companies die every year, and it’s a serious question whether this has any long-term effect.

Research by Quigley and Hambrick of the University of Georgia revealed that since the 1950s, the perception of company performance has been increasingly affected by the perception of the CEO. Quigley and two other associates went on to study how unexpected CEO deaths affected shareholder perception of the company, by looking at stock market performance. In a study collating over 2,000 executive deaths between 1950 and 2009, they zeroed in on 240 deaths that were "unexpected" and studied how they moved the market. They found:

1. The market didn’t show any significant positive or negative bias towards the unexpected death of CEOs. The mean "Cumulative Abnormal Return" (CAR) was slightly negative (~ -0.5%) and did not change much with time.

2. However the absolute value of the CAR following 1 to 3 days after the death has increased over the years, showing that markets are more sensitive to these events. 1 day CAR has increased from 2.35% in 1950 to 6.41% in 2009. 3 day CAR has increased from 3.02% to 7.89% in the same period.

3. In general, there has been a consistent increase of 0.08% in the absolute value of the CAR every year. Standard deviation has also increased.

They noted a definite increase in volatility around unexpected CEO deaths. Over the course of 60 years, the shift in market value caused by an unexpected CEO death increased by approximately $65 million (in 2009 U.S. dollars)!

Buffett's Alpha: Skill or luck?

Warren Buffett is now more myth than man... I think that we do a disservice to Buffett, when we put him on a pedestal and treat every word he says as gospel.
– Aswath Damodaran, Dean of Valuation

Warren Buffett has developed a reputation for having a Midas Touch among investors. Having compounded Berkshire’s stock at 19.2% per year to deliver a whopping 4,384,748% return over the last 59 years, Buffett has developed something of a cult around himself. Yet, some critics and skeptics suspect that while Buffett was definitely an above-average investor, he also benefited from an era of free cash and dollar supremacy.1

In 2012, three investors from AQR Capital published a paper named "Buffett's Alpha" that systematically deconstructed Buffett's method to see if it could be replicated. The first surprising thing was that Buffett’s portfolio had a Sharpe Ratio of 0.64 – far ahead of most mutual funds in the 40 years prior with high average returns, but nothing supernatural, experiencing periods of underperformance and drawdowns as well.

Then what explained his excellent track record? The researchers discovered that a majority of Buffett's returns could be attributable to a disciplined investing approach that relied on a few factors:

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Actionable Insights

• Buffett grew his private account from $0 to $500M, leveraging fringe inefficiencies in the market.

• Companies that were excluded from the ESG list generated statistically significant alpha.

• Low-volatility stocks are more effective than gold in reducing volatility without sacrificing returns.

• Looking at fundamentals, large-cap growth stocks are over-valued, and large-cap value stocks are under-valued.

Little fringe inefficiencies

One of Buffett’s most controversial takes came from an interview he gave to Bloomberg in ‘99.

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money.

I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

Buffett doubled down on this at the 2019 Berkshire Hathaway annual meeting.

I can assure you if Charlie was working with a million, or I was working with a million, we would find a way to make [50% a year] that with essentially no risk, not using a lot of leverage or anything of the sort.

Buffett ended by stating that the key to making these kinds of returns is to focus on "little fringe inefficiencies that people don't spot."

A classic example of such an inefficiency Buffett found was with Bayuk Cigars in 1982. Bayuk was the fourth-largest cigar maker in the U.S. but had been in decline for the past decade. The shareholders voted for the company to liquidate its assets and distribute the proceeds. The expected liquidation value was $27M ($15 a share).

But before the sale could happen, the DOJ blocked the sale of the company to American Maze. Instead of a single sale, Bayuk sold one of their business holdings to Culbro for $10M and hoped to find a buyer for the rest over the next few months.

Buffett started buying Bayuk at $13.50 in March 1982. The idea was that Bayuk would pay $8.00 within weeks (from their sale) and the remaining $4 within the next few months. As Buffett anticipated, Bayuk was able to sell the rest of its business by June for $5M.

Even though the total distribution of $16.13 produced a 20% return on Buffett’s $13.50 purchase, the front-loaded payouts pushed Buffett’s IRR to 50%!

Source: Bayuk Cigars (turtlebay.io)

The Pollution Premium

A 2023 report published in the Journal of Finance highlighted that a long-short portfolio that invests in companies with high toxic emissions generates an alpha of 4.42% per annum. This pollution premium could not be explained by any of the existing systematic risks.

A simpler way to expand this concept would be to check the performance of companies excluded from the ESG index. When researchers backtested the firms that were excluded from Norway’s Oil Fund (oh, the irony), the excluded firms had an alpha of ~5%.

Another interesting finding was that most firms do not change sufficiently to have their exclusions revoked. Only the firms with very high investment needs (or desperate for liquidity) were likely to act to get their ESG ratings upgraded. This is reflected in the portfolio performance as firms that improve their ESG ratings subsequently do not exhibit superior performance.

Source:

• The Expected Returns of ESG Excluded Stocks. Shocks to Firms Costs of Capital? Evidence From the World’s Largest Fund (SSRN)

• The Pollution Premium (SSRN)

Does Gold act as an inflation and volatility hedge?

Warren Buffett’s first rule of investing is to never lose money, and his second rule is to never forget the first rule. While Buffett eschews investing in gold, most investors consider it a great inflation hedge and a safe haven in times of crisis.

To test this theory, Pim Van Vilet and Harald Lohre examined the strategic role gold plays in investment portfolios.

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Does a higher market share imply a higher profitability?

Verdad recently did an interesting analysis where they took all public and private firms in the U.S. and Canada with <$10M in sales and compared their operating margins to the industry average. Conventional wisdom will have us believe that firms with a higher market share can generate a higher profit as they have more pricing power. However, the data shows that market share is not a consistent indicator of firm performance.

Anti-capitalist academics would love to believe that profits derive from companies exploiting their market power, but the reality is companies earn their market share through a better product, better pricing, better service, or a litany of other firm-specific strategic decisions.

It's actually quite rare to see the number-one company in an industry earning far above-market profit margins. In our dataset, 90 companies—or 56% of the industry-leading public firms—have margins below the industry median. — Daniel Rasmussen

While these findings are focused on the financial metrics (and include private companies), our previous analyses have found that monopolies and wide-moat companies that are publicly listed outperform the market.

Investing in Monopolies (Market Sentiment 2022 Analysis)

Monopoly companies on average returned double that of the S&P 500 benchmark during the same period. 65% of the companies in the list beat the benchmark and only in 2 cases would you have lost money on your investments (yes, even adjusting for inflation).

Investing in Moats (Market Sentiment 2023 Analysis)

We benchmarked the performance of the Wide-Moat ETF against the S&P 500, and the ETF managed to give a higher risk-adjusted return against the S&P 500 over the last ten years.

While overall margins might not be proportional to market share, it’s possible to pick companies with high market share and margins. A classic example is Apple, which has one of the highest gross margins among technology companies, often exceeding 40% (For reference, Dell is 25% and HP is 20%).

Source: Market Share & Profitability (Verdad Analysis)

$1 is $1

If you have spent time on fintwit, you know how popular the dividend investing community is. This is surprising, considering that it was proven in 1961 that dividends are irrelevant to stock returns.

A big conflict to the dividend irrelevance theory is the S&P 500 Dividend Aristocrats Index. It tracks S&P 500 companies with minimum liquidity requirements with a 25+ year record of growing dividends. Several ETFs track this index, and there is data to show that the index beats the S&P 500 by about 0.74% annually since 1990.

To dispel this argument, Larry Swedroe recently analyzed the performance of the two largest dividend growth ETFs: ProShares S&P 500 Dividend Aristocrats ($NOBL) and Vanguard Dividend Appreciation ETF ($VIG).

He found that

• Both funds had large and statistically significant exposure to the quality factor

• Both had economically significant negative alphas — meaning the funds were subtracting value for the investors.

The evidence is consistent with economic theory: There is nothing special about dividends, with the returns of dividend-paying stocks well explained by exposure to common factors. Dividends are neither positive nor negative, at least from a pretax perspective.

And if you consider taxes, it’s all downhill from there:

The tax consequences for all taxpaying shareholders are inferior – usually far inferior – to those under the sell-off program. Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts.
- Warren Buffett on dividends, Berkshire Hathaway annual report 2012

Dividends are objectively more tax-inefficient as they are taxed at Federal income tax rates, which are almost always higher than capital gains taxes.

Source: There Is Nothing Special About Dividends (Morningstar)

All that glitters

Gold has been on a tear this year, with spot prices rising more than 13% in 2024 (compared to 9% for the S&P 500). The demand is so high that Costco sells $200 million in gold bars monthly. As if that’s not enough, Meb Faber recently posted an incredible stat that’s hard to believe.

The universal investment benchmark is the 60/40 portfolio of stocks and bonds. What if you replaced the bonds entirely with gold....crazy right?

Turns out it makes no real difference.

This begs the question, is there an investment case for gold?

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Actionable Insights

• Contrary to popular wisdom, investing in high-volatility stocks does not yield exceptional returns.

• Fund managers from poor families outperformed managers from rich families.

• Picking companies based only on great financial metrics will not lead to outperformance.

• We are still far from an “index fund” bubble, as 95% of trading activity is conducted by active traders, pension funds, and institutional investors.

Speculation for speculation’s sake

A classic mistake many investors make is associating a higher return with a riskier asset. Consider the example of investing in treasury notes vs. an upcoming small-cap. With treasury notes, you are assured a 3 to 4% return at the end of the year. There is only one highly unlikely scenario of a U.S. default where you would not get the payout.

Compare this to the small-caps, where the range of outcomes is much higher. The company can go out of business or double its stock price in a year, giving you a windfall.

To compensate for this extra uncertainty, you expect a higher return (compared to treasury notes). No one would invest in small caps if their average expected return was comparable to that of treasury bonds.

If we extrapolate this logic to all other investments, we get a familiar chart like this:

The problem with the above approach is that investors make the wrong conclusion after seeing it. It only communicates the positive relationship between risk and return. In good times, it’s easy to look at the high returns of the riskier investments and then think that they should have invested there.

The better way to think about it is that in order to attract capital, riskier investments have to offer the prospect of a higher return—not a guarantee of a higher return. If we add this nuance to the above risk-return chart, we get a much better way to visualize the risk-return relationship.

The latest update on UBS’s Global Investment Returns Yearbook gives us the best example of the downsides of high-risk investing. They evaluated the stock price performance of various stocks in the U.S. market since 1963 and ranked them based on volatility. The results were mixed for low and medium-volatility stocks, with volatility not affecting the return. But, the stocks with the highest volatility (aka riskiest) dramatically underperformed the rest.

Jim O'Shaughnessy, in his book What Works on the Wall Street, had similar findings using the PE ratio as a metric. When you buy into companies due to an amazing story and an expectation of future growth, you are most likely bound to be disappointed in the end.

(emphasis added throughout, edited for clarity):

Both All Stocks (comparable to the Total Stock Market) and Large Stocks( comparable to the S&P500) with high PE ratios perform substantially worse than the market. Companies with low PE ratios from both the All Stocks and Large Stocks universes do much better than the universe.

In both groups, stocks with low PE ratios do much better than stocks with high PE ratios. Moreover, there’s not much difference in risk. All the low PE groups provided higher returns over the periods, with lower risk than that of the universe. – Excerpt from What works on Wall Street.

Source: How investors get risk wrong (The Economist), What Works on Wall Street (Jim O'Shaughnessy), Global Investment Returns Yearbook 2024 (UBS) — Only a summary version is available to the general public.

Meritocracy triumphs inheritance

Most of us have seen a situation where someone got hired due to their wealth or connections rather than their raw skill. Nowhere is this more prevalent than on Wall Street — When researchers evaluated the income of the families from which the fund managers came, they found that fund managers’ fathers reported a median income of $2,000 (in the 1940s), which put them in the top 10% of national income.

While this can be justified in some ways, what was interesting was that mutual fund managers from poor families outperformed managers from rich families.

We argue that managers born poor face higher entry barriers into asset management.

Consistent with this view, managers born poor are promoted only if they outperform while those born rich are more likely to be promoted for reasons unrelated to performance.

Managers from families in the top quintile of wealth underperform managers in the bottom quintile by up to 1.36% per year (significant at 1%) on the basis of the four-factor gross alpha. Similar results hold for alternative measures of performance, such as benchmark-adjusted fund returns and the dollar value extracted from capital markets — Excerpt from the paper

Source: Family Descent as a Signal of Managerial Quality: Evidence from Mutual Funds

Excellence is over-rated in investing

There’s a popular urban legend known as the Sports Illustrated cover jinx, which suggests that when an athlete makes the cover of Sports Illustrated, he or she will be “jinxed” and not perform up to the expectations. While there is a long list of examples showcasing the jinx, the rational explanation would be that the added press and distractions from the feature might be distracting the athletes.

Michelle Clayman had a similar concept for businesses. In his 1987 article "In Search of Excellence: The Investor's Viewpoint,” he examined the stock market performance of companies identified as “excellent” based on financial characteristics1 and compared them with 39 “unexcellent” (again, chosen based on the same financial characteristics) companies.

The study had two striking results:

1. There was significant evidence of reversion to the mean, with the growth and profitability of the excellent companies slowing over time.

2. The unexcellent companies as a portfolio outperformed both the excellent companies and the S&P 500.

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A quick note before we jump in — We recently introduced a lifetime membership to Market Sentiment. A few of you contacted us regarding the pricing structure, and we wanted to make it clear to all our readers that you will only be charged $399 once and not $399 annually.

Substack currently cannot do a lifetime membership. We manually stop the auto-renew for our lifetime subscribers and extend the subscription forever.

Actionable Insights

• Even if you have long holding periods, there is no guarantee that a 100% stock portfolio will outperform a stock-bond blend.

• The majority of U.S. stock market returns since the end of the Global Financial Crisis were driven by earnings growth.

• The higher your income, the more of it you need to allocate to your retirement (in % terms), and contrary to expectation, your highest spending is at midlife.

• Factor investing is risky, but sticking to it is worth it in the long run.

• The stock market was much more top-heavy in the 1950s than what we are experiencing now.

1. Stocks for the Long Run? Sometimes Yes, Sometimes No

Here is an interesting conundrum: There is an equity risk premium as stocks are considered more risky than T-Bills.

But if it's a near certainty that stocks will outperform in the long run (20+ years), why should there be a premium in the first place?

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The answer partly lies in how far we go back with the backtest. Edward McQuarrie, Professor at Santa Carla University, backtested stock and bond performance in the U.S. dating back to 1793. He did this while improving the data coverage of underlying securities, reducing survivorship bias, and using market cap-weighted index for the analysis.

He found that over the 150 years from 1792 to 1942, stocks and bonds had similar performance. Sometimes stocks outperformed, sometimes bonds. But the beginning of World War II marked the worst bond bear market in U.S. history and skewed our perspectives on long-run returns.

Any 30-year rolling period from 1942 to 2019 had a 99% chance that stocks outperform bonds. But, pre-Civil War (1793 to 1862), the probability drops to zero!

The author argues that U.S. investors must accept that stocks will not always beat bonds, irrespective of the holding period.

US investors must accept that stocks will not always beat bonds, no matter the holding period.

However, presented in isolation, the new 19th-century US data could readily be dismissed as too old and obtained under far different macroeconomic conditions. The expanded international record provides crucial support, showing equity deficits and poor stock returns in recent times.

Source: Stocks for the Long Run? Sometimes Yes, Sometimes No (Financial Analysts Journal)

2. Fundamentals are driving the stock market returns

A common argument among value investors is that a majority of the stock market returns are driven by unsustainable valuations and increasing expectations. While this might be true for a few stocks, the overall market is growing based on fundamentals.

Ben Carlson has been continuously updating the expected stock market returns based on John Bogle’s simple formula:

Expected Stock Market Returns = Dividend Yield + Earnings Growth +/- the Change in P/E Ratio

While there was a significant multiple expansion in the 80’s and 90’s in the run-up to the dot-com bubble, the majority of market returns since the end of the Global Financial Crisis in 2008 have been driven by earnings growth (and not multiple expansion).

Source: What’s Driving the Stock Market Returns? (Ben Carlson)

3. Principles for a Successful Retirement

We recently dove into J.P. Morgan’s Guide to Retirement and found some fascinating insights.

1. If you are a non-smoker in excellent health, you must plan for at least 35 years in retirement.

   

2. If you are a 40-year-old couple with a $175K household income, you should have accumulated at least $500K in your retirement savings by now (to maintain an equivalent lifestyle in retirement).

   

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Actionable Insights

• Contrary to conventional wisdom, a 50/50 allocation to U.S. and International stocks outperforms conservative portfolios and target date funds in all metrics, even in retirement.

• Manager selection is vital in realizing the “market-beating” returns touted by alternative asset classes like Private Equity.

• The latest research indicates that the Buffett Indicator has excellent forecasting abilities, and the best time to invest would be when the indicator is at its lowest.

• Incorporating real assets, value/momentum tilt, and trend following in the traditional 60/40 portfolio can boost its risk-adjusted returns.

1. Rethinking Conventional Investment Advice

Conventional investment advice recommends holding more stocks when you are young and tilting your portfolio to bonds as you near retirement. A popular rule of thumb is 100 minus your age for the % allocation to stocks — so a typical 60-year-old will have 40% of their portfolio in stocks. Even sophisticated target date funds more or less follow this thumb rule for their portfolios1.

But is this the most optimal allocation?

To test this, researchers collected data from 38 developed countries from 1890 to 2019 and ran one million simulations for a U.S. couple’s lifecycle. They compared four critical parameters — Wealth at retirement, retirement income, conservation of savings, and bequest at death across four asset allocation strategies:

1. 100% government bills

2. 100% domestic stocks

3. 50% domestic stocks, 50% international stocks

4. Traditional Target Date Fund (TDF)

As expected, the traditional TDF produces more wealth, higher retirement income, and a lower probability of financial ruin than investing 100% in govt. bills. What was interesting was that the (50% domestic stocks/ 50% international stocks portfolio) outperformed the TDF in all metrics:

• 32% higher average wealth in retirement than TDF.

• TDF portfolio had a 16.9% ruin probability under the 4% withdrawal rate compared to only an 8.2% ruin probability for 50/50 US-International stock allocation.

• The average portfolio size at death was 3.5x higher for the 50/50 portfolio than the TDF ($3M vs $0.86M respectively).

Source: Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice

2. Challenges with Private Investments

Private Equity seems to be all the rage now following the release of The Holy Grail of Investing by Tony Robbins2. Private Equity has historically given a higher return than the public markets. Most of this premium can be explained by the illiquidity premium — Private assets don’t trade regularly and generally have a lock-in period for investments. Investors are compensated for this illiquidity by receiving a premium over public investments.

In addition to the inherent complexities of the private investment universe, manager selection becomes vital in contrast to traditional asset classes. The difference in performance between the top and bottom quartile managers typically does not exceed 2% in the case of stocks and bonds. But for alternative asset classes, this figure routinely exceeds 10%, with U.S. venture capital reaching up to 30% spread between top and bottom managers.

These observations highlight that average returns touted in the Private Equity world should be taken with a pinch of salt. Deep expertise, due diligence, and access to the top investment managers are a must-have to gain an edge with private investments.

Source: Portfolio Implementation Guide for Private Investments (Morgan Stanley)

3. The Buffett Indicator

From 1964 to 1981, the Dow Jones Industrial Average (DJIA) only grew 0.1% compared to the 373% growth in GDP. However, over the next 17 years (1981 to 1998), DJIA increased 497% vs. a 177% growth in GDP.

This mismatch led Warren Buffett to create the market value of equity (MVE) to the gross domestic product (GDP) ratio. Buffett claimed this to be “probably the best single measure of where valuations stand at any given moment”.

MVE/GDP is exceptionally intuitive. When the price of equities (the total value of free cash flow the company can generate in the future) goes up without a proportional increase in economic output (GDP), equities become overvalued, and vice versa.

Based on this ratio, the best time to invest would be when the MVE/GDP ratio is at its lowest. To test this theory, researchers used data from 14 countries going back to 1973.

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Actionable Insights

• Investing in companies having a large number of trademarks relative to their valuation consistently outperformed the market over the last 50 years.

• Political leaning of fund managers significantly affected their investment trends during Presidential elections.

• Motley Fool managed to beat both the S&P 500 and the S&P 400 midcap benchmarks from 2015 to 2022 in risk-adjusted returns.

• Gold performed as a safe haven asset in 60 of the 68 markets under analysis.

1. Alpha from superstar brands

The U.S. Patent and Trademark Office (USPTO) maintains a record of millions of trademarks registered over the past two centuries. Kai Wu of Sparkline Capital recently used AI to classify this data and backtest the performance of companies with the maximum number of trademarks compared to their market capitalization.

As we can see, small brand-intensive firms like WWE, Brunswick Corporation, and Polaris are the companies that have the maximum # of trademarks related to their valuation. Backtesting these firms with high trademark yields shows that the strategy has outperformed the market consistently over the last 50 years (an average of 3.6% per year!).

Source: Superstar Brands (Sparkline Capital)

2. Political beliefs and Institutional investors

It’s well known that the political party you lean toward has a significant impact on your household beliefs and economic decision-making (especially during election years). But is the same applicable to institutional investors?

To test this, researchers collected information about 2,000+ active mutual fund managers and their self-reported political affiliation. Using the 2020 election results, they found that after Joe Biden (Democrat) won, funds managed by Democratic managers purchased a higher share of equity when compared to other funds. The same effect was observed in the 2012 election when Barack Obama won and was reversed when Trump won in 2016.

The political beliefs of mutual fund managers matter for high stakes investment decisions. Mutual fund teams respond in different ways to the same political event depending on whether the fund team has more Republicans or Democrats.

We show that Republican-led mutual fund teams increased their equity share by nearly 2% in the wake of Donald Trump’s surprise 2016 election to the presidency. This effect is an order-of-magnitude larger the response of households to the same shock.

The wedge between Republican and Democratic portfolios not only persists but also grows over time. — William Cassidy and Blair Vorsatz.

As a side note, if you are a long-term investor, who is in power does not matter for the stock market returns. If you don’t believe us, here is Buffett on why it’s important not to have a political view when investing.

I have lived under 15 presidents and invested under 14 of them. 7 were Republicans, and 7 were Democrats. You do not want to have a political view in investing. If you were a staunch Republican or a staunch Democrat, through these 77 years, you would have missed out on a lot of the party.

Source: Partisanship and Portfolio Choice: Evidence from Mutual Funds

3. Does Motley Fool’s stock picks beat the market?

Motley Fool has more than a million customers paying for their stock picking services. Arguably, their most popular service is the Motley Fool Stock Advisor, where they issue 2 stock picks every month. They heavily push the performance of their overall portfolio, which has substantially outperformed the S&P 500 since its inception.

While this outperformance is certainly correct, the thumb rule when someone tells you about their market-beating portfolio is that you should always ask for risk-adjusted returns. You can always “beat” the market by investing in high-growth or meme-stock companies when the times are good, but the drawdowns and swings will be brutal. This is where the Sharpe ratio comes in.

The Sharpe ratio compares the return of an investment with its risk. It's a mathematical expression of the insight that excess returns over a period of time may signify more volatility and risk, rather than investing skill.

Generally, the higher the Sharpe ratio, the better your investment. To test the Motley Fool’s portfolio, we distributed $10K equally to all the active recommendations they had as of 2015. We then compared the returns generated by that portfolio against the S&P 500 and the S&P 400 Mid Cap.

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If you are new here, in Ideastorm, we curate some of the best ideas and distill them into actionable insights. Stick with it till the end, and you can vote to choose the topic you think we should do a deep dive into!

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Actionable Insights

• The majority of financial influencers on Twitter were giving harmful advice, and following it would have yielded a monthly abnormal return of -2.3%.

• Investing in Covered Call ETFs to generate income is a suboptimal approach, with the costs always outweighing the returns.

• Dimensional backtested 720 different market strategies and found that only 4% reliably outperformed. The strategies that outperformed were also extremely sensitive to input parameters.

• Based on AQR estimates, for a repeat of the 2013 to 2023 performance of the U.S. stock market, valuation has to rise higher than the tech bubble peak.

1. Should you trust financial influencers?

Everyone who has even remotely dipped their toes into content creation knows that the easiest way to grow a finance audience is to offer them stock picks. This is why the Motley Fool has over a million paying subscribers, and 7 out of the top-10 finance publications in Substack offer stock picks or trade ideas.

Despite the ever-growing popularity of financial influencers, we know very little about the accuracy and quality of investment advice they provide. But, the latest research from the Swiss Finance Institute gives us interesting insights into the world of Finfluencers.

Based on the backtest of over 29,000 financial influencers on Twitter, researchers found that only 28% provide valuable investment advice (Monthly abnormal return of 2.6%), and 16% provide no value. The stunning yet not-so-surprising finding was that the majority (56%!) of financial influencers were giving harmful advice, and following it would have yielded a monthly abnormal return of -2.3%.

Equally concerning was that the most popular accounts (based on follower count) provided the worst advice, as they created overly optimistic beliefs when the times were good and overly pessimistic beliefs during the tough times. Ironically, a contrarian investment strategy that trades against the advice from these accounts yielded a 1.2% monthly abnormal return.

Finally, the less active financial influencers with fewer followers were among the most skilled. The lower follower count was predominantly due to their contrarian tweets. They don’t ride the momentum (both social media and the market) and make positive tweets after negative returns (or news) and negative tweets after positive returns. On the other hand,

finfluencers with more followers have a higher likelihood to be antiskilled. Antiskilled finfluencers ride return and social sentiment momentum. They make positive tweets after positive returns and negative tweets after negative returns.

Source: Finfluencers (Swiss Finance Institute Research Paper)

2. The problem with Covered Calls

The popularity of dividend stocks shows that many investors are still obsessed with creating a passive income stream using equities. Taking advantage of this, Covered Call ETFs1 promise the best of both worlds — a steady income and lower volatility. For example, the Nasdaq 100 Covered Call ETF($QYLD) generated an incredible yield of 12.51% in the 12 months leading up to Jul ’23.

Instead of relying on the dividends from companies, covered call strategies can be used to control the exact amount of yield. While this might look appealing at first glance, Covered Call strategies have some serious drawbacks that investors often overlook or do not understand.

Consider for example a goal of generating a 6% annualized derivative yield by selling index call options.

Each month, a strike is selected to sell a call option with a targeted price that is 0.50% of the SPX index value. Over the period from 1999 to 2023, these options settled at maturity with a value of 0.54% of the SPX index value versus an average sale price of 0.49% of the SPX index value.

The P&L from selling the call option was a loss of 0.05% per month or an annualized loss of 0.60% —Roni et. al. (NDVR, Inc)

This performance gap can have significant portfolio implications. $10K invested into QQQ (Nasdaq) in 2014 would have grown to over $50K now (CAGR 17.65%, Sharpe Ratio of 0.91). The same amount invested in the QQQ Covered Call ETF would only have grown to $20K (6.9% CAGR and Sharpe ratio of 0.52).

Most investors are attracted to Covered Call ETFs for the wrong reason — i.e., seeking a consistent income source. In reality, they only provide exposure to equity and volatility risk premia.

Covered calls implemented to deliver higher derivative income should be expected to have

(1) lower total returns,

(2) higher tax realizations along the path, and

(3) a more negatively skewed return profile.

Investors who allocate to these strategies for their income alone, without accounting for these other considerations, might have made a devil’s bargain.

Source: A Devil’s Bargain (NDVR, Inc.)

3. Backtesting 720 different market timing strategies

The holy grail of investing is finding a strategy that can consistently time the market. While this quest is exciting and never-ending, investors tend to underestimate how difficult it is to create strategies that work. Dr. Wei Dai, the head of research at Dimensional, recently published a report that backtested 720 different strategies that time the market based on valuation ratio, mean reversion, and momentum.

Of these, only 30 strategies (~4%) could deliver reliable outperformance. The best-performing strategy outperformed the buy-and-hold market portfolio by 5.5% (2001 to 2022). But before you jump in, here is the breakdown of the outperforming strategy:

It uses the valuation ratio to time the market premium in the developed ex-US markets.

At the end of each calendar year, the strategy compares the current price-to-book ratio of the market with its historical distribution over the most recent rolling 10-year period. When the price-to-book ratio exceeds the top 20th percentile of its historical distribution, the strategy gets out of the market and invests in one-month Treasury bills. When the price-to-book ratio drops below the 50th percentile of its historical distribution, the strategy switches back to the market portfolio.

Even if you understood it on the first go (we didn’t), consider the number of parameters that go into the strategy. The funny part is that changing any of these parameters would make the outperformance of this strategy statistically insignificant.

As the saying goes, if you torture the data long enough, it will confess to anything.

Source: We Found 30 Timing Strategies that “Worked”—and 690 that Didn’t

4. What will it take to have a repeat of the past decade of U.S. stock market performance?

The S&P 500 outperformed cash by 11.9% annually from 2013 to 2023 (Q3). This is well above the 90th percentile of the rolling 10-year performance across global developed equity markets (since 1950). This outlier performance was driven predominantly by strong earnings growth and richening valuation (multiple expansion contributed 3.6% compared to the historical 1.8%)

This richening valuation has long-term growth implications. Based on AQR estimates, for a repeat of the 2013 to 2023 performance, the company valuations have to rise higher than the tech bubble peak (Even after assuming a 6% real earnings growth).

Source: Driving with the Rear-View Mirror (AQR)

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Footnotes

1

AQR has a great report on Covered Call strategies. Below is a quick primer.

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Actionable Insights

• On average, ESG funds had 68% of their assets invested in exactly the same holdings as non-ESG funds and charged higher management fees while underperforming the market.

• A portfolio that was set up in 1935, which bought an identical number of shares in 30 stocks and never made any change, continues to outperform the market.

• Investors in index funds underperformed the underlying fund by trying to time their investments.

• If history’s any guide, stocks that tend to join the top-10 list of the largest US stocks tend to lag the market after joining.

1. The problem with ESG funds

In April of 2021, BlackRock launched the U.S. Carbon Readiness Transition fund and raised a record $1.25 billion in one day. The fund was created to invest in companies better positioned to benefit from the transition to a low-carbon economy. But, when you dig into its holdings, the fund has invested in Exxon, Chevron, and ConocoPhillips — all of which feature in the top 20 most polluting firms in the world.

A recent study from Harvard Business School found that ESG funds, on average, had 68% of their assets invested in exactly the same holdings as non-ESG funds. Adjusting for this, the average investor is paying 0.63% more fees to invest in ESG stocks. The fund managers love ESG due to its high fees, and given that most investors are buying the fund in the hope of doing good, they are more likely to stick to the investments even if the fund is not doing great.

Finally, an analysis of 2,000+ research papers in 2015 found that slightly more than 50% of the studies found that following ESG principles improved the company's financials. But, only 16% of the studies found evidence of the outperformance of funds investing in ESG.

Most people assume that ESG Investing is designed to reward companies that are helping the planet. In fact, ESG ratings which underlie ESG fund selection are based on “single materiality” — the impact of the changing world on a company P&L, not the reverse.

— Harvard Business Review

Source:

• Investors’ willingness to pay for ESG funds — NBER

• ESG and financial performance — Friede et al.

2. Winning by doing nothing

The big money is not in the buying or selling, but in the waiting ― Charlie Munger

What if we told you there was a portfolio frozen in time — A fund that was launched in 1935 that picked 30 stocks, bought an equal number of shares in each company, and then never sold or bought any other shares till now?

It held onto the stocks through the World War, Black Monday, the Dot-com bubble, and the Global Financial Crisis without ever selling, and it saw the invention of personal computers, the internet, the iPhone, and even reusable rockets without ever buying into a new company.

As to the question of how the fund has performed, based on our backtest, the fund managed to beat the S&P 500 over the past 30 years while having a better Sharpe ratio and lower volatility.

Between the beginning of 1970 and Nov. 30, 2019, the fund gained an average of 11.1% annually, according to Morningstar Inc.; the S&P 500 returned 10.5% annually over the same period.

It ranks 16th among the 62 U.S. stock funds that have been around since 1970. That’s a stellar result for a fund that doesn’t even have a portfolio manager. — The Wall Street Journal

The fund in discussion is

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Actionable Insights

• If you believe in mean reversion, the golden age of investing is almost certainly over, and you will not enjoy anything like the returns your parents made.

• Based on the loss aversion theory, an investor who closely follows the markets will be deeply unhappy even if they make great long-term returns.

• S&P Global analyzed all additions and deletions to the S&P 500 from 1995 to 2021 and found the index effect to be in structural decline.

• There is a significant and positive relationship between stock age and stock performance.

1. You might not make the returns your parents made

Even after accounting for Black Monday, Dot-com bubble, Global Financial Crisis, and the COVID-19 pandemic, global equity investors enjoyed an annualized return of 7.4% from 1981 to 2021. This was 72% higher than the annualized return of 4.3% from 1900 to 1980.

The global bond market also provided an incredible tailwind for the portfolio of someone who started investing in the ‘80s.

• Annualized return of Global bonds from 1981 to 2021 — 6.3%

• Annualized return of Global bonds from 1900 to 1980 — 0% (yes, that’s not a typo!)

If you believe in mean reversion, the golden age of investing is almost certainly over, and you will not enjoy anything like the returns your parents made.

But rather than trying to perma-bear like Michael Burry, understanding this can help us plan better for long term investing.

Including both the lacklustre years before the 1980s and the bumper ones thereafter, these long-run averages are 5% and 1.7% a year for stocks and bonds respectively.

After 40 years of such returns, the real value of $1 invested in stocks would be $7.04, and in bonds $1.96. For those investing across the 40 years to 2021, the equivalent figures were $17.38 and $11.52. — The Economist

If you are young and choosing a long-term investment goal, it’s better to be conservative and go with the long-run average return instead of focusing on the returns of the past few decades. i.e., assume a 5% CAGR for the stock return instead of the 7.5% we have seen over the past 40 years.

If you are right, you will hit your goal. If you are wrong and the next few decades also generate outsized returns, you will be pleasantly surprised by a bigger portfolio at the end.

Source:

• How the young should invest — The Economist

• Investing Amid Low Expected Returns — Antti Ilamanen

2. The problem with obsessing over stock prices

The S&P 500 has returned nearly 300% in the last 25 years — But the market closed in green only on 53% of the trading days. This small edge, compounded over a few decades, is what matters in investing.

If you follow the markets daily, you will encounter the behavioral economics phenomenon of loss aversion. It’s where a loss is emotionally more severe than an equivalent gain. For instance, the pain of losing $100 is far greater than the joy gained in finding the same amount.

Based on the loss aversion theory, if we assign a +1 happiness score if the markets end in green and a -2 if the markets end in red, we see that someone who checks the market daily will be deeply unhappy no matter the gains.

In his book Fooled by Randomness, Nassim Taleb highlights that a 15% return with 10% volatility translates to a 93% probability of success in a given year. But, the probability of success drops to 54% if we evaluate the investment daily. In other words, give time time!

I never spend any time thinking about the daily stock price.

At almost every all-hands meeting I say: 'Look, when the stock is up 30 percent in a month, don't feel 30 percent smarter. Because when the stock is down 30 percent in a month, it's not going to feel so good to feel 30 percent dumber.'

- Jeff Bezos

3. Index Inclusion Effect

Uber is set to join the S&P 500 index on December 18.

Given the exponential growth of passive indexing over the past few decades, investment inflow to the S&P 500 is now at its highest in history. In theory, when a new stock is added to an index, all the funds that track that index must buy that stock, creating buying pressure (and vice-versa for stocks removed from the index).

A classic example to support this effect was Tesla’s addition to the S&P 500. Tesla was the largest company to be added to the S&P 500 at a valuation of more than $500 Billion. The inclusion of Tesla into the S&P500 was announced on 16th Nov 2020, and the date of inclusion was 21st Dec 2020. There was a 6% jump in stock price and almost 4x normal traded volume on the day of index addition.

While this might look tempting, recent research indicates that the index inclusion effect is becoming weak.

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Actionable Insights

• From 2012 to 2021, S&P 500 had an excellent annualized return of 16.6%, but 41% of this was driven by P/E multiple expansion.

• Investors who opened their accounts during bull markets tend to have significantly higher equity allocation, even several decades later.

• For most investors, a simple annual rebalancing strategy is the optimal point between maximizing risk-adjusted returns and minimizing complexity & transaction costs.

• An active investor who engages in stock selection and market timing without genuine skill underperforms the market by ~2% per annum.

1. What drives shareholder returns?

In the latest report by Counterpoint Global1, Michael Mauboussin breaks down the various drivers of total shareholder return. Over the last decade, the S&P 500 had an excellent annualized return of 16.6%.

However, a concerning aspect of this is that a significant proportion (41.6%) was driven by P/E multiple expansion (i.e., the stock price is rising faster than the underlying earnings). Interest rate drops were the key driver for this multiple expansion.

An interesting side note is that AQR research also recently published a report arguing that the U.S. outperformance (over international stocks) was mainly driven by valuation changes rather than fundamental economic improvements.

(emphasis ours)

Since 1990, the vast majority of the US’s outperformance versus the MSCI EAFE Index (currency hedged) of a whopping +4.6% per year, was due to changes in valuations.

The culprit: In 1990, US equity valuations (using Shiller CAPE) were about half that of EAFE; at the end of 2022, they were 1.5 times EAFE. Once you control for this tripling of relative valuations, the 4.6% return advantage falls to a statistically insignificant 1.2%.

In other words, the US victory over EAFE for the last three decades—for most investors’ entire professional careers—came overwhelmingly from the US market simply getting more expensive than EAFE.

Source: Total Shareholder Return (Counterpoint Global Insights)

2. When you started investing matters more than you think

Imagine two new investors, Bob and Alice, who start investing in the market only five years apart. Bob started investing in the stock market in January 2007, swept up by the euphoria of the bull market. But he’s a prudent investor - Despite the rapid increase, he invests only $100 in the S&P500 every month. But you know where this is going. The market crashed in 2007, and even though Bob continued to invest, his returns kept dropping.

On the other hand, Alice began investing in 2012, and she follows the same strategy of putting in $100 a month. As luck would have it, it seems like the market has nowhere to go but up! In fact, Alice gets in at the beginning of one of the longest bull runs in history, and she never had to worry about her portfolio.

Bob is off to a disastrous start - His portfolio is in the red 78% of the time, and his portfolio drops 41% in value at one point. Even though he has read that the market will bounce back in the long term, his conviction starts to wane. On the other hand, Alice’s portfolio has positive returns in 35 out of 36 months - and the only drop in value is by 4%!

These results will have a massive long-term impact on both Bob and Alice. Technically, Bob has a better buying opportunity than Alice2, but the consistent market decline during the first few investment years becomes the formative experience for Bob and will affect his equity allocation for decades.

Andy Reed, who is the head of investor behavior at Vanguard, points to some interesting evidence that shows that investors' early experience shapes their asset allocation over many years.

Investors who opened their accounts during bull markets tend to have significantly higher equity allocation. The median investor who started investing in ‘98-99 (during the euphoria of the dot-com bubble) had 14% more stock allocation than someone who started in ‘03. Due to the anchoring bias, people's first experiences have undue weight in their minds. Also, humans react more strongly to loss than the prospect of a gain.

3. What is the optimal rebalancing strategy?

In our last deep-dive, we highlighted how a 60/40 portfolio started in 1989 would have had 80% equities by the end of 2021 if you never rebalanced.

The primary function of portfolio rebalancing is to keep the portfolio risk within your risk tolerance. Some of the most popular rebalancing approaches are:

1. Calendar-based rebalancing: This is the simplest approach where we pick a time frame (quarterly, semi-annually, annually, etc.) after which we rebalance the portfolio to target allocation.

2. Threshold-based rebalancing: Here, we allow the portfolio to drift within a tolerance threshold after which we trigger rebalancing. This requires the portfolio to be monitored daily and depending on how small is the threshold, you might have higher transaction costs.

3. Calendar- and threshold-based rebalancing: Combines (1) & (2). For e.g. — at the end of the year, rebalancing will only take place if the thresholds we set have been breached.

So, among these numerous rebalancing methods, which one is the most efficient?

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Actionable Insights

• Certain behavioral biases such as anchoring, overconfidence, and regret avoidance push investors towards holding instead of selling an outsized position.

• By using fundamental measures instead of market cap weighting, it’s possible to create an index that has a higher return and lower volatility than traditional market-cap weighted indices.

• By diversifying effectively, it’s possible to generate positive returns from two uncorrelated assets having zero expected long-term return.

• Companies with the highest employee satisfaction earn an abnormal return of 2.7% per year compared to their benchmark.

1. Psychological barriers to booking profit

Glauber Contessoto was the poster child for Dogecoin. In Feb 2021, he put all his life savings ($188K) into Dogecoin. By April, it had grown to $1 million and in the next 4 weeks, his portfolio grew close to $3 million. A 15x return in 3 months!

As with all bubbles, the crash was inevitable. Just a year later, his portfolio dropped from $3 million to $230K (a 92% drop). From our estimates, if he is still holding, it would be only worth ~$200K. The irony is that if he had sold at the top and put it in treasury bills, he would be earning a cool $150K every year. Contessoto understands this and regrets holding on to his investments:

What I do regret is not taking out some of the profit as cash. If I could go back in time, I probably would have taken out $1 million or $500,000. — source

While it looks easy in hindsight, there are a lot of psychological barriers that prevent investors (or speculators) from booking profit.

These behavioral biases tend to push investors in the direction of holding rather than selling. The media also does not help as it is full of stories of investors and employees who held on to stocks like Amazon, Google, and Tesla. But the performance of most stocks is a far cry from these exceptional successes.

Source: The Enviable Dilemma: Hold, Sell, or Hedge Highly Concentrated Stock?

2. A better way to index?

If you think about it, there are no good reasons why the market-cap weighted index became the gold standard for passive strategies. A key issue with the traditional index is that it follows the buy high, sell low approach — Index additions are usually growth stocks trading at a premium and deletions are usually value stocks that have gone out of favor.

If the market benchmark (S&P 500) is based on “buy the biggest companies that are profitable”, shouldn’t we be able to do better by just going one or two steps deeper?

Research Affiliates recently put out a paper that proposed a novel way to create an index. Instead of using market capitalization, they used the average of four fundamental measures to pick stocks for the index.

• Current book value adjusted for intangibles

• Sales adjusted for the company’s equity-to-asset ratio

• Cash flow plus R&D investments

• Dividends plus share repurchases

Over 30 years from 1991 to 2022, the indices built using fundamental measures outperformed traditional market-cap weighted indices. The higher returns were generated with a lower turnover in the portfolio (leading to lower transaction costs) and at a lower risk.

Source: Reimagining Index Funds

3. Shannon’s Demon

One of the most important investing ideas you've never heard of is 𝗦𝗵𝗮𝗻𝗻𝗼𝗻'𝘀 𝗗𝗲𝗺𝗼𝗻. Using it, we can consistently generate positive returns from two uncorrelated assets having zero expected long-term returns!

Consider a simple coin flip game to simulate an asset with zero long-term returns. If it’s heads, you win 50% of your bet amount; if it’s tails, you lose 33.3%. This game has a long-term expected return of zero (below is an even coin switch simulation).

At first glance, there is no way to win long-term from this game if we are using a fair coin. We will just broadly oscillate around the original portfolio. But, we can completely change the outcome by making a simple change.

Instead of betting all of your portfolio on every bet, rebalance 50% into cash after each flip -- regardless of whether you win or lose. Intuitively, this should not make any difference, as cash has zero expected return. But, in reality, the CAGR is now positive.

While this might look like a purely theoretical thought experiment, it has real-world implications. Gold and stocks are reasonably negatively correlated. For a 40 year period ending in 2010:

Stocks CAGR: 4.9%

Gold CAGR: 4.0%

50/50 Gold & Stocks rebalanced portfolio CAGR: 5.8%

To understand Shannon's Demon, we must recognize the difference between arithmetic and geometric returns.

CAGR: compounded growth rate AVG: average return SD: standard deviation.

When we bet the full amount each time, our average return is higher (~8.4%), but our portfolio volatility is also higher (0.42). Plugging into the above formula gives us a CAGR of zero. 0.084 – (0.421² / 2) ≈ 0%

The volatility has a greater effect than the average return.

By moving 50% of our portfolio to cash, we reduce the average expected return to 4.1%, but the volatility is also cut down to 0.21 instead of 0.42. So, in the new portfolio, the updated CAGR is 0.042 – (0.21² / 2) ≈ 2% This 2% is the edge Shannon's Demon creates.

Source: We have done a detailed breakdown of Shannon’s Demon in this Twitter thread.

4. Do the best companies to work for give the best stock returns?

Fortune annually publishes a list of the top 100 companies to work for globally, a ranking based on an anonymous survey of over half a million employees. This survey measures employee satisfaction and happiness at work and companies try to get on the list by offering perks to attract the best talent.

This raises an interesting question — do companies where people are the happiest generate better returns for their shareholders?

To test this, researchers collected companies that featured in the best companies to work for list going back to 1984 and then created an equal-weight portfolio that gets updated and rebalanced every year.

They found that the equal-weighted portfolio of companies with the highest employee satisfaction earns an abnormal return of about 20 bps per month (~2.7% per year).

In addition to this alpha, companies with high employee satisfaction also managed to handle downturns better.

I think what happens when you have a contented workplace, people are willing to put out more effort to improve operations during really difficult times.

While I think every organization has their ups and downs, the downs are not as pronounced because everybody pulls together to try to get through the crisis. And, of course, this consistently more engaged performance inevitably reveals itself in the firm’s bottom line. — Jerome Dodson (founder of one of the earliest socially responsible funds)

Source: Employee Satisfaction and Long-run Stock Returns

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Our recent deep dives

1. Importance of international diversification

2. The problem with averages

3. How safe are stocks in the long run

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Actionable Insights

• Even with a clear edge, generating consistent alpha is difficult for investors. While it’s logical that taking a constant and moderate amount of risk is the best bet to win long-term, most investors don’t behave rationally when given the opportunity.

• If you have a concentrated stock position, it requires an average annualized alpha of 13% over the index to be worth taking the additional risk of holding it over a diversified index.

• Over 13% of regular gamblers won over a two-year period — But less than 1% of day traders reliably generated a positive return two years running.

• S&P Global report reveals that active managers' outperformance in the first five years didn't predict success in the subsequent years.

1. Can you win when the odds are in your favor?

The holy grail of investing is finding a consistent edge. Imagine if you could predict with 60% certainty whether the market will go up or down tomorrow — theoretically, this should make you a billionaire in no time. But, in reality, most investors cannot take advantage of this edge.

Don’t believe us? — Consider the coin flip experiment by Victor Haghani, one of the founding partners of the now-infamous hedge fund Long Term Capital Management.

You walk into a room with $25. There is a biased coin on the table, which gives a 60% probability for heads. If you make the correct call, you double your money; otherwise, you lose the bet amount. You can bet any amount of your total portfolio on each bet, toss the coin as many times as you want, and change your bet amount each time. The only catch is that if your balance goes to $0, it’s game over. You have 10 minutes — How much do you think you will make?

Before going forward, we highly recommend you play this simulation and see how much you can make.

Haghani conducted the experiment on finance students from top colleges and analysts and associates from leading asset management firms. The results were disastrous. Even with a very apparent edge,

• 28% of the participants went bust

• 33% had less capital than they started off with

• Only 22% of participants had made >$200 (The limit set by the experimenters as the payouts and bets were real $ — The cap of $250 was set as the expected value of the experiment was $3.2M!)

The main problem you would face while playing this simulation is how much to bet. Some of you might bet your total portfolio on one coin toss and bust out, while others might bet too little, which minimizes the total outcome but preserves your portfolio.

The right way to play this game would be to use the Kelly Criterion, which shows that you should only bet ~20% of your portfolio on every toss. If you do this, you have a 95% chance of getting to the maximum payout of $250.

The researchers conclude by raising an important question:

If a high fraction of quantitatively sophisticated, financially trained individuals have so much difficulty in playing a simple game with a biased coin, what should we expect when it comes to the more complex and long-term task of investing one’s savings?

Source: Observed Betting Patterns on a Biased Coin — Victor Haghani, Richard Dewey

2. Does fortune favor the bold?

If you made a very successful investment or are a top executive in a company, chances are you hold most of your wealth in a single stock. What would you think is the best choice for building wealth long-term?

The media is full of stories of investors and employees who held on to stocks like Amazon, Google, and Tesla. But the performance of most stocks is a far cry from these exceptional successes.

Across the 25,967 stocks listed in the U.S. from 1926 to 2016, the most common one-decade buy-and-hold return was -100%. The conventional wisdom on long-term compounding rarely applies to concentrated stock positions — the risk of capital destruction is too high.

In this paper published in The Journal of Wealth Management, the authors argue that the benefit of liquidating a concentrated position significantly outweighs the tax burden of any such liquidation (even when the stock had a higher average return than that of the index and the capital gain tax was assumed to be at 30%).

This was due to the median performance of individual stocks being so low compared to the index. Once you have a substantial negative return (common in individual stocks — the median annualized volatility of IPO stocks in the first five years after listing was ~50%), it’s hard to compound your way out of the loss.

The stock should have an average annualized alpha of 13% over its corresponding index to make it worth taking the additional risk of holding it over a diversified index.

Source: Perils of Volatility for Wealth Growth and Preservation — Nathan Sosner

3. Day Trading vs Gambling

When a study analyzed the performance of 18,000 regular gamblers in casino games, only 13% won over a two-year period. But, less than 1% of day traders reliably generated a positive return two years running.

On any given day, if you walk into a casino and play a game like blackjack, roulette, or slots, you have a 30% chance of making a profit. The only way to win would be to quit while you are ahead, and most of us won't.

But continuing to gamble is a bad bet.

Just 11% of players ended up in the black over the full period, and most of those pocketed less than $150.

The skew was even more pronounced when it came to heavy gamblers. Of the top 10% of bettors-those placing the largest number of total wagers over the two years-about 95% ended up losing money, some dropping tens of thousands of dollars.

How Often Do Gamblers Really Win? — WSJ

While these numbers look atrocious, they are nothing compared to day trading stats. By gambling, you have a 13x better chance of making a profit than when you are day trading.

The study evaluated the long-term performance of 450,000+ day traders from 1992-2006 in the Taiwanese stock market. The data contained 3.7 billion transactions with a transaction value of $10 trillion, and almost all the day trading was done by individual investors. In a given year, 20% of day traders earned a profit net of fees. But less than 1% of traders from this group could generate a profit the following year.

The critical question is whether the alpha produced by this 1% of traders results from luck or skill. This is where it gets interesting. Data shows that the most successful investors continue to earn strong returns, highlighting that some traders are indeed skilled.

The top 500 traders (0.1% of the population) had clear performance persistence and earned outsized alpha of 61 bps per day before costs and 38 bps per day after fees.

In aggregate and on average, trading is hazardous to your wealth. Unless you are in the top 0.1% of traders based on skill, you are much better off gambling -- or, better yet, investing in a low-cost, diversified portfolio.

Source: The Cross-Section of Speculator Skill: Evidence from Day Trading — Barber et al.

4. Persistence of active performance

While we have covered the outperformance of passive over active multiple times, a common argument that comes up is most active managers are not all active managers, and “most of the time” is not all of the time.

Thankfully, S&P Global produces a yearly report that tracks the persistence of active management performance. The test is simple — If the outperformance was due to the genuine skill of the manager, it was likely to persist, whereas if the outperformance was due to luck, it would eventually run out.

For the analysis, S&P picks the top managers (top 50%) in each fund category for the first five years and checks what percentage of these top managers appeared in the top half of fund performance in the next five years. If the performance were completely random, we would see 50% of winners in the first five years to win in the second five years. If it was due to skill, we would see substantially more than 50% repeated in the second interval.

The results indicate that this was not the case — In none of the fund categories, outperformance in the first five years could predict outperformance in the subsequent years.

Source: U.S. Persistence Scorecard Year-End 2022

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Actionable Insights

• GPT 3.5 model successfully summarized and identified corporate risks from earnings call transcripts. The risk exposure measures were associated with significant alpha unexplained by the five-factor asset pricing model.

• Analysis of lifetime returns of 26,000+ stocks listed in the U.S. market from 1926 to 2019 shows that only 4% of stocks outperformed the value-weighted market index, and the top 1,000 companies accounted for all wealth creation.

• Building on the above trend, the JP Morgan group analyzed the factors leading to a business failure and found that most business failures were outside the management's control.

• Researchers generated abnormal returns by detecting outliers and out-of-pattern trades made by insiders from 1.2M corporate insider transactions.

1. Using Gen-AI to uncover corporate risks

Alex G. Kim, Maximilian Muhn, Valeri V. Nikolaev (University of Chicago) — open access

The study leveraged large language models (GPT-3.5) to identify and analyze critical aspects of emerging corporate risks using earnings call transcripts — with respect to Political, Climate-related, and AI risks.

More than 69,000 earnings call transcripts were used in the study, and the GPT model was instructed to make human-readable risk summaries (focusing solely on the transcripts) and risk assessments (incorporating the general knowledge of the AI). The summaries are then converted to a quantitive value.

A higher-risk exposure was directly correlated with a higher market return that was unexplained by the existing five-factor asset pricing model

• Political risk — Annualized alpha of 5.28% (not statistically significant)

• Climate risk — Annualized alpha of 6.72% (statistically significant)

• AI risk — Annualized alpha of 6.36% (statistically significant)

2. Long-run outcomes in the U.S stock market

Hendrik Bessembinder (Journal of Investing) — open access(1), open access (2)

Hendrik evaluated the lifetime returns of every U.S. common stock (26,168 firms!) from 1926 to 2019 and benchmarked it against 1-month treasury bill returns. The results highlight how difficult it is to pick the right stock:

• The U.S. stock market increased shareholder wealth by $47.4 trillion — but the majority (57.8%) of companies underperformed the treasury bill during the same time period.

• Picking a single stock underperformed the value-weighted index in 96% of simulations and the equal-weighted index in 99% of simulations.

• Only 4% of stocks outperformed the value-weighted market index, and 0.3% (86 stocks) collectively accounted for more than half of the entire wealth creation.

• Finally, the top 1,000 stocks (~4% of the entire base) accounted for all the wealth creation — i.e., 96% of the stocks just matched or underperformed the treasury returns.

[emphasis by author]

The results presented here reaffirm the importance of portfolio diversification, particularly for those investors who view performance in terms of the mean and variance of portfolio returns.

The results here focus attention on the possibility that poorly diversified portfolios will underperform because they omit the relatively few stocks that generate large positive returns.

Actively managed portfolios tend to be concentrated. The results, therefore, help to explain why active portfolio strategies most often underperform benchmarks (such as the S&P 500 return) that are constructed as average returns across securities available for investment.

3. Problems with concentration

JP Morgan Asset Management — open access (2021 report, 2014 report)

In their 2021 report, JP Morgan examined the critical reasons businesses fail. They found that more than 40% of the companies in Russell 3000 experienced a catastrophic stock price loss (70%+ decline in stock price) and that the median return for an individual stock in Russell 3000 was negative. Only ~10% of the companies generated more than 500% return over the 40-year period. (1980-2020)

The interesting finding was that most business failures were outside the management's control.

[emphasis by author]

Great fortunes have been created by visionaries who seized a unique opportunity and work singlemindedly to realize their ambition. Concentration is an effective engine of wealth creation: In the US, the top 10 of the “Forbes 400” also made their fortunes through concentration.

As difficult as it is to build a company and amass wealth, it is just as difficult to keep fortunes aloft. Our analysis (and others before it) demonstrates the hard reality that, all too often, continued concentration may ultimately destroy wealth.

4. Is there alpha in corporate insider trading?

Fevzi Esen, Emrah Bilgic, Ulkem Basdas — not open access

The Random Walk theory states that stock prices are random and implies efficient markets. One exception to this can be company insiders — due to the nature of their work, they possess information unavailable to the public.

Researchers investigated more than 1.2M transactions from 2010 to 2018 and used outlier detection to identify out-of-pattern trades made by insiders. The findings indicated that all insider transactions generated significant abnormal returns, with outlier transactions having higher returns.

In general, studies suggest that corporate insiders were willing to exploit their preferential and superior access to non-public information in order to get an unfair informational advantage over the market.

Besides, the profits generated by insiders (i.e., the returns of these trades) were found to be statistically significant

How to detect illegal corporate insider trading? - Fevzi Esen et al.

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Actionable Insights

• There is a negative relationship between consumer sentiment and subsequent stock returns. (particularly interesting given the extreme fear in the market)

• While past performance could predict future outperformance in mutual funds in the 80s and 90s, the latest research suggests that this alpha is vanishing.

• Unsurprisingly, the latest SPIVA report highlights that 92% of large-cap mutual funds have underperformed the S&P 500 over the past 15 years.

• Investing in “sin” stocks generated a Fama-French 6-factor alpha of 4%.

• Companies having wide moats continue to outperform the market and generate excess shareholder returns.

1. Relationship between Consumer Sentiment and Stock Returns

Kenneth L. Fisher and Meir Statman — open access

Guide to the markets — JP Morgan

JP Morgan released a report that highlighted the effectiveness of using consumer sentiment for investing – On average, the S&P 500 returned only 4% in the next 12 months if you invested when the consumer sentiment was at its peak, whereas if you invested when the consumer sentiment was at its lowest, over the next 12 months, your average return would have been 24.9%! A 6x return increase just by investing when everyone else was skeptical.

But, the above analysis suffers from classic hindsight bias – we cannot know in advance if the consumer sentiment we see today is at a new peak or an all-time low.

Kenneth Fisher was one of the first investors to find the edge using consumer confidence & investor sentiment. He found a negative and statistically significant relationship between investors' sentiment and subsequent stock returns. But, he highlighted the shortcomings of using it for asset allocation (emphasis added).

The negative relationship between consumer confidence and subsequent stock returns is useful to investors even if it is too weak for robust tactical asset allocation.

The fact that low levels of consumer confidence predict high rather than low subsequent stock returns should reassure investors that consumer confidence and stock returns do not follow each other in an endless downward spiral.

Indeed, when people lose confidence as consumers, they should regain it as investors. – Kenneth Fisher

2. Can past performance predict the future outperformance of Mutual Funds?

Mark M. Carhart (1997) — open access

James J. Choi & Kevin Zhao (2018) — open access

Mark Carhart published his seminal study on this in '97 and found that past-year performance positively predicted the U.S. equity mutual funds’ future performance. The top 10% of the funds from the previous year outperformed the bottom 10% by 0.67% per month! (1963 - 1993).

The outperformance was mainly attributed to individual stock momentum. Momentum investing is well-proven, and funds with outperformance tend to hold high-momentum stocks. Fund managers rarely sell their winners, and the momentum effect carries over to the following year.

However, the study was done more than 25 years ago. When researchers at Yale University replicated the research done by Carhart and expanded it till 2018, they found that the best-performing mutual funds did not produce any alpha.

The difference in the 10-year rolling alpha of the top and bottom 10% mutual funds has declined over time, and after 2012, the bottom decile funds are performing marginally better.

3. Active vs Passive debate — Latest update from SPIVA

SPIVA report by S&P Global — open access

SPIVA Scorecard is considered the de facto scorekeeper for the active versus passive debate. Their methodology and data are immaculate, with adjustments for survivorship and calculating both equal and asset-weighted returns.

Here are the key takeaways from the latest report:

• 92% of large-cap mutual funds have underperformed the S&P 500 over the past 15 years.

• A majority of large-cap managers outperformed the S&P 500 only thrice in the last 23 years.

• In the first half of 2023, growth was king — 90% of large-cap value managers underperformed the index vs. only 13% of large-cap growth managers.

• The S&P 500 growth index has posted its best first-half performance since 1998 (+21.2%), and last year's worst-performing sector (Communication Services: -22%) was among the best performers in H1’23 (+19%).

• Most of the S&P 500 returns were driven by the index’s largest constituents.

  The average return of the stocks in the S&P 500’s largest capitalization decile was more than double the average return of the next-best-performing decile.

• Finally, over a 10+ year time horizon, there were no categories (small cap, mid-cap, value, etc.) where a majority of active managers outperformed.

4. Investing in sin stocks

Hamid Boustanifar, Patrick Schwarz — open access

Consider this controversial investment strategy: Investing in companies profiting from “sinful” services or products like tobacco, alcohol, and gambling. In 2020, over $15 trillion was invested with negative screening, excluding these companies from most funds, regardless of their appeal. Could this create a pricing imbalance that active investors could exploit?

To find out, the researchers analyzed the annual reports from 13,740 companies (1996 to 2021). Instead of using traditional industry classification to identify sinful companies, they used textual matching. If the company's annual report contained multiple mentions of words and phrases related to sin industries, they considered those companies in the final portfolios.

The portfolios were created using three methods

1. Value-weighted

2. Equal-weighted

3. Sin-weighted (in proportion to the exposure of the companies to sinful industries)

While (1) and (2) had no statistically significant outperformance, a sin-weighted portfolio (3) generated an annualized Fama-French 6-factor alpha of 4%1.

5. Do durable competitive advantages convert to shareholder value?

Srinidhi Kanuri & Robert W. McLeod — not open access

Warren Buffett was one of the first to popularize the concept of economic moats with his 2007 letter to Berkshire shareholders.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.

Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.

Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Kanuri et al (Applied Economics) evaluated the performance of wide moat stocks from 2002 to 2014 using the Morningstar Direct stock database2.

All the wide moat stocks were used to create a portfolio starting in June 2002 and then updated every year based on the new list released by Morningstar. Both equal and market cap weighted indexes were formed for the portfolio backtest. The results were promising.

Wide moat stock portfolios were able to beat both the S&P 500 and Russell 3000 by a significant margin while having lower volatility. The risk-adjusted returns were also excellent, as seen from the Sharpe Ratio. They went one step further and evaluated the performance of the wide moat portfolio during the 2008 financial crisis and found similar trends. (emphasis by author)

Our results indicate that the Wide Moat portfolio performed better/lost less value than both S&P 500 and Russell 3000 indices during the 2007–2009 financial crisis as Wide Moat portfolios (both equal- and value-weighted) had better absolute and risk-adjusted returns over both the indices.

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If I have seen further, it is by standing on the shoulders of Giants — Isaac Newton

A relatively little-known fact is how much of a role Nobel Laureate economist Paul Samuelson played in the creation of the index fund. While John Bogle hinted at the idea of an index fund in his thesis at Princeton University way back in 1951, it was Dr. Samuelson’s challenge in the Journal of Portfolio Management (1974) that gave John the much-needed confidence to take on the industry.

Samuelson laid down an express challenge for somebody, somewhere to start an index fund.

That, at the least, some large foundation set up an in-house portfolio that tracks the S&P 500 Index-if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess

The American Economic Association might contemplate setting up for its members a no-load, no-management-fee, virtually no-transaction-turnover fund.

Bogle took up the challenge and his company The Vanguard Group launched the first index fund in 1976 — The rest is history.

This is just one example of academic research being years ahead of industry. In 1982, Rolf Banz published a report that showed that small stocks had consistently higher average risk-adjusted returns that the efficient market hypothesis could not explain— A trend that exists to this day1 (Since 1990, small-cap stocks have outperformed large-cap stocks by 45%). Momentum strategy was identified more than 30 years ago2 and it has beaten the market consistently and the trend has held in 40 different countries over 12 different asset classes3.

Following academic research is the key to staying informed about emerging trends and innovative investment strategies. What we have found from our last 3 years of exploration is that identifying academic developments early can give investors the much-needed competitive edge to create alpha-generating strategies that are not yet mainstream.

But, this is easier said than done. There are 64 million academic papers published since 1996 and ~5 million articles that are being added every year. Keeping up with the latest developments in their own field is challenging for seasoned academicians.

So, starting this week, in addition to our deep dives, we will be curating a list of the most impactful and interesting developments in the investing space from academia. You can vote on what you thought was the most interesting one at the end and we will do a comprehensive deep-dive on it.

Before we jump in, here is Charlie Munger on how he made $500m from reading finance magazine Barron’s4:

I read Barron’s for 50 years. In 50 years, I found one investment opportunity in Barron’s. I made ~$80m with almost no risk. I took the ~$80m and gave it to Li Lu, who turned it into $400-500 million.

So I have made $400-500 million from reading Barron’s for 50 years and following one idea.

1. Can ChatGPT Forecast Stock Price Movements?

Alejandro Lopez-Lira & Yuehua Tang (University of Florida) — Full paper (open access)

In this, the authors tried to answer the question that’s on all of our minds. They prompted ChatGPT to pretend to be a financial expert and to respond with yes, no, or unknown to the question of whether a particular headline is good or bad for a company.

Based on the average score using all available headlines against each company, they built a simple long-short strategy that buys stocks with a positive score (aka positive sentiment) and sells stocks with a negative score. The results were stunning:

Ignoring the transaction costs, a long-short strategy on ChatGPT-3.5 returned 550% from 2021 Oct to 2022 Dec with both the long side delivering 200% and the short side delivering 250% (during the same period, the S&P 500 was down ~10%!)

2. A Sober Look at SPACs

Michael Klausner, Michael Ohlrogge, Emily Ruan — Full paper (open access)

If there was one thing most investors should have read in 2020, it should have been this. During the bull run of 2020-21, more than 861 SPAC IPOs occurred in the U.S. (compared to the less than 20 per year average over the past decade). Chamath Palihapitiya was the SPAC poster boy and he was even called the next Buffett (he even compared his fund’s performance to Buffett’s).

Almost all of his SPACs underperformed the market with some losing up to 95% of their value. But, by selling most of his shares early, he roughly doubled the $750 million he put in while small investors were left holding the bags.

The authors calculated the staggering total costs associated with a SPAC deal — For all the SPACs that merged from Jan 2019 to Jun 2020, the mean total costs as a percentage of pre-merger equity was 58%!

That means that a SPAC share worth $10 only has $4.10 net cash per share at the time of the merger. They also found that post-merger, the company share price declined in proportion to the pre-merger net cash — Meaning long-term SPAC holders ended up bearing all the costs.

We find that SPAC costs are not borne by the companies they take public, but instead by the SPAC shareholders who hold shares at the time SPACs merge. These investors experience steep post-merger losses, while SPAC sponsors profit handsomely.

3. Why do equally weighted portfolios beat value-weighted ones?

Alexander Swade, Sandra Nolte, Mark Shackleton, and Harald Lohre — Full paper (open access)

A vast majority of index funds and ETFs are value-weighted. As the companies become more valuable, more capital is allocated to them. The top 5 companies (1%) of the S&P 500 contribute close to 22% of the total S&P500 market cap.

Based on existing research5, equal-weighted portfolios have consistently outperformed their value-weighted counterpart. The key reason for the outperformance as found by the authors was that by design, the equal-weighted portfolio overweight into small-cap companies (thereby activating the size premium).

They also found that equal-weighted portfolios tend to perform better when there are short-term trend reversals in the market (As we are focused on selling winners and buying losers in an equal-weight strategy) but suffer from a negative momentum exposure.

4. Can commodities add the necessary diversification to portfolios?

Vianney Dequiedt, Mathieu Gomes, Kuntara Pukthuanthong, and Benjamin Williams-Rambaud — Full paper (open access - preprint & not peer-reviewed)

The study investigated the diversification benefits provided by commodities across 38 different markets. While commodities are usually considered to add diversification benefits to the portfolio6, the authors found that the diversification benefits depend on how much the investor country is dependent on commodities.

Specifically, we establish that investors in high-commodity-dependent countries generally do not accrue benefits from adding commodities to their portfolios. In contrast, those located in low-commodity-dependent countries typically do.

Whether and how much to add commodities to your portfolio is a function of your country’s dependency on commodities. Investors in countries like Brazil, Russia, Australia, etc. who have high dependency on commodities do not tend to benefit by adding commodities to their portfolios.

5. International diversification is still important for U.S. investors

Cliff Asness, Antti Ilmanen, and Dan Villalon (AQR) — full paper (open access)

AQR research recently published a report in which they argued that the U.S. outperformance was mainly driven by valuation changes rather than fundamental improvements in the economy (emphasis by author)

Since 1990, the vast majority of the US’s outperformance versus the MSCI EAFE Index (currency hedged) of a whopping +4.6% per year, was due to changes in valuations.

The culprit: In 1990, US equity valuations (using Shiller CAPE) were about half that of EAFE; at the end of 2022, they were 1.5 times EAFE. Once you control for this tripling of relative valuations, the 4.6% return advantage falls to a statistically insignificant 1.2%.

In other words, the US victory over EAFE for the last three decades—for most investors’ entire professional careers—came overwhelmingly from the US market simply getting more expensive than EAFE.

Almost everyone considers the U.S. to be the best market, which in turn pushes the prices of securities upward. As value investing teaches us, winning simply because the other person is willing to pay more is not a sustainable strategy.

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Data, references, and footnotes