Back in 1984, Warren Buffett wrote an article entitled “The Superinvestors of Graham-and-Doddsville” (referring to the book Security Analysis co-authored by Benjamin Graham and David Dodd) in which he argues that passively managed funds can generate alpha for investors (beat the market) more so than actively managed funds. In the July issue of Advisor Perspectives, Larry Swedroe bolsters this argument through a discussion of his book The Incredible Shrinking Alpha (co-authored with Andrew Berkin and published early last year).
Swedroe and Berkin contend that alpha is steadily morphing into beta; that instead of “beating the market” per se, systematic investing on the basis of factors such as value, size, and profitability can lead to greater overall returns. Specifically, they show that since 1998, the percentage of actively managed mutual funds generating “statistically significant alpha” has dropped from 20% to approximately 2%. Among the culprits identified (including retail investors’ shrinking share of the market and the dramatic increase in funds that are “chasing alpha”), Swedroe underscores the “paradox of skill” occurring in today’s investment community in which the rising number of new and talented investment professionals has led to a keenly competitive environment. So, even though the absolute skill of active managers is increasing, the race for the brass ring has made it increasingly difficult to make the grade.