Mebane Faber at World Beta had a great post up yesterday talking about how difficult it is to sustain high Sharpe ratios over extended periods of time. Meb cites a great post by Wes Gray at the Turnkey Analyst that demonstrates the mathematical impossibility of generating high (20%-ish) returns over the long run. In my book Abnormal Returns: Winning Strategies from the Frontlines of Investment Blogosphere I cited that post as a cautionary tale for anyone claiming the ability to generate high returns for long periods of time.
Faber goes on to make an interesting observation about how it is that big investment themes in retrospect seem obvious. He writes:
What is really interesting to me is that often the great investment approaches seem so obvious in retrospect. Buffett has one of the best track records ever by buying cheap, safe, high quality stocks in a structure that allows for sub T-bill leverage. But the key is that he came to this realization before most. Ditto for the top endowments like Harvard and Yale and their extreme diversification – it is quite obvious now, but they were pioneering these concepts decades ago. The pioneering trendfollowers and managed futures shops caught onto an idea long before computers made it simple, as did Bogle (indexing), and DFA (quant multifactor).
The question is, what will seem obvious 10, or 20 years from now?
That is a great question. If the answer were obvious, Faber wouldn’t have to ask the question. It will be fascinating to see how things play out ten or twenty years hence. However I might argue with the question in that a focus on generating returns from the financial markets may be misplaced effort. What most individuals need is a broader definition of alpha. In my mind it is worth making a couple of general points.
The first is that short-term trading has been overtaken by algorithms. Therefore individuals (and institutions) looking to put their capital to work need to play an entirely different game. One that plays to their advantage. In my mind, that means focusing on the long term where the algorithms have yet venture. However for most individuals a focus on the financial markets isn’t all that helpful.
Second, to a large degree the market for beta, or exposures to asset classes and many strategies, like low volatility or dividends, is largely commoditized. The fees on these types of products are headed asymptotically towards zero. One could argue that beta is free and alpha is really expensive these days. As I argue in my book the only low-hanging fruit for investors these days has to do with strategies and tactics that lie outside the realm of portfolio management. These include maximizing tax benefits through aggressive tax loss harvesting and optimal asset class location.
If the goal of investing is to live a richer, fuller life and the opportunities by doing it through traditional investment techniques seems limited then it makes sense to look elsewhere. Beefing up our savings, more conscious consumption and investing in things, like education, that have the potential to generate returns in excess of financial markets all have the ability to increase our well-being without taking on more financial risk.
There are no easy answers to generating higher returns from the financial markets. The investors who delve into strategies that focus on leverage, complexity and opacity end up hurting many more investors than they help. Ultimately we investors (and consumers) can only pull those levers over which we have some control. While that may not be a satisfying to some one looking for “the answer” in the financial markets, it is more satisfying because it relieves us of the anxiety of putting all energies into something, the financial markets, over which we ultimately have little control.