A new study has claimed that God would eventually be fired if he was an active fund manager as even someone with perfect foresight of the best- and worst-performing companies would experience unacceptable periods of underperformance.
The study, by Wesley Gray, founder of the Alpha Architect asset management group, posed the question: “If God is omnipotent, could he create a long-term active investment strategy fund that was so good that he could never get fired?”
After testing his hypothesis, he said the answer to the question was striking: “God would get fired.”
Gray calculated the five-year total return for the largest NYSE/NASDAQ/AMEX firms since 1927, excluding those without a track record of this length. Then he created decile portfolios based on the forward five-year compound annual growth rate (CAGR), rebalancing the portfolios every fifth year – so the first portfolio was built on 1 January 1927 and held until 31 December 1931; the second portfolio was built on 1 January 1932 and held until 31 December 1936, and so on.
In the chart below, Decile 10 portfolios represent value-weighted portfolios sorted on future five-year top performers and the Decile 1 portfolios represent value-weighted portfolios sorted on future five-year bottom performers.
Source: Alpha Architect
The portfolio of best-performing stocks over five years compounded at nearly 29 per cent a year, but Gray said this is not the most interesting figure.
“The volatility is high on the ‘God’ portfolio — higher than the market,” he explained. “The Sharpe ratio is above 1, but not by much. A far cry from the 2+ Sharpe ratios touted by some hedge funds.
Ratios of best- and worst-performing portfolios vs index
Source: Alpha Architect
“But how about them drawdowns! The perfect foresight portfolio eats a devastating 76 per cent drawdown (Aug 1929 to May 1932).
“But the pain doesn’t end there,” he added, pointing to a chart of the highest maximum drawdowns, which showed nine further periods when the portfolio fell by more than 20 per cent, and four more where it fell by more than 30 per cent.
“Clearly, even a ‘perfect’ long portfolio can bring a long-only investor a ton of pain.”
Worst drawdowns of best-performing portfolio
Source: Alpha Architect
Gray then decided to expand the study – if God has perfect foresight, he would be able to spot the worst-performing companies as well as the best, which he would be able to make money from via shorting.
Therefore, he built a portfolio that went long the Decile 10 portfolios and short the Decile 1 portfolios.
While this “perfect” hedge fund would obviously have done amazingly well, with a CAGR of 46 per cent, this would still have been at the expense of a 47 per cent maximum drawdown, with numerous other occasions when it breached 20 per cent.
Yet Gray pointed out that “as many investment pros painfully recognise, managing money is often not about absolute performance, but relative short-term performance”.
“Another truism is that the S&P 500 ends up being everyone’s benchmark, regardless of the strategy — especially during a long-term bull market,” he said.
As a result, he compared the one-year relative CAGR of God’s hedge fund against the S&P 500 and came to the conclusion that “even God would get fired multiple times over”.
“The relative performance of God’s hedge fund is often abysmal and he’d surely make the cover of Barron’s or the Wall Street Journal on multiple occasions throughout his career,” he said. “The passive index would eat his lunch on multiple occasions — often getting beaten by 50 percentage points or more.
Source: Alpha Architect
“These results highlight the fickle nature of assessing relative performance over short horizons.”
He added: “The famous quote attributed – wrongly – to Keynes is spot-on: ‘Markets can remain irrational longer than you can remain solvent’.
“This study also highlights a truism for all active investors: they must have a long horizon.”
In this month’s edition of FE Trustnet Magazine, to be published this Friday, Svetlana Viteva of the Edinburgh Worldwide IT said that a willingness to accept volatility is one of the keys to the outperformance of her trust.
“The real beauty of investing in equities is the highly asymmetrical return profile that they offer,” she explained.
“If you look at our top performers, the drawdown is up to 70 per cent of the value during the time we have owned them, which does highlight the importance of fighting that urge to sell during periods of weakness.
“There is such a disconnect between the real world and how financial markets judge companies on their ability to deliver smooth operational performance quarter in and quarter out. Progress doesn’t happen in a linear fashion.”