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Factor investing for stock pickers

Throughout the history of the stock market, certain traits have been proven to drive returns time and time again. This guide explains which of these traits beat the market and how you can profit from this knowledge.

The big secret of the best fund managers

CEO of Stockopedia
Ed Croft
CEO of Stockopedia

An eye-opening analysis was run by Mark Carhart in a controversial 1997 research paper titled "On Persistence in Mutual Funds".[1] He studied 31 years of fund returns to see if he could find proof of fund manager skill, or whether their relative performance could be explained by simple exposure to factors and trading costs. The chart below illustrates his breakdown of the 8% performance difference between the best and worst 10% of funds in the typical year.


He found that the best fund managers had a disciplined process for owning cheap and strong stocks, avoiding those that don’t, and keeping costs under control. He showed that the best fund managers didn’t outperform through any magic. Whether they realised it or not they did it through a low cost, systematic ‘factor investing’ process.

While the popular press will continue to glamorize the best performing fund managers, the mundane explanation of strategy and costs account for almost all the important predictability in fund returns. Mark Carhart

Is Warren Buffett the world’s greatest factor investor?

This idea was taken further in an astonishing assessment of Warren Buffett's skill in a 2012 paper “Buffett's Alpha”.[2] For those that don't already know, Warren Buffett is the most successful investor of all time with a fortune north of $100bn. The researchers found that mimicking Buffett's market beating returns would have been possible by any investor with a few simple rules and a bit of leverage.

In essence, we find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails.

The following chart from the paper illustrates the point:

Buffett-s Alpha2 (1)

It seems incredible, but their rigorous research shows that any investor who had systematically bought portfolios of high quality, cheap, low risk stocks with 60% borrowed money would have matched or bettered the great man win for win, decade by decade. Perhaps Warren Buffett's real genius was realising these simple rules outperformed the market decades before anyone else… so let's take nothing away from him!

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