My 'theory'/ reconciliation

The previous post on the forum on whether Buffett, Lynch, Jule Rob and the other legends were great investors or not, along with other WSO HF views along the same sentiment, really got me thinking and helped me reconcile some things I was grappling with.

I've read thru many WSO musings and some things that I've gathered and synthesized are:

(Feel free to skip thru these 3 points if you don't have the time - I've included a TL;DR that summarizes the 3 points)

1) One valid view on Buffett and the rest's returns are that - they are not 'clean alpha' and are mostly just beta. The value investing camp could have simply just rode the value factor and bore the value risk premium which justified the higher expected returns of the value factor. (Same goes for deep value investors who rode the additional size factor beta). These investors plausibly did not generate alpha while holding/ restricting all factors constant. 

(Skip this bracket if you want)

(To expound on this more technically just for fun, we know that Jensen's alpha is the intercept of the Security Characteristic Line. Therefore, Jensen's alpha is the risk-adjusted return where risk is a measure of the asset's contribution to portfolio risk, not just its standalone risk. Remember that the market only rewards systematic risk, because standalone risk can be diversified away. Therefore, Jensen's alpha is the 'real, clean alpha' that we get left over, when all factors, independent variables in our regression model, are held to zero.

The thing is, in performance attribution of legends like Buffett, the only facts that we can observe is their realized returns. The 'lazy' way to segregate alpha and beta is just to say that the market excess return is alpha. However, we don't know for sure what their Jensen's alpha is, after holding all their factors to zero.)

Of course, this view comes from a bias from certain pod shop prestige whores on WSO, who view the market neutral investing of the MMs as the most prestigious. No comment on whose right or wrong - both views are valid.

This view is actually the original rational explanation by the efficient market theorists, posited by Fama-French. They think that these successful investors just bore the factor risk premium and got lucky. Their returns are not due to mispricing. There's of course also the irrational explanation of the excess returns by the behaviouralists, but let's just leave it here for now.

2) One view on value investors is that they are quite annoying and hold some form of intellectual superiority over the others. They think that their long term holdings and search for deep value and margin of safety are some intellectual adherence to value investing principles, when in reality we all read the same books tbh. Value investors think their returns are alpha, and stem from a deep investment philosophy that heralds quality business analysis and of course some faith in eventual mean reversion to intrinsic value. However, academia has their own rationale for the excess returns of value which value investors do not subscribe to. 

In fact, the value factor has sucked for a decade now up until last year (AQR made monster returns in 2022)

3) The final view on the legendary investors that I've synthesized: is that value factor, momentum factor, size factor or WHATEVER aside, they all were riding the ultimate factor/ beta - the massive 20th century equity premium of the US, and US prosperity. 


Where am I getting at? TL;DR: the legendary successful investors MIGHT have just been beta riding.

What's my 'theory' that I'm trying to reconcile? Here's 1st smtg that I was wondering:

I read 'Pioneering Portfolio Management' a few months back and I reflected on the fact that Swensen, and endowments, pensions, foundations and FoFs in general, are so heavy on top-down allocation. (Swensen stresses the importance of both top-down and bottoms-up in his process)

At that time, I was a hardcore value investor. I read Buffett, Greenwald, Klarman, Graham. I adhered to value like a religion and I blocked out evidence to the contrary (e.g., momentum) because they didn't fit Buffett's 'Money Mind'. Therefore, I rejected top-down allocation in favour for bottoms-up security analysis

So I wondered, can a bottoms-up guy run an endowment/ family office/ FoF? Legit run the ENTIRE endowment thru bottoms-up investment selection like Baupost. I wonder how that'd work out.

2 days ago - it clicked to me how to reconcile all these conflicting viewpoints. It dawned to me that top-down allocation and bottoms-up security selection are 2 sides of the same coin. They're joined to the hip. 

Because assuming that the successful legendary investors like Buffett were just riding beta Vol (which is a valid perspective - Fama holds this view), then a way to reconcile top-down and bottoms-up is to DO TOP-DOWN ALLOCATION TO BETA FACTORS. This way, top-down and bottoms-up can be literally the same thing.

Instead of allocating to asset classes like traditional endowments, we allocate to beta.

We have to be extremely smart enough to determine, which factors, ex anteare poised to outperform and deliver higher expected returns (like how Ben Graham was visionary enough in the 1940s to deduce ex ante that value would outperform). Then, we allocate to managers riding those factor Vols.

This doesn't only have to apply to allocators. This can also apply to top-down global macro HFs making big directional bets but which hinge on a chain of assumptions. Instead of making top-down bets on global macro, make top-down bets on ex ante beta factors

Please contribute your views. I would love some constructive feedback. 

Thanks. Please share your thoughts as well if possible - that was my intention in putting my thoughts into writing. To generate healthy pushback

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