DISCLAIMER: The opinions in this article are my personal perspective on a given prospective topic and should not be considered investment advice. Due diligence should be exercised and readers should engage in additional research and analysis before making their own investment decision. All relevant risks are not covered in this article. Readers should consider their unique investment profile and seek advice from an investment professional before making an investment decision. I’m not a client of the IFA. The conversation between Mark and me was private and of an exchange-driven nature.

Just before Christmas 2022, I had the opportunity to talk with Mark Hebner from Index Fund Advisors (IFA) about many different topics in the investment realm. The one-hour planned meeting turned into two and then nearly three hours as we talked about passive investing, index funds, investing history, research, and data.

The IFA has $4.41 bn in assets under management and an investment strategy that provides investors returns in line with the expected returns of different benchmarks. Mark’s team builds passively managed portfolios that balance expected returns with volatility to adapt to the investor’s risk appetite.

Here is a link to an interesting chart that shows IFA’s Asset under management growth over the last 20 years.

The IFA and Mark provide a plethora of free resources for people who would like to learn more about passive investment strategies and how they have historically related and outperformed actively managed funds, stock-picking, and other investment strategies.

Let's jump to our conversation!

The Random Walk Theory

One key topic in our discussion was the random walk theory. Coined by the economist and statistician Alfred Cowles in the early 20th century. The book “A Random Walk Down Wallstreet” written by Burton Malkiel argues that stock prices are unpredictable and that it is impossible to consistently beat the market using past performance to predict future prices.

Understanding the random walk theory requires us to look at the very basics of a normal distribution. The best example of how the normal distribution works is to look at a Galton board.

The Galton board consists of a vertical board with interleaved rows and pegs. Small beads are dropped from the top, and when level, they drop through a small center funnel and bounce either right or left when they hit the pegs. The beads traverse through the board and fall into different bins. No matter how many times you repeat this test, the result will always be that the beads distribute in the shape of a bell curve throughout the bins.

Why is the Galton board crucial to understand when thinking about investing?

The stock market consists of millions of individuals buying and selling equities at different prices, weighing risk and reward, and processing information. The free market is a highly efficient system that garners, comprehends, and processes information from many different sources and allocates it in the form of prices from one area to the other.

The idea is simple, investors, companies, industries, and whole economies react to market demands. If you find a highly profitable industry, other market participants want to participate, increasing participation and decreasing profitability until the market reaches some equilibrium.

The core idea is that the market already processed all available information in the price. Even the most active investors in the world with access to real-time data can't outperform the information processing skill of the market - so how can individual investors?

Enough studies have shown that they can't. Especially not consistently over 20-30 years. There are many reasons for the underperformance of individual and active fund managers; some include trade frequency, style shifts, trading costs, emotions, buy-high-sell-flow trades, and many others. The issue is that people often see the few that outperform the markets and think their style is replicable. They don't consider that the return distribution of individual investors is also normally distributed. There will always be a few that outperform those on the very right side of the Galton board. But most investors won't outperform index investing and actively give up potential gains by pursuing stock-picking techniques.

Even in studies that show that individual investors can outperform the markets, these studies specifically state that only the minority can do so, while the majority underperforms when pursuing stock-picking strategies.

Yet, saying that stock-picking doesn't work for the majority of people would make stock-picking subscriptions meaningless. So, it's not very popular on forums like Twitter and platforms.

Here are a few studies that discuss individual investor performance vs. market returns:

Rob Bauer, Mathijs Cosemans, Piet M. A. Eichholtz: "Option Trading and Individual Investor Performance
Steffen Meyer et al.: "Just Unlucky? - A Bootstrapping Simulation to Measure Skill in Individual Investor's Investment Performance"
Coval et al.: "Can Individual Investors Beat the Market?"
Schlarbaum et al.: "Realized Returns on Common Stock Investments: "The Experience of Individual Investors"
Barber et al.: "The Behavior of Individual Investors"
Barber et al.: "The Common Stock Investment Performance of Individual Investors"

These studies compare active fund managers' performances to market returns. Here are a few studies that discussed this topic in detail:

Mark M. Carhart, "On Persistence in Mutual Fund Performance"
Edwin J. Elton, Martin J. Gruber, Christopher R. Blake, "Fundamental Economic Variables, Expected Returns, and Bond Fund Performance"
SPIVA Institutional Scorecard
ESMA Report on Trends, Risks and Vulnerabilities: "Net performance of active and passive equity UCITS"

Cost of Capital, Expected Return, and Fair Price

At the beginning of our conversation, Mark and I discussed a company's fair price. There is no "correct" price, only a fair price, which is used to calculate the expected fair return.

When it comes to the fair price of a stock, investors must understand the company's cost of capital, risk premium, intrinsic value, and expected return on the stock. When buying a piece of a company in the form of stock, the ownership of the stock must provide at least the company's cost of capital + the risk premium. Otherwise, investing in the company would be unwise.

The cost of capital represents the minimum return that investors require for providing capital to a company, and it is used to evaluate potential investments and projects. The cost of capital is typically made up of the returns required by different types of investors, such as equity holders and debt holders. The return for equity holders, such as stockholders, is represented by the company's stock price and dividends, while the return for debt holders, such as bondholders, is represented by the interest rate on the company's bonds.

The interest rate on a company's bonds is directly related to the company's cost of debt capital. When a company issues bonds, it promises to pay bondholders a fixed interest rate over the bond's life. This interest rate, also known as the coupon rate, is determined by the bond market and reflects the level of risk associated with the company's bonds.

The conclusion is that the price is always right because the seller's (the company) cost of capital is the investor's rate of return. These two are fighting for the right price to trade.

On the IFA website is a nice animated chart showing how the random walk theory operates on the stock market. It balances the uncertainty of expected returns against the fair price and tilts the probabilities for the expected return of the buyer and the expected cost of capital for the seller. Access the animated chart through this link (Chart name: The Random Walk of monthly Market Returns.)

I would like to provide an example to make this point clearer:

Let's say a company, XYZ Inc., is looking to raise $10 million to expand its business. The company has two options to raise this capital: issuing new shares of stock or issuing bonds.

If the company chooses to issue new shares of stock, it will need to offer a return to shareholders that is high enough to attract them to invest. Let's say that the required return for shareholders is 10%. In this case, the company's cost of equity capital is 10%.
If the company chooses to issue bonds, it will need to offer a return to bondholders that is high enough to attract them to invest. Let's say that the required return for bondholders is 5%. In this case, the company's cost of debt capital is 5%.

The company's overall cost of capital is the weighted average of the cost of equity and the cost of debt. To calculate the overall cost of capital, multiply the cost of equity by the proportion of equity in the capital structure and the cost of debt by the proportion of debt in the capital structure and sum them up.

Assuming that the company has decided to raise 60% of the $10 million in equity and the remaining 40% in debt. The overall cost of capital is: (0.6 * 10%) + (0.4 * 5%) = 6% + 2% = 8%

In this example, the company's cost of capital is 8%, which means it needs to generate a return of at least 8% on its investments (the projects it's working on) to attract capital from investors. If the company generates a return of 10% for shareholders and 7% for bondholders, it is meeting the return requirements of its investors and maintaining a fair price for the stock.

Existing shareholders don't want to sell their stocks after generating their 10% return when the future cost of capital remains high. That's why they require a higher price at which they would sell to reflect the future returns that the company would provide them.

On the other hand, the company wants a higher stock price to reduce its cost of capital. They can raise capital with a higher stock price by issuing new shares at a lower cost. In our example, at a 2x share price, the company could raise the same amount of capital at half the cost of equity.

A higher stock price can also indicate that the market perceives the company as having a higher intrinsic value, which boosts investors' confidence and attracts new capital to the firm, allowing it to raise more capital at a lower cost.

In summary, the cost of capital is the minimum return that investors require for providing capital to a company, and it is used to evaluate potential investments and projects. A lower cost of capital means that a company can access capital at a lower cost, which can benefit the company's growth and profitability. Shareholder return is the return that investors receive from the company, and it is usually measured by the company's stock price and dividends.

In a future article, I will discuss this matter in more detail. Mark and I discussed this topic in detail, and I had a lot of questions about it.

Volatility and Returns

Quoting Mark directly:

"Don't expect high returns without a high degree of volatility or uncertainty."

The reason why it's not possible to generate low risk and high returns is that the seller would keep the security as long as it takes to realize the high return and only sell the security for the future price at the lower risk.

Government bonds have such low returns because they're very safe with a low degree of volatility and uncertainty. On the other end of the spectrum are startups. These entail very high risk and uncertainty that has the potential to generate very high returns. These types of investments are not available for most people, as they also lock up the money for a long time, and selling shares is not straightforward for private entities.

The degree of uncertainty is usually measured with the standard deviation of the security.

Portfolio Construction

Talking with Mark about portfolio construction, he mentioned two critical ideas of the last 60 years.

The efficient market hypothesis
Factor Portfolios

The efficient market hypothesis is a well-known construct that free capital markets operate efficiently in determining the prices of securities. The core message that I took with me during this part of our conversation was that it's impossible to beat the market consistently over long periods. By using ETFs, investors can generate an expected rate of return by balancing known volatility and risk. I won't dive deeper into this topic as Mark explains this topic in much more detail on the IFA's website in his article "The Hebner Model: A Framework for How Markets Work."

The second part of this conversation was exciting. Mark investigated that all returns can be explained by three factors - Size, Value, and Profitability.

I wrote a long article discussing this topic, and it's closely related to research from Fama and French that investigated the returns of small and big stocks (above and below media company market cap within markets), value, and growth (growth stocks often have high profitability which rewards them with higher multiples, value stocks trade close to intrinsic value due to lower growth expectations.)

I studied the papers and came up with the following conclusions:

Small stocks earn higher returns than big stocks as they migrate from small to big. As the name suggests, big stocks have it more difficult to migrate higher. Big value (big stocks with low P/B ratio) can migrate towards neutral and growth. The probability for negative returns is highest for big growth stocks (high P/B ratios)
Value stocks are more likely to experience positive returns from improving their type (moving from value to growth, for example).
Growth stocks are more likely to experience negative returns from deteriorating their type.
Value stocks that stay in the same portfolio from one year to the next tend to have higher average returns than growth stocks that stay in the same portfolio.

Mark stated that the specific industries don't matter when looking at the return because the aforementioned three factors can mostly explain all returns.

Who can generate Statistically Significant Returns?

After we discussed market returns, stock-picking, portfolio construction, and volatility, we got into statistics. The equity market allows companies to access capital in exchange for a return for the investor. We already know that the return for the company is related to the company's cost of capital, the risk premium, its size, and the investor's risk appetite.

Can investors generate an alpha against the market consistently?

Mark says no.

The reason lies in statistics. When looking at the returns, Warren Buffett outperformed the market in the years after establishing Berkshire Hathaway until 2002. Between 2002 and 2022, his returns looked very different, and he could not consistently generate alpha. Warren Buffet underperformed or matched the market in 11 and outperformed in 9 out of 20 years.

An important statistical indicator for consistent outperformance is the t-stat (top right in the chart above.)

I will briefly explain the t-stat but will write an in-detail article about it in the future.

The t-stat is used in hypothesis testing to determine whether there is enough evidence to conclude that a portfolio generates a "statistically significant" return over a certain sample period. It also allows us to determine what returns we can expect going forward. Here is a nice article discussing this topic concerning investing.

Until 2002, Warren Buffett's t-stat was 2.97. A t-stat greater than 2 results in a 97.5% confidence that the outperformance is statistically significant. In the years following 2002, Warren Buffett's t-stat dropped to 0.3, which indicates that outperformance is attributable to luck rather than skill.

Over the whole 40-year period, Warren Buffett's t-stat is 2.63. This means that his returns can be attributed to skill rather than luck over the lifetime of Warren Buffett's fund. But investors that invested in his fund after 2002 could have invested in the Russel 1000 Value and generated similar results.

Most fund managers don't have a t-stat anywhere near the 97.5% confidence level, and the few that do are those few exceptions that always exist in a normal distribution.

SUMMARY

My conversation with Mark Hebner was enlightening. Mark has been in the investing space for over 20 years and has provided investors with automated, low-cost investing strategies that have provided consistent returns for over 20 years.

The IFA has an exceptional track record balancing risk and returns with its passive investment strategies. They choose high-quality mutual funds and ETFs with the three factors of size, value, and profitability to create portfolios with varying volatility and returns over 20-30 years. On the IFA charts page, you’ll find a neat compilation of their passively managed funds vs a plethora of stocks and fund managers. You can access that chart here. The name of the chart is “Why Diversify? Stocks vs. IFA Index Portfolios and Indexes”.

Active investors burden themselves with increased volatility, uncertainty, and risk by picking individual stocks to which they're prone to react emotionally when experiencing significant downturns. On the other hand, Index investing reduces volatility by using diversified ETFs that use the cost of capital, risk premium, and expected rate of return to reduce volatility and generate returns that move in line with the companies' cost of equity.

DISCLAIMER: The opinions in this article are my personal perspective on a given prospective topic and should not be considered investment advice. Due diligence should be exercised and readers should engage in additional research and analysis before making their own investment decision. All relevant risks are not covered in this article. Readers should consider their unique investment profile and seek advice from an investment professional before making an investment decision. I’m not a client of the IFA. The conversation between Mark and me was private and of an exchange-driven nature.

My Conversation with a $4 bn AUM Registered Investment Advisor