Great analysis of Warren Buffett’s above-market returns. The authors find two reasons for his success: 1) stock selection tilted towards high-quality companies available at great prices, and 2) use of low-cost leverage. Not exactly a RP article, but helpful connections regarding leverage.
Read the original:
Important Points for the RP Investor:
Warren Buffett’s demonstrated ability to achieve returns in excess of the market as a whole is certainly legendary. The authors cite +18.6% in excess returns over T-bills from 1976 until March 2017, and honestly, if you could achieve the same returns over the next forty years, you’d hardly need to worry about 4% withdrawal rates of risk-balanced portfolio construction. To look at the reasons behind Buffett's success, the authors promise “a thorough empirical analysis of Buffett’s results in light of some of the latest research on the drivers of returns” (35). Namely, the authors examine Buffett's returns in relation to the standard factors: market risk, size, value, and momentum (43) and then add two more: Betting Against Beta (which amounts to over-weighting low-beta stocks), and quality (preference for profitable, growing, and safe companies with higher payouts (45).
Through their analysis, the authors find that Buffett’s success is not well explained by the first four standard factors. By adding the two other factors, though, the authors find that Buffett’s holdings in Berkshire Hathaway are tilted significantly towards low-beta and towards quality. Basically, he buys “safe, high-quality, value stocks” and when accounting for these in the analysis, the alpha for Buffett’s portfolio drops to a “statistically insignificant annualized .3%” (45).
A second key to Buffett’s success is his use of leverage within Berkshire Hathaway. The authors calculate his average leverage somewhere between 1.4 and 1.7, depending on how it is calculated. In addition, part of this leverage is from the “float” of the insurance business - people pay premiums regularly, creating a pool of low-cost capital (1.72%, about three percentage points less than T-bills) on which to draw. The leverage by itself would only increase a market rate return to 12.7%, so Buffett’s 18.6% average return is clearly enhanced by leverage but not solely attributable to it.
In all, not exactly a paper directly connected to Risk Parity, but there is definitely something that Risk Parity practitioners can take from the article, namely that modest amounts of leverage, applied to a sensible, risk-balanced portfolio, can be used to positive effect. Recall the two approaches to RP: risk-balanced portfolios without leverage or with leverage, and the experience of Berkshire Hathaway is a positive example of the second half.
Other Resources Related to this Paper:
- A paper that really ties this one to Risk Parity is another by two of the same authors, Frazzini and Pedersen, this time with Cliff Asness. They argue that RP is a good approach to portfolio construction, but not implemented as much as it theoretically should be due to investor’s aversion to using leverage. Unwilling to try that approach, but unsatisfied with the annual returns of risk-balanced, non-leveraged portfolios, they abandon diversification in pursuit of riskier concentrations in asset classes with higher expected return.
- I haven’t read them yet, but this paper cites two previous papers by Frazzini and Pedersen that are now on my list: 1) “Embedded Leverage” from 2012, and 2) “Betting Against Beta” from 2014. I’ll read them soon, and if they fit, can see their addition to this collection of resources.
- The authors are all affiliated with AQR Capital Management. Andrea Frazzini and Lasse Pedersen are both Principals, and David Kabiller is a Founding Principal.