Looking at its 35-year track record, some now consider the Sequoia Fund (SEQUX) an anomaly; it is an actively managed fund that has persistently generated positive risk-adjusted returns, outperforming its peers and its benchmark. Should investors expect this outperformance to persist?
The Sequoia Fund has long been one of the foremost names in mutual funds. Morningstar reports that, as of the end of January 2015, the fund had more than $8 billion in assets.
The fund maintains a reputation as a value-oriented investor forged in the mold established by Benjamin Graham and David Dodd. In a 1984 speech Warren Buffet gave in honor of the 50th anniversary of the publication of Graham and Dodd’s book, Security Analysis, he identified Sequoia as one of “The Superinvestors of Graham-and-Doddsville.” The fund currently carries Morningstar’s coveted five-star rating.
From its inception on July 15, 1970 through December 2014, the fund returned 14.54% per year. Compare that to a 10.98% per year return for the S&P 500 Index. Not only did Sequoia provide much higher returns than the S&P 500, but its risk-adjusted returns were also much greater. For the period from 1971 through 2014, Sequoia’s Sharpe ratio was 0.57 versus 0.40 for the S&P 500.
The fund’s reputation certainly seems well deserved. Before drawing any firm conclusions, however, let’s dive deeper into the fund’s performance. We’ll begin by analyzing data to determine the factors to which the fund was exposed and whether or not it generated risk-adjusted alpha. The data is available beginning in February 1980.
To start, we’ll perform a three-factor analysis (beta, size and value). The table below provides the factor loadings and alpha from February 1980 through December 2014.
2/1980-12/2014 |
Market (Beta) |
Size |
Value |
Annual Alpha |
SEQUX |
0.71 |
-0.16 |
0.29 |
2.63 |
t-stat |
23.3 |
-3.2 |
5.9 |
1.7 |
Not surprisingly, the three-factor analysis shows the fund tended to buy large value stocks and generated an annual alpha of 2.63%. Although the alpha was not quite statistically significant at the 5% confidence level, it certainly was economically significant.
Next, we’ll look at the performance for the last 15 calendar years, 2000 through 2014, to see if there was a trend in the fund’s ability to generate alpha.
1/2000-12/2014 |
Market (Beta) |
Size |
Value |
Annual Alpha |
SEQUX |
0.62 |
-0.16 |
0.41 |
4.39 |
t-stat |
14.0 |
-2.2 |
6.3 |
1.9 |
We see that the fund’s annual alpha actually was higher over the most recent 15 years at 4.39%. The loadings show that it continued to stick to its knitting as a large value investor. The alpha came very close to being statistically significant at the 5% confidence level.
We’ll now move to a four-factor analysis, adding the momentum factor. We begin with the analysis for the period beginning February 1980.
2/1980-12/2014 |
Market (Beta) |
Size |
Value |
Momentum |
Annual Alpha |
SEQUX |
0.70 |
-0.18 |
0.26 |
-0.09 |
3.52 |
t-stat |
22.0 |
3.7 |
5.3 |
-2.9 |
2.2 |
The results are fairly similar to those observed in the initial three-factor analysis. The annual alpha of 3.52% was statistically significant at the 5% level.
As we did before, we’ll also analyze the most recent 15-year period, 2000 through 2014.
1/2000-12/2014 |
Market (Beta)
|
Size |
Value |
Momentum |
Annual Alpha |
SEQUX |
0.58 |
-0.17 |
0.40 |
-0.10 |
4.98 |
t-stat |
13.0 |
-2.4 |
6.2 |
-3.0 |
2.2 |
The results are once again similar, though the alpha has jumped to about 5%, and it’s statistically significant at 5%.
Now we’ll expand our analysis to include a fifth factor, quality. Research has shown high-quality stocks that are profitable, stable, growing and have a high payout ratio outperform low-quality stocks with the opposite characteristics. These are the kind of stocks Warren Buffett has always said he likes to buy.
2/1980-12/2014 |
Market (Beta) |
Size |
Value |
Momentum |
Quality |
Annual Alpha |
SEQUX |
0.86 |
0.04 |
0.36 |
-0.12 |
0.56 |
-1.21 |
t-stat |
24.9 |
0.7 |
7.6 |
-4.5 |
8.4 |
-0.78 |
The loadings on value and quality are high and have high t-stats. There’s also a small positive loading on the size factor, but it’s not close to being statistically significant. The big change we see is that adding the quality factor turned a large positive annual alpha into a negative one (-1.21%), though it’s not statistically significant.
In other words, the great performance of Sequoia isn’t explained by great individual stock picking skills. Instead, it can be explained by identifying, well before the academics did, the type of stocks to buy. These are quality stocks with the following characteristics: low earnings volatility, high margins, high asset turnover, low financial and operating leverage and low idiosyncratic risk.
The authors of the papers “Buffett’s Alpha” and “Betting Against Beta” found that once the exposure to common equity factors of Berkshire Hathaway’s public holdings were accounted for, a large part of Buffett’s performance was explained and his alpha was no longer statistically significant. The data sets for these studies are available on AQR’s website.
In his book The Intelligent Investor, Benjamin Graham provided the following seven criteria for investing:
Adequate size.
A sufficiently strong financial condition.
Continued dividends for at least the past 20 years.
No earnings deficit in the past 10 years.
Ten-year growth of at least one-third in per-share earnings.
Price of stock at no more than 1.5-times net asset (book or “balance sheet”) value.
- Price no more than 15-times average earnings of the past three years.
Only the last two characteristics would be considered value characteristics by most definitions. The first five are indicators of quality.
The latest academic findings don’t take anything away from the performance of the “superstar investors from Graham and Doddsville,” including Buffett and Sequoia. After all, they discovered the “secret sauce” decades before the academics did. The quality factor didn’t even exist until very recently.
However, we do know now that the source of Sequoia’s great performance wasn’t in picking individual stocks but in identifying the characteristics of stocks that generated the above market returns — value and quality — and then heavily loading on them, particularly on quality.
As before, we’ll also take a look at the last 15 years, 2000 through 2014, taking those factors into account.
1/2000-12/2014 |
Market (Beta) |
Size |
Value |
Momentum |
Quality |
Annual Alpha |
SEQUX |
0.82 |
0.10 |
0.39 |
-0.13 |
0.58 |
-0.01 |
t-stat |
15.0 |
1.3 |
6.9 |
-4.0 |
6.6 |
0.0 |
In terms of loadings, the results are pretty similar to those of the full period. But the annual alpha went from a statistically insignificant -1.21% to a statistically insignificant 0.
We can also compare Sequoia’s returns with those of the passively managed U.S. Large Value Fund (DFLVX) from Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.)
The table below presents the returns for the last 5-, 10- and 15-year periods ending January 31, 2015. For comparison purposes, the returns of Vanguard’s 500 Index Fund (VFINX) are also shown. Data is from Morningstar.
Fund |
5-Year
Annualized Return (%)
|
10-Year
Annualized Return (%) |
15-Year
Annualized Return (%) |
SEQUX |
17.6 |
9.2 |
9.6 |
DFLVX |
16.4 |
7.8 |
8.6 |
VFINX |
15.4 |
7.6 |
4.5 |
Over the 5-, 10- and 15-year periods, Sequoia outperformed DFLVX by 1.2 percentage points, 1.4 percentage points and 1.0 percentage point, respectively. Its results are particularly impressive because, even with the survivorship bias in Morningstar’s data, DFLVX’s percentile rankings were 3, 16 and 6, respectively. Thus, DFLVX outperformed 97%, 84% and 94% of the actively managed large value funds surviving the period. The margins of outperformance versus the fund’s category were an impressive 3.1 percentage points, 1.4 percentage points and 2.2 percentage points, respectively. And, again, that’s even with survivorship bias in the data.
The following analysis demonstrates the sources of the returns for the two funds over the 15- year period from 2000 through 2014. The t-stats are in parentheses.
1/2000-12/2014 |
Market (Beta) |
Size |
Value |
Momentum |
Quality |
Annual Alpha |
SEQUX |
0.82
(15.0) |
0.10
(1.3) |
0.39
(6.9) |
-0.13
(-4.0) |
0.58 (6.6) |
-0.01
(0.0) |
DFLVX |
1.17
(41.2) |
-0.01
(0.37) |
0.67
(22.2) |
-0.14
(-8.3) |
0.33
(7.1) |
-0.84
(-0.8) |
We see further evidence of Sequoia’s outstanding performance in comparing its Sharpe ratio (SR) to that of DFLVX:
For the full period 1994-2014, SEQUX’s SR ratio was 0.62 versus 0.50 for DFLVX.
For the 15-year period 2000-2014, SEQUX’s SR was 0.63 versus 0.42 for DFLVX.
For the 10-year period 2005-2014, SEQUX’s SR was 0.58 versus 0.41 for DFLVX.
For the 5-year period 2010-2014, SEQUX’s SR was 0.72 versus 0.48 for DFLVX.
Summary
Sequoia’s results are clearly impressive. While DFLVX’s rankings provide a strong example of how active management is a loser’s game, Sequoia’s results also demonstrate that it’s not impossible to win a loser’s game, just highly unlikely.
As other fund families incorporate the latest research into their fund construction strategies, outperformance becomes even more challenging. This is the topic of my new book, co-authored with Andrew Berkin, The Incredible Shrinking Alpha. We present four themes that we believe have raised the hurdles to generating alpha: the sources of alpha are being converted into beta (loading on common factors), the supply of victims needed to exploit is shrinking (every year the percentage of dollars invested in active strategies is decreasing), the remaining competition is getting tougher (as the losers, with less skill, drop out), and more dollars are chasing the shrinking supply of alpha.
With the source of Sequoia’s great performance – the quality factor – now well known, will they be able to continue to generate such great relative returns? This is an interesting question that only time will answer.
Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.
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