For good reason, Warren Buffett has long been considered one of the greatest investors of his generation. In fact, Berkshire Hathaway (BRK ) has a higher Sharpe ratio (a measure of risk-adjusted returns) than any stock or mutual fund with a history of more than 30 years. Even after taking into account the four traditional factors (market, size, value and momentum), Berkshire has a significant alpha, or returns above an appropriate benchmark.

Which leaves the question: Whats the source of Buffetts alpha?

The conventional wisdom has always been that his success is explained by his stock-picking skills and his discipline. However, a new study by Andrea Frazzini and David Kabiller of AQR Capital Management, and Lasse Pedersen of New York University and the Copenhagen Business School, provides us with some very interesting and unconventional answers. The following is a summary of their findings:

• From November 1976 through December 2011, Berkshire realized an average annual return of 19 percent in excess of the Treasury bill rate, significantly outperforming the general stock markets average excess return of 6.1 percent.
• Berkshire stock also entailed more risk, realizing a volatility of 24.9 percent, 58 percent greater than the market volatility of 15.8 percent.
• Berkshires Sharpe ratio was 0.76 over the period November 1976-December 2011, nearly double the ratio of the overall stock market (0.39).
• That high Sharpe ratio does reflect high average returns, but it also reflects significant risk and periods of losses and significant drawdowns. For example, from July 1998 through February 2000, Berkshire lost 44 percent of its market value, while the overall stock market gained 32 percent. Not many fund managers could survive a 76 percent shortfall. However, the authors note that Buffetts impeccable reputation and unique structure as a corporation allowed him to stay the course and rebound as the Internet bubble burst.
• Buffett has boosted returns through the use of leverage, estimated at about 1.6.
• Buffett has stuck with his strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift.
• Buffett buys stocks that are safe (have low beta and low volatility), cheap (value stocks with low price-to-book ratios), high-quality (stocks that are profitable, stable, growing and with high payout ratios), and are large. They also found no exposure to the momentum factor.

The studys most interesting finding was that stocks with these characteristics low risk cheap, and high quality tend to perform well in general. High-quality companies, which have historically provided higher returns, especially in down markets, tend to have the following characteristics:

• Low earnings volatility
• High margins
• High asset turnover (indicating efficiency)
• Low financial and operating leverage (indicating a strong balance sheet and low macroeconomic risk)
• Low specific stock risk (volatility unexplained by macroeconomic activity)

In other words, its Buffetts strategy that generated the alpha, not his stock selection skills. The authors adjusted Buffetts performance for what is called the Betting-Against-Beta (BAB)  factor and the quality factor. The authors found that once all the factors (beta, size, value, momentum, BAB, quality and leverage) are accounted for, a large part of Buffetts performance is explained.

To demonstrate this finding, the authors created a portfolio that systematically tracks a Buffett-style portfolio and found that it performs comparably to Berkshire Hathaway the correlation between the systematic portfolio and Berkshires public stock portfolio is 75 percent, meaning that the systematic portfolio explains 57 percent of the variance of the public stock portfolio.

Its important to note that this finding doesnt detract in any way from Buffetts performance. After all, he figured out the strategy well before the authors found his secret sauce. As my friend and fellow author Bill Bernstein points out, being the first, or among the first, to discover a strategy that beats the market is what buys you the yachts, not copying the strategy after its already well known and all the low-hanging fruit has been picked. However, the findings do provide us with insight into why he was so successful it was strategy, not stock picking.

Buffetts genius thus appears to be in recognizing long ago that these factors work, applying leverage without ever having to fire sale, and sticking to his principles, the authors write. They note that it was Buffett himself who stated in Berkshires 1994 annual report: Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.

The authors also considered whether Buffetts skill is due to his ability to buy the right stocks versus his ability as a CEO. To address this, they decomposed Berkshires returns into a part due to investments in publicly traded stocks and another part due to private companies run within Berkshire. The idea is that the return of the public stocks is mainly driven by Buffetts stock selection skill, whereas the private companies could also have a larger element of management skill. They found that the public companies performed better. So its not his skill as a manager thats responsible for his alpha. However, they did find that the companies Berkshire owns provide a steady source of financing at a very low cost, allowing him to leverage his stock selection ability 36 percent of Buffetts liabilities consist of insurance float with an average cost below the Treasury-bill rate.

Another advantage, though a less important one, is that: Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment. Accelerated depreciation acts just like an interest-free loan.

While the Berkshires leverage helps, it only would boost the markets excess return of 6.1 percent to about 10 percent. However, once the authors accounted for all the style factors, the alpha of Berkshires public stock portfolio drops to a statistically insignificant annualized 0.1 percent. In other words, these factors almost completely explain the performance of Buffetts public portfolio. The bottom line is that we now know that Buffetts secret sauce is that he buys safe, high-quality, value stocks and applies low-cost leverage.

Finally, I would add that while you dont have access to the type of low-cost leverage to which Buffett has access, you can access the other factors that created his alpha. For example, Dimensional Fund Advisors, Bridgeway and AQR Capital are three providers of mutual funds that use strategies that involve a systematic and highly disciplined approach to capturing or harvesting a particular return or style premium. While not index funds, their funds do fall under the broader category of what I would consider to be relatively low-cost, passively managed funds.

• By: Larry SwedroeLarry Swedroe is a principal and director of research for The Buckingham Family of Financial Services. He has authored or co-authored 10 books, including his most recent, The Quest For Alpha. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.