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How Long Will You Wait For Smart Beta To Work?

In my last post I shared some insights from Ben Carlson’s A Wealth of Common Sense , which argues that investors are generally better off keeping their portfolios simple and straightforward. This idea has little appeal for index investors who hope to improve on plain-vanilla funds by using so-called smart beta strategies. “Smart beta” refers to any rules-based strategy that attempts to outperform traditional cap-weighted index funds. Now more than a decade old, fundamental indexing is the granddaddy of smart beta, while factor-based strategies are the newer kids on the block. In each case, the goal is to build a diversified fund that gives more weight to stocks with certain characteristics (value, small-cap, momentum, and so on) that have delivered higher returns than the broad market over the long term. Many proponents of passive investing see huge potential in factor-based strategies because they combine the best features of indexing-low-cost, broad diversification, and a rules-based process-with the potential to overcome the shortcomings of traditional cap-weighting. Indeed, many of our clients at PWL Capital use a combination of traditional ETFs and equity funds from Dimensional Fund Advisors (DFA) , which have greater exposure to the small-cap, value and profitability factors . The academic research on factor-based investing is robust and convincing, and building your portfolio using these principles may be rewarding over the long term. Ben Carlson thinks so, too, despite the emphasis he puts on simplicity. But he has some cautionary words for those who are ready to jump on the smart beta bandwagon. “I think these strategies can make sense as part of a broadly diversified portfolio if you know what you’re getting yourself into,” he writes. A costlier, bumpier ride Let’s start with the most obvious caveat: smart beta is cheap compared with active strategies, but it’s significantly more costly then traditional ETFs. Cap-weighted ETFs carry almost negligible costs these days, with fees as low as 0.05%, while factor-based funds tend to have MERs in the range of 0.40% to 0.80%. That means they need to deliver significant outperformance before fees to simply break even on an after-cost basis. Second, any outperformance is probably going to involve a rockier ride. While it’s not true over every period, small-cap and value stocks are typically more volatile than the broad market, so their excess returns may require you to endure more swings in your portfolio. Over the last five years, for example, that standard deviation (a measure of volatility) for both value and small cap stocks was higher than that of the broad market in Canada, the U.S. and international markets. And as Carlson notes: “One of my common sense rules of thumb states that as the expected returns and volatility of an investment increase, so too does poor behavior.” Which brings us to the biggest challenge for investors who use smart beta strategies. The waiting is the hardest part Investors who embrace smart strategies are usually familiar with the research showing that small-cap and value stocks have outperformed over the very long term in almost every region. But few appreciate that to those premiums can take a long time to show up-and were not talking about a mere five or 10 years. In his book, Carlson explains that from 1930 to 2013, small-cap value stocks in the US delivered an annualized return of 14.4%, compared with 9.7% for large caps. However, small-cap value lagged the S&P 500 for a 15-year stretch in the 1950s and 1960s, then for seven more years from 1969 to 1976, and finally for a gruelling string of 18 years in the 1980s and 1990s. “Eventually they paid off, but that’s a long time for investors to wait. Patience is a prerequisite for these strategies.” That’s an understatement. It’s not uncommon for investors to lose faith in a strategy after a year or two. It’s hard to imagine many will hang on to an underperforming smart beta fund as it lags the market for even five years-let alone 18-because they’re confident it will outperform over a lifetime. Almost no one has that kind of patience-with the possible exception of Leafs fans . “You have to commit to these types of strategies, not use them when they feel comfortable,” Carlson says. “The reason certain strategies work over the long term is because sometimes they don’t work over the short to intermediate term.” Tracking error regret Just this week, Larry Swedroe expanded on this idea by looking at the probability that the small and value premiums will be negative over various periods. He demonstrates that there’s a significant chance of underperformance over even a decade or two. “My almost 20 years of experience as a financial advisor has taught me that even the most disciplined investors can have their patience sorely tested by as little as even a few years of underperformance,” he confirms, “let alone a 10-year period without higher returns for value (or small, or international, or emerging market) stocks.” Swedroe goes on to coin a brilliant term for the anxiety indexers feel when their smart beta strategies go awry: tracking error regret . “These are investors who regret their decision to maintain a portfolio that performs differently than the market. Tracking error regret causes many investors to abandon their well-thought-out, long-term plans.” The point here is not that you should ignore alternatives to portfolios built from traditional index funds. Smart beta strategies may indeed reward the patient, disciplined investor over the very long term. But no investors should ever feel they’re settling for second-best with a simple solution. In the end, these traditionalists will likely find it easier to stay on course, and may just end up looking like the smart ones.

Over-Rated: Do Fund Asset Classifications Tell The Whole Liquidity Story?

By Hamlin Lovell, CFA Suspensions of dealing by the credit mutual funds Third Avenue and Stone Lion have prompted various knee-jerk requests for a simple rule of thumb to help avoid recurrence: Beware Level 3 assets. It is reported that Third Avenue owned 18% in Level 3 assets. Many credit funds have zero or less than 1% of their assets in this category. Behavioral finance teaches us that we are susceptible to messages that simplify the complex. Unfortunately, financial market liquidity may not be amenable to such simple rules. Level 3 assets are assets for which a fair value can’t be determined by observable measures such as models or market prices. Though they are commonly dubbed mark-to-model, any unobservable input applied to modify a market price can also lead assets to be classified as Level 3 despite their valuation not being entirely model driven. Furthermore, relying on the Level 1/2/3 breakdown as a proxy for liquidity can result in both false positives and false negatives. Let’s start with the false negatives. Absent or insufficient market prices or dealer quotes can be reasons for Level 3 classifications, but they are not the only reasons. For instance, derivatives with non-standard maturities may be valued by interpolating between broker quotes on those derivatives with standard maturities. So a six-week currency option might be valued roughly halfway between a one-month and a two-month quote, but if the fund in question offers quarterly dealing, there need not be grounds for concern about asset/liability mismatches. But Level 3 is a broad range. At the other end of the spectrum, Level 3 could include private equity that might never be monetized, leading to an immortal “zombie” fund. Many assets might fall between these negative extremes; structured credit, for example, can be self-liquidating if cash flows from underlying assets accrue to various tranches according to the predetermined schedule. Some short-dated structured credit assets could generate cash flows faster than, say, zero coupon or payment-in-kind (PIK) bonds, where there may be indicative broker quotes – but you’d only find out if the borrower could repay (or refinance) at the maturity date! So using Level 3 categorizations to avoid illiquids is a crude tool. Of course, for those investors not worried about missing some adequately liquid assets falling under the Level 3 umbrella, a “Level 3 is bad” rule should still avoid many of the least liquid and completely illiquid assets. Less discussed and of greater concern are the false positives that can arise from assuming Level 1 and Level 2 must be liquid. That assets have an exchange price or some form of counterparty quote does not mean they can be traded in unlimited amounts, as the price or quote may only be good up to certain volume levels. Indeed, Third Avenue claimed it cannot liquidate “at rational prices,” which may imply they could sell at discounted prices. Any asset’s liquidity needs to be seen in the context of the fund’s position size, and I have seen funds take months or years to exit some Level 1 or Level 2 securities when they are holding a substantial multiple of volumes. The bottom line is that valuation methods should not be used to draw inferences about liquidity. Credit Ratings Third Avenue owned significant amounts of assets with a CCC credit rating, which may be deemed extremely speculative. The impulsive response here is to suggest that funds with higher credit ratings are more liquid, or less risky, or both, than those with lower (or no) credit ratings. Let us remind ourselves that some asset-backed security vehicles stamped AAA and backed by subprime mortgages ended up worthless and illiquid during and after the 2008 crisis, to the chagrin of institutional investors ranging from Norwegian pension funds to German municipal banks. Some money market funds that were perceived as super-safe cash substitutes also had to suspend dealing in 2008, and they were, broadly speaking, required by Rule 2a-7 to hold assets bearing the highest two short-term credit ratings. Since September 2015, money market funds are no longer bound by this constraint , as Dodd-Frank requires them to ensure assets meet a range of appropriate criteria. “Unrated” Assets When an asset is unrated, it generally means that the issuer has declined to pay for a credit rating rather than that the ratings agency has declined to provide one. The amount of C-rated issuance seen in the United States and Europe over the past two years shows that agencies are perfectly willing to provide some of the lowest credit ratings to companies that may be stressed or distressed. Convertible debt is often not rated, but this does not necessarily mean it is less liquid. I recall convertible bond funds largely comprising unrated names in 2008 paying out plenty of redemptions on time. In any case, credit ratings are not necessarily a reliable proxy for liquidity. Some credit assets reportedly see higher volumes after they get downgraded or default, partly because some holders become forced sellers and specialist distressed investors then become interested in the higher potential returns on offer. So, neither valuation hierarchies nor credit ratings can necessarily guarantee fund liquidity. Nor can regulation – both US mutual funds and US money market funds are now allowed to suspend dealing, and the SEC has approved Third Avenue’s suspension. Investors and advisers need to broaden and deepen their levels of analysis to get a better handle on liquidity risks. Quantifying fund liquidity is not only nuanced but also fluid, particularly as there can be seasonal variations, with calendar year-end reportedly a less liquid time. Investors and asset management companies may be drawn to the apparent certainty of putting funds into a small number of boxes, buckets, or categories, but this may prove to be a false comfort. Exact estimates of fund liquidity could prove to be spuriously precise, so the concept needs to be presented in broad brush terms that allow plenty of margin for error. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Seth Klarman On Value Investing In A Turbulent Market

Investors must employ an investment philosophy and process that serve as a bulwark against a turbulent sea of uncertainty and then navigate through confusing and often conflicting economic signals and market head fakes. Amidst the onslaught of gyrating securities prices, fast and furious corporate developments, and an unprecedented volume of data, it is more important than ever to maintain your bearings. Value investing continues to be the best (and perhaps only) reliable North Star for those who are able to remain patient, long-term oriented, and risk averse.” – Seth Klarman year-end 2015 letter to investors. 2015 was a bad year for Seth Klarman and his Boston-based hedge fund Baupost. The fund lost money for its investors, a rare event – it’s only happened three times since the fund’s founding in 1982. Click to enlarge Off the back of such a terrible performance, Seth Klarman devoted the majority of his year-end letter to investors explaining that value investing isn’t a precise science in his usual calm and philosophical manner. It’s unlikely that Klarman would have been aware what was in store for the markets in the first few months of 2016, but as it turns out, his words couldn’t have come at a better time for value investors seeking reassurance in a turbulent market. Seth Klarman: Take advantage of Mr. Market Value investors gain clarity by thinking about their investments not as quoted stocks whose prices whip around on a daily basis, but rather as fractional ownership of the underlying businesses.” – Seth Klarman year-end 2015 letter to investors . To be a successful investor, you must be able to take advantage of Mr. Market’s bipolarity. You must be able to step in and buy shares when Mr. Market offers them to you at a knock-down price, but you need to be able to ignore his calls to sell at lower levels. Klarman writes that the two extremes of human nature, fear and greed drive market inefficiency. Fear is primal, the effect of confronting the apparent loss of what you have. Your shares still represent the same fractional ownership in a business as when they traded higher yesterday, however, people are now en masse delivering the verdict that your shares are actually worth less. You have to find a way not to care or even to relish this eventuality. Warren Buffett has written that one should not invest in stocks at all if uncomfortable with the possibility of a 50% drawdown. The mistake some investors make is to accept the market’s immediate verdict as fact and not opinion, and become disappointed, even frustrated.” — Seth Klarman year-end 2015 letter to investors . Losses can cause people to lose their bearings. It’s natural to want to sell everything after your portfolio has been marked down sharply. Watching your net worth evaporate in front of you as the market falls isn’t a pleasant experience. However, this is the wrong way of thinking about equities. Klarman writes that for an investor to overcome the desire to sell at the bottom and take advantage of Mr. Market’s erratic movements, they must think not about what the market will pay for the securities today, (the stock price) but rather the true value of the securities you own based on such attributes of the underlying businesses as free cash flows, private market values, liquidation values, downside protection, and growth prospects. Klarman continues, saying that when the market, in the absence of adverse corporate developments, drives an undervalued security down in price to become an even better bargain, that’s not a reason for panic, or even for mild concern, but rather for excitement at the prospect of adding to an already great buy. When tempted to sell: Investors must think not only about what they would be getting (the end of pain that accompanies the certainty of cash) but also what they’re giving up (a significantly undervalued security which, emotion aside, may be a far better buy than a sell at today’s market price).” – Seth Klarman year-end 2015 letter to investors . This is why conducting your own rigorous due diligence is essential. The insights gained from due diligence give you the justifiable confidence to maintain your bearings – to hold on and consider buying more – even on the worst days in the market. Seth Klarman: Don’t be greedy Greed works alongside greed to eat away at your confidence and push you to make decisions that are hazardous to your wealth. The angst felt when others are succeeding while you are not can lead you to make poor decisions, on this topic Klarman cities J.P. Morgan, who said “Nothing so undermines your financial judgment as the sight of your neighbor getting rich,” and Gore Vidal who dryly noted, “Whenever a friend succeeds, I die a little.” What’s more, the fear of missing out can be a kill switch for risk aversion in that it tempts people into paying up and then holding on too long. Fear of missing out, of course, is not fear at all but unbridled greed. The key is to hold your emotions in check with reason, something few are able to do. The markets are often a tease, falsely reinforcing one’s confidence as prices rise, and undermining it as they fall. Pundits often speak of the psychology of markets, but in investing it is one’s own psychology that can be most dangerous and tenuous.” – Seth Klarman year-end 2015 letter to investors . To show just how dangerous (and damaging) fear and greed can be to investors’ returns, Klarman lets the figures do the talking. The data shows that over the 30-year period from 1984 to 2013, the S&P 500 Index returned an annualized 11.1%. However, according to Ashvin Chhabra, head of Euclidean Capital and author of ” The Aspirational Investor ,” the average returns earned by investors in equity mutual funds over the same period was ” a paltry 3.7% per year, about one-third of the index return .” Bond investors were dealt even more pain. While the Barclays Aggregate Bond Index returned an annualized 7.7% over the 30-year period from 1984 to 2013, bond funds produced an annualized return of 0.7%. The underperformance in both cases was a direct result of investors pulling money out of the funds at precisely the wrong times. In short, by letting fear and greed take over their emotions, retail investors have underperformed both the markets and the very funds in which they were invested since 1984. That’s a statistic that’s difficult to ignore. So to conclude: In the moment, public market investors have no ability to control investment outcomes, but they can control and improve their own processes. We never shoot for high near-term investment returns. Trying too hard to earn positive results, or assessing performance too frequently, can drive anyone into short-term thinking, herd-like behavior, and incurring higher risk…We believe that by remaining focused on following a well-conceived process, we will make good risk-adjusted, long-term investments. And we know that if we do that, we will indeed earn good returns over time.” – Seth Klarman year-end 2015 letter to investors. Disclosure: None.