Tag Archives: portfolio-strategy

What Smart Beta Can’t Do

The growth of assets in Smart Beta ETFs is staggering. From Michael Batnick : Investors have become enamored with alternative ways to slice and dice the indices. According to Morningstar , “Strategic Beta” now accounts for 21% of total industry (ETP) assets, up from under 5% in 2000. As assets have exploded, so too has the number of strategic-beta ETPs, which have grown from 673 to 844 in the past year, while assets grew 25% to $497 billion. While much of the focus is on the nomenclature- “smart” vs. “factor” vs. “strategic,” perhaps the most important aspect is being overlooked; like all things investing, the product won’t to be drive returns as much as your behavior will. To demonstrate this point, I chose five popular strategies that differ from the traditional plain vanilla cap-weighted index: Nasdaq US Buyback Achievers Index, S&P 500 Equal Weight Index, Nasdaq US Buyback Achievers, MSCI USA Momentum Index and the S&P 500 Low Volatility index.* Every one of these Smart Beta strategies has outperformed the S&P 500 from 2007-today**. The problem investors run into, as you can see below, is that very often the best performing in each year lagged the S&P 500 in the prior year. Myopia is a huge impediment to successful investing as much of our “discipline” is driven by “what have you done for me lately?” Each of these five strategies has outperformed the S&P 500 over the previous eight years. Had you chased the prior year’s best strategy, you would have compounded your money at just 3.5%, less than the 6% you would have earned if you invested in the prior year’s worst strategy. This goes to show that mean reversion is a powerful force for a proven, repeatable process. Interesting. There are all kinds of studies showing that when it comes to individual stocks, buying last year’s winners works great (click here for just one of the white papers written on this topic). However, Batnick is arguing that buying last year’s winning Smart Beta ETF is not effective (at least in this short sample) when it comes to investment factors. This has important implications for building an asset allocation that includes a variety of Smart Beta factors: You may well be better off simply seeking to identify those factors that are likely to outperform over time (we like momentum and value in particular) and make passive allocations to those factors rather than trying to time your exposure to them. Smart Beta has, in our view, been a tremendous positive for investors. However, it won’t keep performance-chasing investors from hurting themselves if they fail to allocate money to them in a prudent way. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. Share this article with a colleague

Why Indexing Works [New Research]

It’s no secret that I think most investors should index. To be more precise, I’d call most “investors” savers. And if you’re treating your portfolio as if it’s your savings, then your financial goals are pretty simple: 1) outpace inflation and 2) reduce the risk of permanent loss. You don’t need to “beat the market” or just maximize returns. The best way to achieve these two goals is to implement a diversified, low fee and tax efficient portfolio. Given all that, indexing is the obvious way to achieve this given its inherent diversification, low fees and tax efficiencies. Of course, there are lots of ways to index and I personally prefer a countercyclical indexing approach (as opposed to a more traditional procyclical indexing approach), but that’s not what this is about. This post is just highlighting a nice new paper that was released yesterday further discussing why indexing works: “We develop a simple stock selection model to explain why active equity managers tend to underperform a benchmark index. We motivate our model with the empirical observation that the best performing stocks in a broad market index perform much better than the other stocks in the index. While randomly selecting a subset of securities from the index increases the chance of outperforming the index, it also increases the chance of underperforming the index, with the frequency of underperformance being larger than the frequency of overperformance. The relative likelihood of underperformance by investors choosing active management likely is much more important than the loss to those same investors of the higher fees for active management relative to passive index investing. Thus, the stakes for finding the best active managers may be larger than previously assumed.” [ Why Indexing Works ] This is consistent with something I posted not too long ago . One of the problems with stock picking is that the gains tend to be highly skewed. Your top performers produce most of the returns. The distribution is very uneven. So, it’s not like you’re just trying to pick the stocks that outperform the average. In order to create consistent market beating returns you basically have to know which stocks will be in the 20% of the outliers. Add on taxes and fees and you’re climbing a huge uphill battle. Anyway, go have a read. It’s a pretty good one and it even makes a slight case for stock picking in case you’re looking for it… Share this article with a colleague

The Paradox Of Risk: Central Planning Is Linear, Reality Is Non-Linear

You thought it was safe to drive 90 miles an hour on a rain-slicked narrow road while you were tipsy because the airbag would save you, but it still hurts when you crash. I first discussed the Paradox of Risk in August 2008, just before the stock market melted down : The Unintended (Risky) Consequences of “Backstopping” Risk (August 12, 2008). This is the Paradox of Risk: the more risk is apparently lowered, the higher the risk we are willing to accept. I recently covered a related topic, The Dangerous Illusion That Risk Can Be Offloaded Onto Others (October 2, 2015). The paradox is that believing risk has been eliminated leads us to take on insane levels of risk – levels that we would never have accepted before, levels that essentially guarantee our financial destruction. I recently had the opportunity to discuss these topics with Max Keiser: Keiser Report: Global Paradox of Risk (25:40 – I join Max and Stacy in the 2nd half) 1. The Fed Put, the belief that the Federal Reserve will never let stocks decline by more than a few percentage points before it steps in and saves the market from any further decline. 2. The belief that hedges dependent on counterparties paying off when the market craters have effectively transferred risk to others. 3. The belief in Modern Portfolio Management, i.e. that risk can be hedged or reduced to near-zero by diversifying one’s portfolio, investing in assets with low correlation, etc. All of this is nice, but fatally flawed. Max and I discuss the reality that markets are not linear, they are fractal. Central planning is linear, but reality is non-linear. The net result is the Fed can do whatever it wants, whenever it wants, and markets will still crash from time to time. That markets crash is predictable, but not when they crash. I’ve prepared a chart that depicts the downside of the Paradox of Risk: everyone who believes in the Fed Put, hedges or Modern Portfolio Management will view any decline in stocks as temporary. As a result, they won’t sell as markets plummet. When markets finally hit bottom, believers will assure themselves that the Fed is going to push stocks higher any day now, because they have always done so in the past. When central planning efforts to push stocks back up falter, the believers that risk has been banished grow frustrated; come on, Fed, do whatever it takes! Alas, the Fed has done whatever it takes but it has failed to produce the desired effect. Now the market starts another slide to fresh lows, and the believers finally start recognizing that risk has not been disappeared: counterparties start failing, hedges don’t get paid off, and a sense that events are spiraling beyond the control of central planning is spreading. Sorry, believers that risk has been banished: it’s too late, you’re wiped out. You thought it was safe to drive 90 miles an hour on a rain-slicked narrow road while you were tipsy because the airbag would save you, but it still hurts when you crash: Keiser Report: Global Paradox of Risk (video).