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Understand Your Smart Beta: A U.S. Min Vol Example

Summary Smart beta strategies are not always smart and are not just beta. USMV is a smart beta strategy that demonstrates alpha. Don’t buy USMV to reduce volatility, buy it because you believe it has alpha. Smart beta is active management and you should understand the source of outperformance for a given strategy. Smart beta strategies are not always smart and are not just beta. Smart beta ETFs can be used to take active positions relative to a given index. The goal of the smart beta ETF is to outperform the index, after adjusting for risk. This is the same goal as any other active investment strategy. There needs to be an underlying reason the active positions, in a smart beta ETF, will continue to outperform on a risk adjusted basis. The Theory: A great example is the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). USMV purchases a portfolio of U.S. equities such that volatility is minimized, given a set of constraints. From a marketing perspective it is a great idea. Who doesn’t want to buy lower volatility stocks? However, if USMV does not offer alpha then it serves no purpose in a portfolio. Now, let’s bring in the theory. CAPM says that all returns are explained by their exposure to market beta. CAPM assumes markets are efficient & normally distributed. I am not saying that CAPM is a perfect theory, but it should be the starting point for an analysis. The Fama-French Three Factor Model was the first “smart beta” model. The three factor model says there are other factors that can explain the return and tilting to those may factors increases risk adjusted return, i.e. alpha. Market inefficiencies need to exist for CAPM not to work and for a given smart beta strategy to work. Inefficiencies can come from several places including market structure, behavioral, information availability and other factors. The Formula: Smart Beta Strategy Return = Beta*(Market Return) + Alpha. The alpha can come from factor tilts that occur in smart beta. This assumes the risk free rate is 0.0%. The Inefficiency: Please don’t say you want to buy USMV to lower your volatility! You can buy the Vanguard S&P 500 ETF ( VOO) + cash to achieve the same exact beta, it is also a lot cheaper. Buy USMV for the correct reason. USMV outperforms the market, after adjusting for risk, because it picks up a market inefficiency. USMV has been shown to have an alpha of 4.2% from October 2011 to July 2015. (click to enlarge) It is important to understand the market inefficiency that USMV relies on. The inefficiency is from U.S. mutual funds owning cash and wanting a beta of 1 or higher. For a mutual fund to have a beta of 1, while also owning cash, it must purchase higher beta stocks. Therefore higher beta stocks (high volatility stocks) receive a higher flow of dollars. This makes lower beta stocks (lower volatility stocks) are cheaper than they otherwise would be. USMV owners are effectively taking their excess return from U.S. equity mutual fund investors. Conclusion: When Investing in Smart Beta… Certain smart beta strategies outperform the index due to inherent market inefficiencies. Understand the underlying reason why a smart beta strategy will outperform an index (at least check that it shows alpha historically after adjusting for market beta). Don’t buy USMV to reduce volatility, buy it because you believe it has alpha. If you want to reduce volatility then sell risky assets and buy cash. Smart beta is active management and you should understand the source of outperformance for a given strategy. USMV has historically shown positive alpha of 4.2% and I expect the market inefficiency that it relies on to continue. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Share this article with a colleague

Plan And Act, Don’t React

An investor can and should learn from the past. He should never react to the recent past. Why? The past can’t be changed, but it can be known. Reacting to the recent past leads investors into the valleys of greed and regret – good investments missed, bad investments incurred. We’ve been in a relatively volatile environment for the last two weeks or so. Markets are down, with a lot of noise over China, and slowing global growth. Boo! The markets were too complacent for too long, and valuations were/are higher than they should be, given current earnings, growth prospects and corporate bond yields. It’s not the best environment for stocks given those longer-term valuation factors, but guess what? The market often ignores those until a crisis hits. The FOMC is going to tighten monetary policy soon. Boo! The things that people are taking on as worries rarely produce large crises. They could mark stocks down 20-30% from the peak, producing a bear market, but they are unlikely of themselves to produce something similar to 2000-2 or 2008-9. Let’s think about a few things supporting valuations and suppressing yields at present. The overarching demographic trend in the market leads to a fairly consistent bid for risky assets. It would take a lot to derail that bid, though that has happened twice in the last 15 years. Ask yourself, do we face some significant imbalance where the banks could be impaired? I don’t see it at present. Is a major sector like information technology or healthcare dramatically overvalued? Maybe a little overvalued, but not a lot in relative terms. There are major elections coming up next year, and a group of politicians harmful to the market will be elected. This is a bad part of the Presidential Cycle. Boo! Take a step back, and ask how you would want your portfolio positioned for a moderate pullback, where you can’t predict how long it will take or last. Also ask how you would like to be positioned for the market to return to its recent highs over the next year. Come up with your own estimates of likelihood for these scenarios, and others that you might imagine. We work in a fog. We don’t know the future at all, but we can take actions to affect it, and our investing results. The trouble is, we can adjust our risk profile, but our ability to know when it is wise to take more or less risk is poor, except perhaps at market extremes. Even then, we don’t act, because we drink the Kool-aid in those ebullient or depressed environments. We often know what we should do at the extremes, but we don’t listen. There is a failure of the will. This is a bad season of the year. September and October are particularly bad months. Boo! I often say that there is always enough time to panic. Well, let me modify that: there’s also always enough time to plan. But what will you take as inputs to your plan? Look at your time horizon, and ask what investment factors will persistently change over that horizon. There are factors that will change, but can you see any that are significant enough for you to notice, and obscure enough that much of the rest of the market has missed it? Yeah, that’s tough to do. So perhaps be modest in your risk positioning, and invest with a margin of safety for the intermediate-to-long term, recognizing that in most cases, the worst-case scenario does not persist. The Great Depression ended. So did the 70s. Valuations are higher now than in 2007. (Tsst… Boo!) The crisis in 2008-9 did not persist. That doesn’t mean a crisis could not persist, just that it is unlikely. Capitalist systems are very good at dealing with economic volatility, even amid moderate socialism. Go ahead and ask, “Will we become like Greece? Argentina? Venezuela? Russia? Spain? Etc.?” Boo! It would take a lot to get us to the economic conditions of any of those places. Thus, I would say it is reasonable to take moderate risk in this environment if your time horizon and stomach/sleep allow for it. That doesn’t mean you won’t go through a bear market in the future, but it will be unlikely for that bear market to last beyond two years, and even less likely a decade. Disclosure: None.

With Further Market Declines Likely, Keep The Long Run In Mind

This article originally appeared on the Independent Observer Blog . August was the worst month for U.S. markets in more than three years, so say the headlines. I suspect it was also the worst month in at least that long for many international markets as well. And, as today’s numbers show us, we aren’t done yet. As I write this, U.S. markets are down about 2.5 percent, and European markets closed down around 3 percent. There is actually not much more I can add to what I’ve already written. Current valuations remain relatively high , and there is certainly the potential for further declines if the market adjusts to more typical valuation levels. From a correction standpoint, the S&P 500 is still down less than 10 percent from the peak. In other words, for all the hype and worry, we are in a market decline that, by historical standards, is both small and normal. This is not to minimize the current situation, however. Substantial technical damage has been done to U.S. markets, which remain below both the 200-day and 400-day moving averages. This suggests to me that more weakness is very likely. Indeed, the odds of a more substantial decline are, in my opinion, rising as confidence continues to erode. Many decision rules that have tested well in the past are now pointing to more declines as well. With further market declines likely, what should you do? If you have longer-term money invested (i.e., you don’t need it for 10 years or more), try to stay put. And if you’re still contributing to your portfolio, remember that the decline actually represents an opportunity, since you can invest at lower prices and benefit from potential future growth. If you have shorter-term money invested (i.e., you need it in the next couple of years), or if you’re already drawing down your portfolio in retirement, work with your financial advisor to determine what effect a large decline would have on your financial well-being. Hopefully, your portfolio is structured in a way that any decline will have minimal impact over time. If not, you might want to consider making changes to ensure that is the case. Once your portfolio design meets your needs, though, unfortunately, there is little left to do but buckle up and endure the ride. Why this decline looks different I won’t say enjoy the ride, of course, but to make it less painful, consider that this decline is different: First, many previous and major, long-lasting declines – 2000 and 2008 being the most recent – came at the end of multiyear debt-fueled booms. We might get to that point eventually, but we’re not there now. Households have actually continued to pay off debt during the past few years, not add to it. Second, sustained declines typically took hold during periods of recession while, today, the U.S. economy continues to grow in a sustainable way. Third, the lack of corrections like this over the past few years has, arguably, been unhealthy. The current decline is actually a painful but necessary step to clear out market excesses and lay the groundwork for further advances. This prescription – prepare and keep the long run in mind – is neither easy nor satisfying. The only real thing it has going for it is that, over time, it generally works. That is what I try to focus on, and I suggest you do the same.