Tag Archives: time

Indexing Pioneer Vanguard Skeptical Of Smart Beta

Vanguard revolutionized investing with its low-cost, passive indexing products. But after the TMT (tech, media, and telecom) blowup of 2000-2002, when cap-weighted indexes became overstuffed with overvalued dot-coms, critics began maligning cap-weighted index funds as “dumb beta.” The alternative, in their view, was to weight stocks according to factors other than market cap – so-called “smart beta.” Smart-beta strategies have been hailed as the “new paradigm” in passive, index-based investing. But Vanguard, the indexing pioneer, disagrees: The firm’s Don Bennyhoff, Fran Kinniry, Todd Schlanger, and Paul Chin – authors of an August 2015 white paper titled ” An Evaluation of smart beta and other rules-based active strategies ” – insist that smart-beta strategies are in fact active strategies, and that market cap is still the best basis to weight the components of an index. How Active is Smart Beta? In Vanguard’s view, smart-beta strategies should be considered “rules-based active strategies,” by definition , since their security-selection and -weighting methodologies can produce “meaningful security-level deviations” – i.e., “tracking error” – versus a broad cap-weighted index. In the August 2015 white paper, Mr. Bennyhoff and his co-authors looked at the “active share” of smart beta ETFs and index funds. “Active share” is a measure of how much an index’s holdings deviate from a cap-weighted baseline, which in this case was the Russell 3000 – an index of the 3000 largest U.S. stocks, including the mid-to large-cap Russell 1000 and the small-cap Russell 2000: Source: Vanguard. All data as of December 31, 2014. In general, the more stocks in the index or portfolio, the less the “active share.” Smart-beta ETFs and funds had “active share” that ranged from a bit less than 30% to roughly 60%, generally much more than cap-weighted indexes, but less than “traditional, actively managed equity funds.” Smart-beta strategies also had less “active share” than ETFs focused on specific risk factors like value, momentum, and size – and its exposure to these factors that provides much of smart beta’s appeal, in Vanguard’s analysis. Which Factors and When? Vanguard admits that the performance of alternatively weighted indexes has been “compelling” over time. For instance, the alternative FTSE RAFI Developed Index returned an annualized 7.2% from 2000 through 2014, with a Sharpe ratio of 0.42. The cap-weighted FTSE Developed Index, by contrast, returned just 4.2% per year with a Sharpe ratio of 0.26. This relationship holds for most regions, too. But particular risk factors fall into and out of favor, and as a result, the performance of smart-beta strategies – relative to the broad market – has deviated substantially over time. Should investors only concern themselves with certain factors, such as dividends, cash flow, book value, sales, and volatility? Or should they consider all factors, which are too numerous to list? Vanguard says market cap-weighting captures all of these factors through the market-pricing mechanism – a compelling argument. Taking the Gloves Off Near the end of the white paper, Bennyhoff et al. take off their gloves: Smart beta doesn’t represent a “new paradigm” of indexing nor a “smarter” way to invest. The strategies’ excess returns can partly – in some cases largely – be attributed to “time-varying factor exposures,” which make smart-beta strategies effectively active and not passive. “We found little evidence that such smart-beta strategies have been able to capture any security-level mispricings in a systematic and meaningful way,” the authors wrote. An index of securities is supposed to represent “the risk-and-reward attributes of a market” or segment thereof. In Vanguard’s view, market-cap-weighting isn’t broken, and therefore isn’t in need of fixing. For more information, download a pdf copy of the white paper . Jason Seagraves contributed to this article.

Alternative ETFs 2015 Scorecard

Here it is. The end of another year. Time to look back and salute auld lang syne . But if you’re an investor in liquid alternatives, you learned to keep aspirin alongside your champagne ahead of the final closing bell of 2015. When we assessed the performance of 16 diverse alternative investment ETFs at this time in 2014 (see ” The Best and Worst Alternative Investment ETFs ), we found only one – an actively traded real estate portfolio – topping the performance of the S&P 500. In 2015, there were four outperformers. Good news? Sort of. In 2014, the blue chip index was cooking along with a nearly 15 percent gain. Now, the S&P was flat for the previous year. The performance bar’s been lowered BIG time. But outdoing the broad market’s gain isn’t what liquid alts are really designed to do. They’re supposed to provide uncorrelated returns. And on that score, alternative ETFs are pretty much doing what they did in 2014. The funds averaged a .24 correlation to the S&P 500 that year. The mean was .25 in 2015. Still, alt funds have struggled. In 2014, the 15 extant funds produced a mean 1.6 percent gain with a volatility of 9.1 percent. In 2015, they lost 2.5 percent, while cranking a 13.9 percent standard deviation. Most interesting, though, is the reversal of fortune for 2014’s worst performers. The QuantShares U.S. Market Neutral Momentum ETF (NYSEARCA: MOM ) took 15th place in 2014’s 16-fund derby, with an 8.4 percent loss. MOM comes in first now with a 23.5 percent gain, a real bottom-to-top turnaround when you consider that 2014’s last-placed ETF – the ProShares 30 Year TIPS/TSY Spread ETF (NYSEARCA: RINF ) – has since been shuttered. Coming in second in 2015 was the ProShares Global Listed Private Equity ETF (BATS: PEX ), a fund that limped across the finish line in 14th place in 2014 with a 5.4 percent loss. Click to enlarge Aside from these shifts, there wasn’t much movement in the table, though the WisdomTree Managed Futures Strategy ETF (NYSEARCA: WDTI ) moved up five notches with its 4.1 percent loss. Oddly enough, 2014’s 5.4 percent gain put WDTI in a rather lowly 10th place. Will history repeat? Will 2015’s last be this year’s first? For that to happen, you gotta believe in small stocks. Small stocks do tend to outperform large caps in rising rate environments, but I’d still keep that aspirin handy. Happy new year!

It’s Not Possible For A New Understanding Of How Stock Investing Works To Become Popular Without People Losing Confidence In The Old Understanding

By Rob Bennett Valuation-Informed Indexing is the future. Buy-and-Hold is the past. Or at least so I believe. But as of today, Buy-and-Hold is far more popular. About 80 percent of stock investors do not believe it is necessary for them to change their stock allocations in response to big valuation shifts. Another 10 percent see the merit of the idea, but are reluctant to adjust their allocations too much, because few investors do this, and they see risk in going against conventional opinion. About 10 percent follow a Valuation-Informed Indexing strategy. I want to spread the word about the new model, which I view as the first true research-based strategy (because Shiller’s 1981 finding that valuations affect long-term returns discredited the belief rooted in Fama’s research that the market is efficient). So I need to point out the dangers of Buy-and-Hold. I wish it weren’t so. I greatly admire the Buy-and-Hold pioneers. I buy into all of their beliefs except for the one about there being no need for investors to take price into consideration when buying stocks. Moreover, the 80 percent who believe in Buy-and-Hold are offended when I find fault with the strategy. If there were some way to make the case for Valuation-Informed Indexing without criticizing Buy-and-Hold, I would win over a lot more people and encounter a lot less friction as a result of my efforts to do so. It can’t be done. Fama said the market is efficient. That means stocks are always priced properly. Buy-and-Holders often object to that statement. They say an efficient market is just one in which all available information is incorporated into the price, but the price that results is not necessarily the right one. That’s a hyper-technical distinction. If the market price incorporates all known information, the market price is as close to perfect as it could possibly get. Buy-and-Holders are essentially saying the market price is always right. If the market price is always right, indicators of overvaluation and undervaluation are meaningless. Buy-and-Holders don’t consider valuations when buying stocks for a logically sound reason. They don’t believe valuation metrics tell us anything. According to the Buy-and-Hold model, the P/E10 value is noise. Shiller showed the P/E10 value is not noise. It effectively predicts long-term returns. By undermining the foundational belief of the Buy-and-Holders, Shiller turned our understanding of how stock investing works on its head. It’s not true that stocks are risky; the risk largely goes away for investors who take valuations into consideration when buying stocks. It’s not true that the safe withdrawal rate is the same number for all retirees; the safe withdrawal rate is a number that ranges from 1.6 percent when stocks are priced as they were in 2000 to 9 percent when stocks are priced as they were in 1982. It’s not true that bad economic times cause stock crashes; stock crashes become inevitable once overvaluation gets too out of control and the losses experienced in the crashes cause consumer spending power to dry up and the economy to falter. Shiller’s finding is all positive. It’s like the discovery of electricity; it leaves us all big winners. But it represents a big change. Shiller’s finding will eventually take us to a very good place, but starting a national debate regarding the implications of his finding has been a disruptive experience. How people invest to finance their retirements is an important and sensitive matter. Telling people they got it all wrong upsets them. People want to move forward in their understanding. But it hurts them to let in the knowledge that they could have earned higher lifetime returns at less risk had they caught on to the significance of the Shiller revolution earlier in life. The normal way for a new idea to catch on is through exposure in the marketplace of ideas. When the Beatles showed up on the Ed Sullivan show with their long hair, a debate was launched as to whether it was okay for men to wear their hair at that length. Arguments were advanced from both sides of the divide in opinion. Eventually, a resolution was reached in the minds of most people. The Beatles won that one (for the most part, but not entirely). Most people of today find long hair acceptable on men. The big problem in the investing realm is that the debate has not yet been successfully launched. People who believe valuations matter keep quiet about it when they are speaking in the presence of Buy-and-Holders. It is viewed as rude to mention how dangerous Buy-and-Hold will prove to be if it turns out Shiller really is on to something. There’s no way to know for certain that Shiller is right. The historical data supports him. But data from earlier times can be dismissed on the grounds that the economic conditions under which that data was produced no longer apply. And the data from the time of Shiller’s finding until today is inconclusive. From 1981 forward, Buy-and-Hold has performed slightly better than Valuation-Informed Indexing. Valuation-Informed Indexers say that’s because stock prices are high today; Valuation-Informed Indexing will be revealed as the superior strategy with the next price crash, which is inevitable, according to the Shiller model. But that way of thinking about things begs the question: to say Valuation-Informed Indexing will prove superior because today’s valuations will produce another crash is to say Valuation-Informed Indexing will prove superior once again because Valuation-Informed Indexing has always been superior. The crash hasn’t come yet. So we don’t know for certain. To be fair, the Buy-and-Holders are begging the question too. They say we cannot know that another crash is coming soon, because the market is efficient and returns are thus not predictable. All of the beliefs of those following both strategies follow from their core premises. If the market is efficient, Buy-and-Hold is the ideal strategy. If valuations affect long-term returns, Buy-and-Hold is dangerous. I believe I need to point that out to my Buy-and-Hold friends. I don’t want to hurt their feelings. I want them to consider what might happen to their retirement portfolios if it turns out Shiller is right. I criticize their strategy not to upset them, but to alert them to a new way of thinking about how stock investing works that I strongly believe we all need to know about. Disclosure: None.