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Don’t Overpay For An Epic Investing ‘Fail’

Summary Lowering the cost of actively managed funds is an important step in improving the odds of outperformance. Highly rated funds are not good predictors of future performance. Why a holistic approach with good judgment, including quantitative and qualitative elements is a “WIN!” By Chris Philips, CFA An investing “FAIL”? Pop culture and investing rarely cross paths. After all, pop culture is hip, exciting, and flashy. Conversely, we’ve seen that successful investing is generally anything but. Nevertheless, the last decade or so has seen the rise of an internet meme that may be applicable to the investing world-“FAIL.” So what are a “FAIL” and its illustrious cousin “epic FAIL”? Both are generally used to describe embarrassing events, such as setting your kitchen on fire as you film yourself attempting to light birthday candles (FAIL)-by using a blowtorch to be cool (epic FAIL). Now I hope none of us have burned down a house while reviewing an investment portfolio! So I can’t visualize an investing epic FAIL in this vein (although some may suggest that the global financial crisis would suffice), but there are at least three areas where I can confidently say FAIL: cost, ratings, and performance. The cost-value riddle First up is the issue of cost. People intuitively associate higher cost with value and performance. Unfortunately, it’s backwards. For example, see Figure 1, where I break out U.S. equity and fixed income funds into deciles according to their reported expense ratios. Cost and performance ARE related. However, the data show that the lower the cost, the better the experience (on average). You should pay more for performance? FAIL (click to enlarge) Relying on ratings Next is the question of industry ratings. The allure of something-anything-that could potentially help us do better by our clients is strong. Figure 2 illustrates this -investors have clearly favored higher-rated funds and shunned lower-rated funds. These patterns wouldn’t be noteworthy if 4- and 5-star-rated funds consistently added value. (Or perhaps they would be, if they revealed a metric that could reliably predict performance!) However, in the research underlying Figure 2, we showed that highly rated funds in one rating period tended to be the worst performers relative to a style benchmark over the next 3 years-underperforming on average by 138 basis points per year. Funds with 1-star ratings also underperformed, but at a much more modest rate of 15 basis points per year. You should stick to top-rated funds? FAIL Patience and performance Of course, some may dismiss the cash-flow example as “retail” investors chasing returns. However, there’s also evidence of return-chasing among institutional investors.[1] After all, we are all human, whether acting in a fiduciary capacity or on our own behalf. In an article published in The Journal of Finance , Amit Goyal and Sunil Wahal reported on the outcomes of hire/fire decisions across a broad sample of plan sponsors. They found that underperforming managers were (not surprisingly) replaced with managers who demonstrated significant outperformance (represented with blue bars in Figure 3). I say “not surprisingly,” because what fiduciary would want to keep an underperforming fund or asset on the books? However the twist is in what happened following the replacement. On average, those managers who were hired to replace the poor performers underperformed the same managers they replaced in the next 1-, 2-, and 3-year periods! In Figure 3, this record is shown by the green bars. You should systematically replace underperformers? FAIL Avoiding FAIL The moral of this story is that while ratings and cost should not be summarily dismissed, we should take a collective step back and think about what really matters when constructing portfolios or looking to provide clients with the best opportunity for success. Controlling costs is critical, to be sure. But equally important is a robust evaluation process that includes many variables for considering whether fund A, B, or C should be added, dropped, or ignored. Such a qualitative process can complement the quantitative metrics that have been shown to potentially lead us astray. A holistic approach with good judgment, including quantitative and qualitative elements? Now that’s a WIN! Footnotes Mark Grinblatt, Sheridan Titman, and Russ Wermers initiated the academic literature on return-chasing behavior among institutional investors in their paper “Momentum investment strategies, portfolio performance, and herding: A study of mutual fund behavior,” The American Economic Review , 85(5), 1995. Notes All investing is subject to risk, including the possible loss of the money you invest. Past performance does not guarantee future results.

Problems With ‘The Short-Term’

Earlier this year I spoke about the problem of “the long-term” . This is the tendency for modern finance to emphasize a long-term view due to the fact that assets tend to perform well over the long term. This is empirically true. If we look at the performance of stocks, bonds and the broader economy the performance tends to skew to the upside the longer your perspective is. Unfortunately, as I’ve noted, everyone doesn’t have a “long-term”. In fact, even most young people live a life of short-terms inside of a long-term. Our financial lives aren’t this start-and-stop ride where we get on when we’re young and get off when we retire. At times the ride stops along the way and we have to get off for marriages, new homes, college expenses, emergencies, etc. That said, we also shouldn’t be in the financial markets if we have a short-term perspective. That is, given that you have to expose yourself to principal risk with any financial instrument with more than a few months of duration, you can’t be remotely long-term if you have no stomach for principal loss. This is particularly pertinent at times like these when we’re going through a substantial commodity unwind and foreign market turmoil. It’s a near certainty that any well-diversified portfolio has at least some exposure to these events. The reality is that most of us have a multi-temporal or a cyclical time frame of the financial world. It’s neither a long-term nor a short-term. It’s usually something in the middle. And when we veer too far in one direction or the other we tend to get in trouble. The problem with the short-term is multifaceted: A short-term view tends to result in account churning, higher fees, higher taxes and lower real, real returns. A short-term view often results in reacting to events AFTER the fact rather than knowing that a well-diversified portfolio is always going to experience some positions that perform poorly in the short term. Short-term views are generally consistent with attempts to “beat the market” which is a goal that most people have no business trying to achieve when they allocate their savings. If you have an excessively short time horizon you probably aren’t going to respond well to market turmoil. I’ve found that there is nothing more difficult in the investment world than understanding how the concept of time applies to someone’s portfolio. As with so many things in life the truth often resides somewhere in the middle. And if you can maintain that cyclical view without being irrationally long-term or short-term you’re very likely to achieve performance that is in line with your broader financial goals. Share this article with a colleague

iShares MSCI South Korea Capped ETF: 12-Month Strategy

Summary With the exception of exports, South Korea is on track for recovery from slowed economic growth. This is reflected in the growth projection for annual GDP, retail sales, consumer spending, consumer confidence, and consumer credit. Samsung Electronics’ financial performance has been an area of concern, although valuation and conservative growth ahead slightly offset this risk; 21.52% of the fund’s assets invests into Samsung Electronics. Investing in the MSCI South Korea Capped ETF and holding for 12 months is an excellent strategy for investors to take advantage of the fund’s low valuation. Based on my investigation of South Korea’s economy, I have determined that investing in South Korea and holding for 12 months presents a strategic opportunity for investors. The iShares MSCI South Korea Capped ETF (NYSEARCA: EWY ) has had a sharp decline in price since August 2014. With the projected holistic growth ahead for South Korea, with the exception of a slight decline in exports, a rebound in the fund’s price is certainly ahead. The fund is currently trading at 51.18, a far cry from its 52-week high of 66.99 . The current valuation of the fund provides further benefits for investors, as the drop in fund price due to slowed economic growth has been sensationalized. Investors should turn their attention to the iShares MSCI South Korea Capped ETF, as its valuation is among the lowest for ETFs investing in Asia: P/E: 10 P/B: 0.97 P/S: 0.74 Further benefits of this fund include the fact the fund invests into a diverse portfolio of companies, with the top 10 holdings only accounting for 44.6% of the fund. The fund’s industry approach is also very diverse, as it invests into the following industries: Technology: 37.82% Financial Services: 14.5% Consumer Cyclical 13.54% Industrials: 11.46% Basic Materials: 8.89% Consumer Defensive 7.73% The remainder of the fund’s assets invest into the following industries: healthcare, communication services, energy, and utilities. South Korea Economic Outlook The overall outlook for Korea’s economy is very positive, and presents clear potential for investors to profit by investing now and holding until the 2nd quarter of 2016. Annual GDP growth will continue to be conservative and increase to 2.93% by the 2nd quarter of 2016. Exports will fall slightly during the next 12 months, although South Korea has the relative strength of having diverse exports and being a strong oil import country; 31% of its imports are petroleum. Consumer Spending is projected to increase by 1.5%, while growth in retail sales is projected to increase from its current level of 0.8% to 4.51%. Consumer confidence and consumer credit will also both increase by 1% and 7.4% respectively. Overall, considerable growth and recovery is ahead for South Korea, with the only concern being slowed growth in exports due to the appreciation of its currency. Investors can benefit from the drop in fund price, which has resulted from temporary slowed economic growth in South Korea. GDP growth is expected to recover, and it is clear to see that the increase in retail sales, consumer spending, consumer confidence, and consumer credit will all attribute to a recovery in the performance of the fund. Over 20% Samsung: An Ambivalent Outlook One weakness of the fund has been Samsung Electronics ( OTC:SSNLF ), which has recently had slowed growth due to its loss of its market share for smart phones in China and India . Although the outlook for South Korea is overall favorable, the fact that this company represents over 20% of the fund’s portfolio presents a threat to the fund’s performance. Past and recent performance, valuation, and future outlook for the company provide a mixed outlook. The company recently posted 2nd-quarter results for 2015 , which produced somewhat disappointing results: The company’s revenue fell by 2% quarter on quarter. The company’s operating profit fell by 15% from its level one quarter ago. The appreciation of the South Korea Won, and slowed sales of global smart phones and tablets attributed to this loss. The company’s future outlook and relative advantage in its industry make things look more favorable for the company: The company has extremely attractive valuation : its P/E is 8.75, P/S is 0.77, and P/B is 0.95. While concerns due to past performance are befitting, it is clear that the company is still undervalued, and could be a wise endeavor if coupled with recovery and growth. The following mean projections provide further insight for the future growth outlook for Samsung Electronics: Between December 2015 and 2016, sales are projected to increase by 3.3% Between December 2015 and 2016, EPS are projected to increase by 6.5% While this growth is not very substantial, and not enough to represent full recovery from past financial performance, it is clear to see that the combination of attractive valuation and moderate growth ahead will not make Samsung Electronics a threat to the portfolio’s performance. Moreover, the remaining portion of the fund’s portfolio is extremely diverse, providing diverse exposure to South Korea’s projected growth and recovery for the next 12 months. Conclusion Slowed growth and projected recovery in South Korea have both created an excellent buy opportunity. This fund has better valuation than the majority of ETFs that invest into high growth countries in Asia, such as Indonesia , the Philippines , Vietnam , and Thailand . A 12-month investment strategy is a clear ideal starting point, while a long-term hold would be more suitable for a country in Asia with higher growth; the catch is that funds with exceptionally low valuation are hard to find, unless investors are willing to consider closed-end funds . The economic stability of South Korea, growth ahead, and attractive valuation of the fund, all attribute to this being a conservative endeavor for investors. This ETF may be the best means to access South Korea’s economic growth and recovery. Investors who feel extremely confident about South Korea’s potential for recovery, may find it ideal to invest with triple the leverage, via the Direxion Daily South Korea Bull 3X ETF (NYSEARCA: KORU ). 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.