Wednesday, April 15, 2015

The Biggest Mistake Investors and Advisers Make

Study after study of the money managers who have had the best long term performance shows the same thing----while the money managers made a lot of money over time, the average client lost money.  This isn't some sort of Ponzi scheme, it is because investors and advisers tend to buy into money managers or strategies when they are doing well and sell out when they are doing poorly.

Wall Street does a good job of hammering home the point that past performance doesn't predict future results.  Regardless of how bold that statement is on every marketing piece people still believe the most recent investment past will equal the future.  Last year's top money manager or strategy will be next year's top performer.  Last year's bottom performer will be next year's bottom performer.  This ignores two basic facts about how markets work----investment strategies cycle in and out of favor and everything eventually mean reverts.

It is no secret that investment styles and strategies cycle in and out of favor.  In the asset allocation world there are times when value outperforms growth and times when growth outperforms value.  There are times when small stocks outperform large stocks and times when large stocks outperform small stocks.  In the tactical world there are times when momentum strategies do well and times when the don't.  There are markets that are perfect for counter trend strategies and markets that aren't.  The best investment strategies might crush whatever benchmark you use over time, but day to day, week to week, month to month, there will be times it underperforms.  If investors are constantly getting out during the underperforming periods they usually get out of one strategy at the wrong time and into another at the wrong time.

Investments are also mean reverting.  What goes up big eventually goes down to more normal levels. This happens over and over again with asset classes and strategies---Gold, Apple, Biotech, Japan, etc. Investors always like to buy into what is hot.

We see this in our investment strategies, most new client money flow goes into whatever strategy has had the best recent performance.

I get it, it is much easier for someone to reconcile buying into what is hot than it is to buy into what is not.  But if you constantly rotate from what isn't  hot to what is then you are asking for mediocre investment results at best.  Instead of focusing on buying past performance focus on buying into a process that should produce the best results (tolerable volatility and the best possible returns) going forward and stick with it through the inevitable ups and downs.

Sunday, April 5, 2015

Avoiding Momentum Head Fakes

Momentum is an extremely powerful investment strategy.  The basic idea is that objects that are in motion tend to stay in motion---when stocks are strong they tend to stay strong, when bonds are strong they tend to stay strong, etc.

Momentum investing is based on individual investor psychology. When an asset class starts to move from a downtrend to an uptrend generally the "smart money" gets in first.  This is followed by the "not as smart, but still pretty smart money", then the "still pretty smart, but not quite as smart money", and so on and so forth until the inexperienced investor gets in somewhere near the top.  This cycle generally plays out long enough for the momentum investor to get in once the uptrend has started, get out once a downtrend is established, and still make a lot of money on the trade.

Hundreds of research papers have been written proving that momentum works across asset classes and across time frames.  However, just like any investment strategy, momentum can cycle in and out of favor.  The worst type of market for a momentum strategy is a choppy one, which can result in a number of momentum head fakes.  In a choppy market an asset class might move up for one period, causing a momentum investor to enter, and then move down the next period, causing the momentum investor to exit with a loss.  Repeat this cycle over a year or so and it can be a pretty frustrating experience for investors as they always seem to be buying high and selling low.

Every investment strategy has an Achilles heal, for buy and hold it is a bear market, for momentum it is a choppy market like the kind we experienced in 2014.  This presents a particular problem for momentum strategies as investors tend to be more forgiving of losses when the market is down, misery loves company.  However, they tend to be less forgiving of losses when the market is going up.  A negative year for a momentum strategy while the overall market is up can cause investors to jump ship and miss out on the future benefits of momentum.

The answer to this problem comes from diversification.  Not diversification by asset class---large cap stocks, small cap stocks, international stocks, value, growth, etc, but diversification by methodology:

Option 1: A Core/Satellite Approach---In Core/Satellite approach the investor would have a fixed core of a portfolio surrounded by a momentum based overlay.  In a choppy market the momentum overlay would still be subjected to momentum head fakes but the fixed core would remain invested.  In a bear market the investor would be exposed to higher drawdowns but the losses would be shifted to a down market which is psychologically more easy to tolerate than losses in an up market.

Option 2: Multiple Momentum Approaches---Many tactical managers try to optimize the one best momentum methodology.  A smarter approach would be to combine multiple, uncorrelated momentum methodologies together.  The idea would be that when one is being subjected to momentum head fakes the others are not.

Just because momentum strategies struggled in 2014 doesn't invalidate their effectiveness.  Every investment strategy has a market environment that it will struggle in and momentum did exactly what it was supposed to do in 2014.  As practitioners we need to constantly innovate to address these issues as much as we can to ensure the best possible investment experience for clients.

Thursday, April 2, 2015

ETF Trading Basics

Now that our ETF is out we have been getting a lot of questions about how to trade ETFs.  Here are some basic guidelines:

1. Volume has nothing to do with liquidity--The ability to trade an ETF has nothing to do with volume, it is all based on the liquidity of the underlying basket.  

2. Know the fair value of the ETF when you want to trade it---Quote systems only show the last trade, so if the ETF last traded at 10am and you want to place a trade at 3pm the price you see will be old.  A better way to gauge the value of the ETF is either looking at the Indicative Value (you will need some sort of advanced quote screen for this), or the bid/ask spread, which can be found on Yahoo Finance.

3. Try to avoid trading during the first and last 15 minutes of the trading day--During the open in takes market makers a bit to figure out the prices of all the underlying securities in an ETF.  During that time bid/ask spreads are likely to be wider.  At the end of the day you can see a lot of order imbalances that can also impact spreads.

4. Try to avoid market orders---Market orders put you at the mercy of the market, you are better off placing limit orders.  We can help you decide where to place your limits.

5. Call you block desk on trades over 5,000 shares---Larger trades are better facilitated through your custodians block desk.  They will reach out to various market makers and come back to you with the best price.

Thursday, March 26, 2015

How The Bull Market Might End

Yesterday I was on CNBC talking about how bull markets die slowly and how the sell off was not the beginning of the end, yet:

What yesterday might have been though is a sneak peak at what the end will look like.  In this Fed induced bubble bad economic news should be good as it means that Fed tightening will probably be pushed out.  When bad economic news is bad, then that is bad, because it means that the market thinks the Fed might be out of bullets.  If the Fed has exhausted their playbook and we are still headed towards a recession then we have a problem.  Over the past few years we have had a bunch of V shaped moves in the market, something knocks us down but we know the Fed has our back so the market rallies back up.  If we know the Fed has our back but we also don't believe they have any options left then one day we have a decline that doesn't rally back.

As I said on CNBC this bull market will die slowly, but all bull markets eventually die.  Investors who are prepared will be fine, those who have come to believe "this time is different" will get hurt like they always do.

Sunday, March 22, 2015

What is Better---Index Funds or Active Managers?

The active and passive investment shops always argue it out over what is better---active money managers or indexing.

I just read a paper from Vanguard that, as you would expect, makes the case for index funds:

The Case For Indexing

Put alongside the paper from Ted Theodore about there being better times to be active and better times to be passive it brings up an interesting idea:

Dig We Must

What if they are both right?  There are times when stocks are uncorrelated that a good stock picker (someone who is not just hugging an index) can add some real value.  There are also times when stocks are very correlated where it is much harder for an active manager to add value.   Given this, it is very easy for both sides to data mine and pick out the times when there way outperformed as proof that one way is better than another.

However, this argument ignores the 800 pound gorilla in the room about what happens when the market goes down?  Neither active stock pickers or passive indexes will protect investors from market declines.

The better approach could be twofold:

1. Instead of active or passive how about smart beta?  Smart beta strategies fall somewhere in between, they are passive because a computer is picking the stocks just like an index fund, but they have a semblance of being active because the portfolio manager is using some sort of formula other than simple market cap weighting to pick stocks.  The smart beta strategies out there today have all been backtested and show to beat the market.  Yes, I know that nobody has ever seen a bad backtest so time will tell whether these strategies are robust going forward.  We think they will be because we believe they benefit from a value and size effect which should persist.

2. You need a tactical overlay.  Smart beta may beat the market over time but it won't protect you when it crashes either.  A tactical overlay on top of a smart beta strategy makes smart beta smarter.

Friday, March 20, 2015

Is It a Stock Pickers Market or a Global Macro Market?

If you watch financial news enough you will hear someone come on and talk about how the current market is for stock pickers, but what does that mean?  Just watching the market day by day you see times when it seems like all stocks go up or down together and you also see times when there are a bunch of divergences.  It would seem to make sense that during times when stocks are moving together that there isn't a ton of value trying to pick individual stocks.  On the flip side, it would seem that during times when there is a lot of divergences between stocks that stock picking would have much more value.  As a money manager we have individual stock strategies and strategies that just buy broad market based ETFs.  If we could identify times when our stock strategies were likely to outperform and times when it made more sense to concentrate on broad markets, that could be very useful.

Ted Theodore over at QAS just wrote a real interesting piece on how to measure this.

ETF Strategist-Dig We Must

Saturday, March 14, 2015

Why Smart Beta Strategies Work---It's Not What You Think

Smart Beta strategies are hot.  Go to any ETF conference and the majority of presentations will be about Smart Beta.  Smart Beta is any type of indexing methodology that is not market cap weighted, in an index like the S&P 500 companies are weighted by how large they are.  A Smart Beta approach to the S&P 500 would weight companies differently---equal weight, fundamental weight, low beta, high beta, etc.

It makes sense that Smart Beta is hot right now, ETFs are the future of asset management but we don't need another market cap weighted index.  So if you are going to issue a new ETF it has to be something different.  Add in the fact that the research shows that just about any other way to weight an index beats market cap weighting over time.

The million dollar question is why does Smart Beta outperform market cap weighting and will it persist?  One idea why is simple, curve fitting.  With computer technology you can find a bunch of anomalies that beat the market.  To guard against this you need to start with a valid premise that should work, and then test it to see if it does.  For example, weighting companies by fundamental factors, meaning the companies in the best shape get a larger weight in the index and the companies in the worst shape get a lower weight, should beat simple market cap weighting.  You can then test it and see what the results are.

The link below it a video from Rob Arnott talking about Smart Beta, it is a couple of years old but makes an interesting point about why Smart Beta strategies likely outperform.

He took a look at a bunch of different Smart Beta approaches and found that they beat market cap weighting.   He then took the opposite of those approaches and found that they also beat market cap weighting.  On the surface this makes no sense.  For example, if overweighting low beta stocks beats market cap weighting because their is something uniquely powerful about low beta stocks, the the inverse, overweighting high beta stocks, shouldn't beat market cap weighting, but it does.

The answer most likely is that Smart Beta strategies, regardless of how they are constructed, encompass two tilts---value and size---that do better than market cap weighting.  In a market cap weighted index you are always going to overweight the most expensive and therefore the largest stocks.  In most Smart Beta approaches you are going to tilt more towards value and smaller stocks, this is most likely where the outperformance comes from.

For example, we use the Guggenheim Equally Weighted S&P 500 (RSP) ETF a lot in our strategies. Like the name suggests it equally weights all the companies in the S&P 500.   According to Morningstar over the past 10 years (as of 3/13/15) RSP has an average annual return of 9.13% vs. a return of 7.76% for the S&P 500.  Also according to Morningstar, the average market cap of the portfolio is $21.9 billion vs. $73.4 billion for the market cap weighted S&P 500.  So where did the outperformance come from?  It could be a random anomaly that was curve fit, but most likely it is the size tilt towards smaller cap stocks.

Will Smart Beta outperformance persist?  Who knows.  However, it makes sense that value---buying something for a low price, and small stock outperformance should continue over time so any strategy that tilts towards those factors should be fine.