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 your 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.