With approaches to investing such as is described in the following excerpt from a post on Musing On Markets blog (written by a professor at NYU), is it any wonder that factor-based investing (aka “Smart Beta”) is taking off?
Assume that you value a stock at $20 and it is trading at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don’t buy the stock, or perhaps, sell it short! Now let’s say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing. Even if you believe that markets are not always rational, you worry that the market knows something that you don’t. The second is envy. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take.
- Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
- Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor.
- Preserve the value illusion and look for “intrinsic” ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.
The level of subjective decision-making described above is a recipe for ulcers, unhappy clients, and likely a short career in this industry. Such an investor follows a different discipline (I use that term loosely in this context) every day. Every change in investment philosophy is largely based on changes in feelings.
One of the major reasons why there has never been a better time to be an advisor in this industry than today is because of the ability to access disciplined investment strategies (aka “Smart Beta”) in rules-based indexes where the risk of the manager not following the discipline is largely removed. Books, such as What Works on Wall Street by Jim O’Shaughnessy, clearly point out that there are a number of return factors that have been able to generate excess return over time. In my opinion, one of the biggest reasons that “actively managed strategies” have had such a poor track record, in aggregate, over time is because the investment committee of these strategies sits around and goes through some variation of steps 1-3 shown above on a regular basis. In other words, there is no discipline!
Consider the following exchange between Tom Dorsey and IndexUniverse from last year on the topic of the future of the ETF industry. Tom was asked to explain his statement that the future of the ETF market is “ETF Alchemy.”
Dorsey: Think about this for a second: If I take H2 and I add O, what do I get?
IU.com:Water.
Dorsey: Yes, water. Each one of those two elements is separate. But when I combine the two, I come up with a substance—water—that you can’t live without. Each one separately is not as good as the two combined. And the concept here is, What’s out there in terms of ETFs I can combine together to make a better product?
Take for instance the Standard & Poor’s Low Volatility Index—and if you add that to PDP, which is our Technical Leaders Index, and combine the two, it’s like taking two glasses of water and pouring them into one bigger glass of water, 50-50. I end up with a better product than either one of them separately.
You’ll find this as we go along: the ability to combine different ETFs to create a better unit where the whole is better than the sum of its parts.
A little later in the interview, Tom Dorsey spoke to just how important the ETF has been to the industry:
Dorsey: Yes, and I can’t tell you how many seminars I have taught to professionals on ETFs and the eyes that widen and the lives that change once they understand it and understand how to use it; it tells me we’re on the right path and this is the exact right product.
Like I’ve said to you before, it’s probably the most important product ever created in my 39 years in this business. And I believe back then when I talked to you that we’re in the first foot of a 26-mile marathon.
With some reasonable amount of due diligence, advisors today can identify a handful of investment factors that have historically provided excess return. The advisor can then combine these strategies—now plentifully available in ETF format—for a client in a way that provides diversified and disciplined exposure to winning return factors at a reasonable cost.
Dorsey Wright is the index provider for PDP. For more information, please see www.powershares.com. A momentum strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Past performance is no guarantee of future returns. Potential for profits is accompanied by possibility of loss.
