Is Active Investing Hopeless?

August 19, 2013

Every time I read an article about how active investing is hopeless, I shake my head.  Most of the problem is investor behavior, not active investing.  The data on this has been around for a while, but is ignored by indexing fans.  Consider for example, this article in Wealth Management that discusses a 2011 study conducted by Morningstar and the Investment Company Institute.  What they found doesn’t exactly square out with most of what you read.  Here are some excerpts:

But studies by Morningstar and the Investment Company Institute (ICI) suggest that fund shareholders may not be so dumb after all. According to the latest data, investors gravitate to low-cost funds with strong track records. “People make reasonably intelligent choices when they pick active funds,” says John Rekenthaler, Morningstar’s vice president of research.

The academic approach produces a distorted picture, says Rekenthaler. “It doesn’t matter what percentage of funds trail the index,” says Rekenthaler. “What matters most is how the big funds do. That’s where most of the money is.”

In order to get a realistic picture of fund results, Rekenthaler calculated asset-weighted returns—the average return of each invested dollar. Under his system, large funds carry more weight than small ones. He also calculated average returns, which give equal weight to each fund. Altogether Morningstar looked at how 16 stock-fund categories performed during the ten years ending in 2010. In each category, the asset-weighted return was higher than the result that was achieved when each fund carried the same weight.

Consider the small-growth category. On an equal-weighted basis, active funds returned 2.89 percent annually and trailed the benchmark, which returned 3.78 percent. But the asset-weighted figure for small-growth funds exceeded the benchmark by 0.20 percentage points. Categories where active funds won by wide margins included world stock, small blend, and health. Active funds trailed in large blend and mid growth. The asset-weighted result topped the benchmark in half the categories. In most of the eight categories where the active funds lagged, they trailed by small margins. “There is still an argument for indexing, but the argument is not as strong when you look at this from an asset-weighted basis,” says Rekenthaler.

The numbers indicate that when they are choosing from among the many funds on the market, investors tend to pick the right ones.

Apparently investors aren’t so dumb when it comes to deciding which funds to buy.  Most of the actively invested money in the mutual fund industry is in pretty good hands.  Academic studies, which weight all funds equally regardless of assets, don’t give a very clear picture of what investors are actually doing.

Where, then, is the big problem with active investing?  There isn’t one—the culprit is investor behavior.  As the article points out:

But investors display remarkably bad timing for their purchases and sales. Studies by research firm Dalbar have shown that over the past two decades, fund investors have typically bought at market peaks and sold at troughs.

Active investing is alive and well.  (I added the bold.)  In fact, the recent trend toward factor investing, which is just a very systematic method for making active bets, reinforces the value of the approach.

The Morningstar/ICI research just underscores that much of the value of an advisor may lie in helping the client control their emotional impulse to sell when they are fearful and to buy when they feel confident.  I think this is often overlooked.  If your client has a decent active fund, you can probably help them more by combatting their destructive timing than you can by switching them to an index fund.  After all, owning an index fund does not make the investor immune to emotions after a 20% drop in the stock market!

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Correlation and Expected Returns

July 31, 2013

Modern portfolio theory imagines that you can construct an optimal portfolio, especially if you can find investments that are uncorrelated.  There’s a problem from the correlation standpoint, though.  As James Picerno of The Capital Spectator points out, correlations are rising:

A new study from the Bank of International Settlements (BIS) raises doubts about the value of commodities as a tool for enhancing portfolio diversification. The paper’s smoking gun, so to speak, is that “the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis.”

Correlations are a key factor in the design and management of asset allocation, but they’re not the only factor. And even if we can find assets and strategies with reliably low/negative correlations with, say, equities, that alone isn’t enough, as I discussed last week. You also need to consider other factors, starting with expected return. It may be tempting to focus on one pair of assets and consider how the trailing correlation stacks up today. But that’s hardly the last word on making intelligent decisions on how to build a diversified portfolio.

As more investors pile into commodities, REITs, hedge funds, and other formerly obscure corners, the historical diversification benefits will likely fade. Granted, the outlook for expected diversification benefits fluctuates through time, and so what looks unattractive today may look considerably more compelling tomorrow (and vice versa). But as a general proposition, it’s reasonable to assume that correlations generally will inch closer to 1.0. That doesn’t mean that diversifying across asset classes is destined to become worthless, but the expected payoff is likely to dim with the passage of time.

Mathematically, any two items that are not 100% correlated will reduce volatility when combined.  But that doesn’t necessarily mean it’s a good addition to your portfolio—or that modern portfolio theory is a very good way to construct a portfolio.  (We will set aside for now the MPT idea that volatility is necessarily a bad thing.)  The article includes a nice graphic, reproduced below, that shows how highly correlated many asset classes are with the US market, especially if you keep in mind that these are 36-month rolling correlations.  Many asset classes may not reduce portfolio volatility much at all.

Source: The Capital Spectator  (click on image to enlarge)

As Mr. Picerno points out, optimal allocations are far more sensitive to returns than to correlations or volatility.  So even if you find a wonderfully uncorrelated investment, if it has a lousy return it may not help the overall portfolio much.  It would reduce volatility, but quite possibly at a big cost to overall returns.  The biggest determinant of your returns, of course, is what assets you actually hold and when.  The author puts this a slightly different way:

Your investment results also rely heavily on how and when you rebalance the mix.

Indeed they do.  If you hold equities when they are doing well and switch to other assets when equities tail off, your returns will be quite different than an investor holding a static mix.  And your returns will be way different than a scared investor that holds cash when stocks or other assets are doing well.

In other words, the return of your asset mix is what impacts your performance, not correlations or volatility.  This seems obvious, but in the fog of equations about optimal portfolio construction, this simple fact is often overlooked.  Since momentum (relative strength) is generally one of the best-performing and most reliable return factors, that’s what we use to drive our global tactical allocation process.  The idea is to own asset classes as long as they are strong—and to replace them with a stronger asset class when they begin to weaken.  In this context, diversification can be useful for reducing volatility, if you are comfortable with the potential reduction in return that it might entail.  (We  generally advocate diversifying by volatility, by asset class, and by strategy, although the specific portfolio mix might change with the preference of the individual investor.)  If volatility is well-tolerated, maybe the only issue is trying to generate the strongest returns.

Portfolio construction can’t really be reduced to some “optimal” set of tradeoffs.  It’s complicated because correlations change over time, and because investor preferences between return and volatility are in constant flux.  There is nothing stable about the portfolio construction process because none of the variables can be definitively known; it’s always an educated approximation.  Every investor gets to decide—on an ongoing basis—what is truly important: returns (real money you can spend) or volatility (potential emotional turmoil).  I always figure I can afford Maalox with the extra returns, but you can easily see why portfolio management is overwhelming to so many individual investors.  It can be torture.

Portfolio reality, with all of its messy approximations, bears little resemblance to the seeming exactitude of Modern Portfolio Theory.

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Factor Performance and Factor Failure

July 30, 2013

Advisor Perspectives recently carried an article by Michael Nairne of Tacita Capital about factor investing.  The article discussed a number of aspects of factor investing, including factor performance and periods of factor underperformance (factor failure).  The remarkable thing about relative strength (termed momentum in his article) is the nice combination of strong performance and relatively short periods of underperformance that it affords the investor seeking alpha.

Mr. Nairne discusses a variety of factors that have been shown to generate excess returns over time.  He includes a chart showing their performance versus the broad market.

Source: Advisor Perspectives/Tacita Capital  (click on image to enlarge)

Yep, the one at the top is momentum.

All factors, even very successful ones, underperform from time to time.  In fact, the author points out that these periods of underperformance might even contribute to their factor returns.

No one can guarantee that the return premia originating from these dimensions of the market will persist in the future. But, the enduring nature of the underlying causes – cognitive biases hardwired into the human psyche, the impact of social influences and incremental risk – suggests that higher expected returns should be available from these factor-based strategies.

There is another reason to believe that these strategies offer the prospect of future return premia for patient, long-term investors. These premia are very volatile and can disappear or go negative for many years. The chart on the following page highlights the percentage of 36-month rolling periods where  the factor-based portfolios – high quality, momentum, small cap, small cap value and value – underperformed the broad market.

To many investors, three years of under-performance is almost an eternity. Yet, these factor portfolios underperformed the broad market anywhere from almost 15% to over 50% of the 36-month periods from 1982 to 2012. If one were to include the higher transaction costs of the factor-based portfolios due to their higher turnover, the incidence of underperformance would be more  frequent. One of the reasons that these premia will likely persist is that many  investors are simply not patient enough to stay invested to earn them.

The bold is mine, but I think Mr. Nairne has a good point.  Many investors seem to believe in magic and want their portfolio to significantly outperform—all the time.

That’s just not going to happen with any factor.  Not surprisingly, though, momentum has tended to have shorter stretches of underperformance than many other factors, a consideration that might have been partially responsible for its good performance over time.  Mr. Nairne’s excellent graphic on periods of factor failure is reproduced below.

Source: Advisor Perspectives/Tacita Capital (click on image to enlarge)

Once again, whether you choose to try to harvest returns from relative strength or from one of the other factors, patience is an underrated component of actually receiving those returns.  The market can be a discouraging place, but in order to reap good factor performance you have to stay with it during the inevitable periods of factor failure.

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Alternative Beta

July 22, 2013

…has been discovered by the Wall Street Journal.  Recently, they wrote an article about better ways to index—alternative beta—and referenced a study by Cass Business School.  (We wrote about this study here in April.)

Here’s the WSJ’s take on the Cass Business School study:

The Cass Business School researchers examined how 13 alternative index methodologies would have performed for the 1,000 largest U.S. stocks from 1968 to 2011.

All 13 of the alternative indexes produced higher returns than a theoretical market-cap index the researchers created. While the market-cap index generated a 9.4% annualized return over the full period, the other indexes delivered between 9.8% and 11.4%. The market-cap-weighted index was the weakest performer in every decade except the 1990s.

The most interesting part of the article, to me, was the discussion of the growing acceptance of alternative beta.  This is truly exciting.

Indeed, a bevy of funds tracking alternative indexes have been launched in recent years. And their popularity is soaring: 43% of inflows into U.S.-listed equity exchange-traded products in the first five months of 2013 went to products that aren’t weighted by market capitalization, up from 20% for all of last year, according to asset manager BlackRock Inc.

And then there was one mystifying thing: although one of the best-performing alternative beta measures is relative strength (“momentum” to academics), relative strength was not mentioned in the WSJ article at all!

Instead there was significant championing of fundamental indexes.  Fundamental indexes are obviously a valid form of alternative beta, but I am always amazed how relative strength flies under the radar.  (See The #1 Investment Return Factor No One Wants to Talk About.)  Indeed, as you can see from the graphic below, the returns of two representative ETFs, PRF and PDP are virtually indistinguishable.  One can only hope that relative strength will eventually gets its due.

The performance numbers above are pure price returns, based on the applicable index not  inclusive of dividends, fees, commissions, or other expenses. Past performance not indicative of future results.  Potential for profits accompanied by possibility of loss.  See for more information.  

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Factor Investing

July 18, 2013

Factor investing is one of the new frontiers in portfolio construction.  We love this trend because relative strength (known as momentum to academics) is one of the premier factors typically used when constructing portfolios.  The Technical Leaders ETFs that we construct for Powershares have really benefited from the movement toward factor investing.

Larry Swedroe recently wrote a glowing article on factor investing for Index Universe that serves as a good introduction.  His article is full of great points distilled from a paper in the Journal of Index Investing.  (The link to the journal paper is included in his article if you want to read the original source.)

The basic idea is that you can generate superior performance by building a portfolio of return factors.  A corollary benefit is that because some of the factors are negatively correlated, you can often reduce the portfolio volatility as well.  A couple of excerpts from his article should give you the flavor:

The evidence keeps piling up that investors can benefit from building portfolios that diversify across factors that not only explain stock market returns but that also generate superior returns.

The authors found that investors benefited not only from the exposure to each of the factors individually, but also from the low or negative correlations across these factors. The result was more efficient portfolios than ones that were concentrated in a market portfolio or in single factors.

They concluded: “The fact that momentum and value independently deliver market outperformance, with negatively correlated active returns and a low probability of simultaneous market underperformance, provides the motivation for pursuing a momentum and value diversification strategy.”

We concur with the research that shows momentum and value make a great pairing in a portfolio.  The table included in the article showed that these two factors were negatively correlated over the period of the study, 1979-2011.

What brought a smile is that Mr. Swedroe is a well-known and passionate advocate for “passive” investing.  Factor investing is about as far from passive investing as you can get.

Think about how a value index or relative strength index is constructed—you have to build it actively, picking and choosing to get the focused factor exposure you want.  What is a value stock at the beginning of one period may not be a value stock after an extended run-up in price, so activity is also required to reconstitute and rebalance the index on a regular basis.  Stocks that lose their high relative strength ranking similarly need to be actively replaced at every rebalance.  Whether the picking and choosing is done in a systematic, rules-based fashion or some other way is immaterial.

Market capitalization-weighted indexes, as a broad generality, might be able to “kinda sorta” claim the passive investing label because they don’t generally have to be constantly rebalanced—although the index component changes are active.  A factor index, on the other hand, might require a lot of activity to reconstitute and rebalance it on a regular schedule.  But that’s the point—the end result of the activity is focused factor exposure designed to generate superior performance and volatility characteristics.

And spare me the argument that indexing is passive investing.  Take a look at the historical level of turnover in indexes like the S&P 500, the S&P Midcap 400, the S&P Smallcap 600, or the Russell 2000 and then try to make the argument that nothing active is going on.  I don’t think you can do it.  The only real difference is that you have hired the S&P index committee to manage your portfolio instead of some registered investment advisor.  (In fact, the index committees typically incorporate some element of relative strength in their decisions as they dump out poor performers and add up-and-coming stocks.  Look at the list of additions and deletions if you don’t believe me.)  Certainly the level of turnover in a value or momentum index belies the passive label as well.

Index investing is active investing.

I think where passive investing advocates get confused is on the question of cost.  Index investing is often low-cost investing—and cost is an important consideration for investors.  I suspect that many fans of passive investing are more properly described as fans of low-cost investing.  I’m not sure they are really even fans of indexing, since research shows that many so-called actively managed funds are really closet index funds.  Presumably their objection is the big fee charged for indexing while masquerading as an active fund, not the indexing itself.  (But the same research suggests that an active fund that is truly active—one with high active share—is not necessarily a bad deal.)

Even a factor index is active by definition, but if it is well-constructed and low cost to boot, it might worth taking a close look at.

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Smart Beta vs. Monkey Beta

April 9, 2013

Andy wrote a recent article entitled Smart Beta Gains Momentum.  It’s gaining momentum for a good reason!  A recent study at Cass Business School in London found that cap-weighting was not a very good way to construct an index.  Lots of methods to get exposure to smart beta do better.  The results were discussed in an article at Index Universe.  Some excerpts:

Researchers have found that equity indices constructed randomly by ‘monkeys’ would produce higher risk-adjusted returns than an equivalent market capitalisation-weighted index over the last 40 years…

The findings come from a recent study by Cass Business School (CBS), which was based on monthly US share data from 1968 to 2011. The authors of the study found that  a variety of alternative index weighting schemes all delivered superior returns to the market cap approach.

According to Dr. Nick Motson of CBS, co-author of the study, “all of the 13 alternative indices we studied produced better risk-adjusted returns than a passive exposure to a market-cap weighted index.”

The study included an experiment that saw a computer randomly pick and weight each of the 1,000 stocks in the sample. The process was then repeated 10 million times over each of the 43 years.   Clare describes this as “effectively simulating the stock-picking abilities of a monkey”.

…perhaps most shockingly, we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index,” said Clare.

The findings will be a boost to investors already looking at alternative indexing.  Last year a number of European pension funds started reviewing their passive investment strategies, switching from capitalisation-weighting to alternative index methodologies.

Relative strength is one of the prominent smart beta methodologies.  Of course, cap-weighting has its uses—the turnover is low and rebalancing is minimized.  But purely in terms of performance, the researchers at Cass found that there are better ways to do things.  Now that ETFs have given investors a way to implement some of these smart beta methods in a tax-efficient, low-cost manner, I suspect we will see more movement toward smart beta in the future.

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Retirement Stress

March 20, 2013

AdvisorOne ran an interesting article recently, reporting the results of a retirement study done by Franklin Templeton.  Investors are feeling a lot of stress about retirement, even early on.  And given how things are going for many of them, feeling retirement stress is probably the appropriate response!  In no particular order, here are some of the findings:

A new survey from Franklin Templeton finds that nearly three-quarters (73%) of Americans report thinking about retirement saving and investing to be a source of stress and anxiety.

In contrast to those making financial sacrifices to save, three in 10 American adults have not started saving for retirement. The survey notes it’s not just young adults who are lacking in savings; 68% of those aged 45 to 54 and half of those aged 55 to 64 have $100,000 or less in retirement savings.

…two-thirds (67%) of pre-retirees indicated they were willing to make financial sacrifices now in order to live better in retirement.

“The findings reveal that the pressures of saving for retirement are felt much earlier than you might expect. Some people begin feeling the weight of affording retirement as early as 30 years before they reach that phase of their life,” Michael Doshier, vice president of retirement marketing for Franklin Templeton Investments, said in a statement. “Very telling, those who have never worked with a financial advisor are more than three times as likely to indicate a significant degree of stress and anxiety about their retirement savings as those who currently work with an advisor.”

As advisors, we need to keep in mind that our clients are often very anxious over money issues or feel a lot of retirement stress.  We often labor over the math in the retirement income plan and neglect to think about how the client is feeling about things—especially new clients or prospects.  (Of course, they do feel much better when the math works!)

The silver lining, to me, was that most pre-retirees were willing to work to improve their retirement readiness—and that those already working with an advisor felt much less retirement stress.  I don’t know if clients of advisors are better off for simply working with an advisor (other studies suggest they are), but perhaps even having a roadmap would relieve a great deal of stress.  As in most things, the unknown makes us anxious.  Working with a qualified advisor might make things seem much more manageable.

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Advisors Turning to ETFs

September 12, 2012

Most professionals have noticed the move to ETFs happening, but a recent article at AdvisorOne makes the magnitude of the shift more clear:

Since the beginning of 2012, investors have pulled almost $15 billion from U.S. stock funds, while boosting money put into ETFs by $16 billion, according to industry studies.

In the latest AdvisorBenchmarking report, for example, 54% of advisors say they are likely to increase their use of the ETFs in the near future, with 43% saying they expect their use of ETFs over the next three years to remain the same.

What is the strategic role of ETFs in portfolios? According to the survey, many strategies lie behind ETF implementation. While “core” and “sector” exposures were most common, several other approaches were all within a few points of each other, including: alternatives exposure, directional market positions, factor or asset class exposures and country/region exposure. Clearly, ETFs are providing advisors and investors with attractive options for expressing their views, and that is translating into strong, consistent growth for these vehicles.

AdvisorBenchmarking provided a nice graphic on the strategic uses of ETFs.  It’s clear that ETFs are multipurpose vehicles because advisors are using them to meet a lot of different objectives!

Source: AdvisorBenchmarking/AdvisorOne (click on image to enlarge)

According to their survey, only 8% of ETF use is coming from directional market positions—far less than imagined by people who criticize ETF investors as reckless market timers.  For the most part, advisors are using ETFs to get exposures that were unavailable before, whether it is to a specific sector, country, or asset class.

Most of the ETFs now available offer passive exposures to various indexes.  More interesting to me are the small number of semi-active ETFs that are designed to provide factor exposure in an attempt to generate alpha.  Research suggests that combining factor exposures might be a superior way to capture market returns.

The Technical Leaders indexes are constructed to provide exposure to the momentum (relative strength) factor and there are a couple of low-volatility ETFs around as well.  There are a few ETFs explicitly designed for value exposure, although I don’t think this area has been well-exploited yet.  (I’m sorry to see Russell close down their suite of ETFs, which I thought had a lot of promise.)

With more and more options available to advisors, I would not be surprised to see ETF use continue to surge.

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Factor Investing

May 8, 2012

Diversification, risk management, and returns are all important in investing.  Increasingly, factor exposure is being used to accomplish these goals.  A Wall Street Journal article covered the issue very well (may be behind a pay wall, sorry).

By changing the way you spread out your stock holdings, you can reduce risk and boost returns—even in a highly correlated market like today’s.

The trick? A concept known as “factor investing,” which originated in academia two decades ago and now is finding favor among institutional investors and high-end financial advisers.

Factor investing replaces traditional asset allocation—such as a portfolio with 30% in U.S. stocks, 20% in developed international markets, 10% in emerging markets and 40% in bonds—by focusing on specific attributes that researchers say drive returns. These “risk factors” include the familiar—like small versus large-size companies or growth versus value stocks—as well as more esoteric measures such as volatility, momentum, dividend yield, economic sensitivity and the health of a company’s balance sheet.

As a reader of this blog, you’re probably already familiar with factor investing through relative strength—something that academics call momentum.  Using factors rather than style boxes has some advantages.

“There are a lot of nuances you may be missing by focusing only on style and size,” says Savita Subramanian, head of equity and quantitative strategy at BofA Merrill Lynch Global Research. “You may be missing a whole layer of outperformance you could have gotten.”

Some fairly high-end investors are converting portfolios to focus on factor exposures.  By converting to factor exposure, investors are trying to drill down to the actual return drivers.

Big investors are taking heed. In 2009, researchers assigned to analyze the Norwegian Government Pension Fund recommended it reorient its portfolio around risk factors. And the California Public Employees’ Retirement System underwent a similar change in approach in 2010.

After 2008, big investors discovered that they had factor exposure anyway—it was just exposure they were not aware of and hadn’t controlled.  There’s a lot less potential for surprise if the factor exposures are constructed deliberately!

New products are becoming available to feed the demand for factor exposure as well.

Until recently, it was hard for small investors to dabble in factor investing. But that is changing.

In the past year at least six firms—BlackRock’s iShares, Russell Investments, Invesco PowerShares, Factor Advisors, QuantShares and State Street Global Advisors—have launched factor-based exchange-traded funds, or have filed paperwork to do so.

Of course, overlooked among the rush of big firms racing to create factor exposure is the grand-daddy of relative strength, the Powershares DWA Technical Leaders Index (PDP).  It’s actually been around more than five years and has performed nicely over that time, beating the S&P 500 despite a market environment that has been hostile to relative strength strategies.  (We’re looking forward to seeing how it performs in a better RS market!)

One of the big advantages of factor exposure is that some factors offset one another beautifullyWe’ve written before about the nice efficient frontier that is created by combining relative strength and low volatility.  (You can see the chart below.)  These factors work well together because the excess returns are uncorrelated.

Source: Dorsey Wright    (click to enlarge to full size)

In short, there’s more to portfolio construction than asset allocation and style boxes.  Factor exposure should be considered as well if the result is a better portfolio for the client.

See for more information about PDP.  Past performance is no guarantee of future returns.  A list of all holdings for the trailing 12 months is available upon request.

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