With investing, expectations and reality aren’t always the same. You may choose an investment based on its past performance, only to be disappointed by future results. Dalbar’s 2017 Quantitative Analysis of Investor Behavior Study suggests that despite their best intentions, investors routinely miss the mark.
News Mentions & Press Releases
For every social media darling claiming to have struck it rich with Bitcoin, there’s a prominent investor calling it a fraud or bubble. You’d probably want to trust Warren Buffett over @MrMoneyBags on Twitter, right? As the College Football Analyst, Lee Corso, likes to say, “Not so fast my friend!” The funny thing about bubbles is that they usually aren’t deemed as such until after they have burst. That makes pinning Bitcoin a bubble ready to burst very difficult. Following the housing market crash, Forbes wrote an article detailing the five steps of a bubble. The following will look at where Bitcoin may fit into the stereotypical bubble.
1) Displacement: A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low.
Bitcoin, or better yet, blockchain technology, seems to fit the bill here. Blockchain is being tabbed as an extremely disruptive technology for many industries. Many people see Bitcoin as the way to invest in the underlying technology.
Theoretical approaches to decision making assume rationality. However, early assumptions about how humans would make decisions, particularly with regard to finances, failed to account for how we as humans make choices in the face of uncertainty. The reality is that human beings actually make decisions by considering the probabilities of gains and losses associated with competing alternatives, rather than solely considering the end-state.
Behavioral economists were among the first to consider human irrationality in decision making. Research showed that in scenarios where people could choose certain loss of a small amount vs. possible loss of a great amount, people consistently chose the latter, because it had the benefit of uncertainty. The same model framed as gains led to the opposite result. As such, researchers concluded that utility in decision outcomes is a perception held by individuals, rather than an objective state.
In 2016, for example, the performance of the average stock mutual fund investor lagged the Standard & Poor’s 500 index by a margin of 4.7 percent. Investors earned a 7.26 percent return on average, while the broader market gained 11.96 percent. Although the margins for 20-year annualized returns were narrower, the average investor still lagged the S&P 500 by 2.89 percent.
Overall, investors correctly guessed which way the market would move 42 percent of the time in 2016. That’s a steep decline from 2015, when investors guessed right 75 percent of the time. But in both years, the average stock fund investor still couldn’t keep pace with the market.
Why Smart Beta Wins
They capture the essence of active management because the factors that construct smart beta ETFs are typically the same fundamental screens many money managers use when building portfolios.
All else being equal, lower cost always wins. Thus, smart beta is attractive because many investors use active management to achieve superior, risk-adjusted performance, but smart beta strategies allow them to do so at a far lower cost.
While the average actively managed mutual fund has an expense ratio of more than 1% per year, the average smart beta ETF has an expense ratio of approximately 0.3-0.35%, or about a third of the cost. That’s a good head start for better performance.
If there was ever an industry in transition, it’s the investment management industry. The pace of change is accelerating and transforming investing.
This continuous march in industry transformation began in the mid-1970s with the de-regulation of commissions, which unleashed disruption that is still present. On May 1, 1975, and for the first time in 180 years, trading fees were set by market competition, instead of the government.
Online trading further accelerated this industry disruption, bringing trade commissions down from hundreds of dollars to just a few only 20 years later.
Innovation in the development of financial tools has been tremendous over the last several decades. There have been advances in robust risk-modeling software, algorithmic trading, and the evolution from investment vehicles, such as mutual funds with various front-end and back-end loads to low-cost ETFs.
The ETF industry continues to experience exponential growth and has seen inflows of $380 billion in 2017 so far. As ETFs gain favor with investors, innovation is accelerating. When ETFs first launched in the early 1990s, they were developed as short-term trading vehicles that allowed investors to quickly gain exposure to broad-market baskets at intra-day pricing.
These days, enhanced indexing, also known as smart beta, is growing in popularity. This systematic, rules-based approach attempts to isolate particular factors or themes that are proven to add incremental value over time and are necessary to correct some of the pitfalls of market-cap-weighted exposure.
At CLS Investments, we are heavy users of smart-beta ETFs, so understanding smart beta is key to understanding CLS portfolios.
Smart-beta ETFs have become increasingly popular, but they are not always easy to explain. Though adoption rates by investors are quickly increasing, surveys show the leading reason adoption rates aren’t even higher is that investors are still trying to understand exactly what smart-beta ETFs are and what they’re used for.
Smart-beta (factor-based) ETFs are, technically, any ETF that is passively managed and weights its securities based on something other than market capitalization, like revenues or earnings. Put simply, smart-beta ETFs capture the essence of active management at a fraction of the cost.
CLS teams up with ETF providers to offer no-fee strategy
CLS Investments has partnered with five ETF providers to launch Smart ETF Models with a zero percent strategist fee, the firm said. The firm said it teamed up with Deutsche Asset Management, First Trust, JPMorgan Asset Management, Pimco and PowerShares by Invesco to offer these models.
Currently CLS offers eight Smart ETF Models that are globally diversified portfolios composed of smart beta and active ETFs, as well as smaller satellite positions in ETFs focused on specific sectors, countries and alternative assets.
A little more than a week before one of the year’s biggest shopping days, ProShares launched an ETF designed to capitalize on poor performance of brick and mortar stores.
The ProShares Decline of the Retail Store ETF (EMTY) provides short exposure to companies in a sector that has struggled and shows few signs of turning around. While shares of Abercrombie & Fitch Co. and Foot Locker, Inc. both leapt more than 25 percent last week after stronger than expected earnings reported, the future for many companies in the retail sector feels grim.
ProShares points to declining sales and bankruptcies by more than 30 major retailers in the last three years, including Toys “R” Us, RadioShack and Payless.
The apparel segment accounts for more than 28 percent of the index, followed by department stores, at 10.71 percent, and then similar weights across others within the sector. J.C. Penny Co. Inc., Sears Holdings Corp., Barnes & Noble Inc. and others that have made headlines in recent years for poor performance are also in the index. The 56 companies are equally weighted.
— Editor’s note: This article is the second in a series by CLS Investments CEO Ryan Beach covering his firm’s research on advisor-client relationships. Read the first installment here.
As in the medical world, in the financial world we are dealing with individuals, each one unique, each one presenting different scenarios and unique solutions to those scenarios. Medicine and biology are to doctors what finance and psychology are to wealth managers.
Taken as a whole, it may be rather daunting for advisors to consider the endless possibilities they may be presented with when taking a client’s financial life into account. However, it is reassuring to know that if we add certain principles of psychology to the equation, we can apply some order to the inherent chaos. We can begin to understand, to get to the root cause of various issues — external and internal forces that together define a person’s path forward and cause them to take financial action — sometimes positive, sometimes not.