There are a few aspects of investment analysis that I’ve found to be particularly wanting – for example, the subjectivity of traditional tire kicking analysis and the pitfalls of doggedly adhering to only one form of analysis (fundamental, technical, quantitative, etc). Can a so-called “passive” investment strategy using index-tracking products like exchange-traded funds truly overcome these weaknesses?
The premise of my criticisms of traditional analysis and strategy relies to some extent on the concept of the Efficient Markets Hypothesis (EMH). This is essentially the theory that because all available information is incorporated into securities pricing, targeted research seldom produces returns commensurate to justify the expenses and resources devoted to doing the work. In many ways, it was this hypothesis, in addition, to works like Burton Malkiel’s book A Random Walk Down Wall St. that really gave impetus to concepts of market indexation.
Why passive strategies work
As market participants built observable and testable databases of fundamental and pricing metrics, a clearer picture started to form. Over the years, researchers have developed a number of conclusions about why these passive strategies seemingly provided comparable, if not better, performance than their actively-managed counterparts. The passive, index-based approach generally provides the following:
* The systematic nature of investment, devoid of any interpretation, emotion, and the human element.
* The strict adherence to a rules-based mechanism that deploys capital in an unbiased fashion into stocks that quantitatively met key metrics.
* Lower cost. Active management is costly, and in many instances the gross returns (before fees) show better performance relative to indexes. But when you add in the costs of flying analysts and investment managers around the world, the resulting net fee returns (after fees) tends to be worse.
* Removal of market timing. Investors can’t make decisions in an objective fashion and get caught up in trying to time the markets.
Why active management often underperforms
There are a number of reasons for the underperformance of do-it-yourself investors relative to professional managers. There are number of the reasons for this.
As investors gain increasing access to financial information, their behavior is dictated by emotional thinking, categorized by behavioural finance theorists as follows: anchoring (to familiar circumstances and/or prices); over-optimism; regret; house-money effect (playing with profits), etc.
Many of these inherent psychological aspects of human behavior are the making of our downfall – and can be observed even among professional money managers.
How is it that exchange-traded funds have demonstrated a level of outperformance over their active mutual fund and DIY counterparts? It’s because the human element has been minimized. Individual preferences and biases have been removed from decisions on what stocks to invest in, how much to invest in them, and when to deploy capital. Furthermore, relative to their actively-managed counterparts, ETF fees tend to be lower. If you can invest in a strategy that has 2% less fees than alternatives, those active alternatives have to work harder to make that money back.
When ETF strategies become “active”
So, our two main objectives should be to remove emotion and lower fees. But is that enough? Not really. Another myth in our business that is propagated time and time again to clients is conflating the usage of ETFs with the outperformance that can be demonstrated by using passive strategies. This not true. Just because you own a passive, systematic, blended portfolio of securities doesn’t mean that you’re somehow conferred the benefit of passive investments. There are countless times I’ve seen DIY investors and managers espouse the belief that because they use ETFs, they have accessed the passive returns attributable to passive ETFs.
Let’s be clear about this. Passive investments, like ETFs, are securities like any other. If they are combined in some fashion, using some methodology to balance on a strategic (long-term asset allocation basis) or tactical (making decisions on short-term asset allocation in response to markets), they no longer provide the benefits of being truly passive. There is still the matter of deciding how to mix different ETFs, how to trade them, how to react to short-term market circumstances, etc. In this context, “passive” now becomes “active,” and the element of human behavior has been re-introduced.
Using a passive strategy means you identify an index/strategy, buy it, and hold it.
So, are ETFs and the concepts of passive investing the panacea that we return-seekers are looking for? Not really. The markets are inherently emotional. At their very core they represent your everyday decision-making and sentiment concerning price. And it’s not just price of a stock that’s at play here, but what underpins the price of a stock, say, the price of the coffee you buy on the way to work, the price of the computer you buy, the car you buy, the perceived value in buying super as opposed to regular, gas and yes, the financial securities you buy.
The list goes on and on. One day I may wake up and say to myself, “I deserve that high-priced coffee.” That same day I share the price I paid for that coffee with you and you think, jokingly, “I can buy a small village for that.” As time goes on, our thinking may reverse. Pricing has two components; the objective aspects of pricing – the actual cost that goes into producing that coffee and delivering it to you and the subjective aspects, where you think, “Gee, I really love this house (or coffee), and I’m willing to pay more because it makes me feel good.” Indexes suffer from our collective assessment of what’s objective and subjective in price. Hence, they are also subject to some very volatile short-term swings
What’s the outcome? There tends to be a long-term trend to security prices. However, pricing swings can occur in the short-term that price securities higher or lower than what they are really worth. In many instances these short emotional and subjective swings are large. Other times, they are small enough not to really elicit much of a reaction.
How does this relate to ETFs? ETFs are constructed to mimic the construction of an underlying index. Some indices weight their underlying constituents heavily, based on the impact of price. Some of the largest indices are constructed this way and therefore suffer from the bias of emotionally-driven pricing swings. I think we can do better.
Fine-tuning an index strategy
Concepts like “Smart Beta” have lately become fashionable among money managers. But these concepts are not actually that new. They’ve been kicking around for a long time and have been used by managers that mesh the best aspects of systematic indexation, fundamental analysis, and technical analysis.
The result tries to achieve a fine tuning of passive indexation through passive application of fundamental concepts like price-to-earnings ratios, debt-to-equity ratios, pricing momentum, etc. What we’re starting to see is the idea of replacing traditional tire-kicking analysis with more of a systematic approach to breaking down readily available data through algorithmic filtering and setting tolerance levels for acceptable levels of P/E, D/E, earnings variance, and so on. The end result is to minimize the cost of analysis by allowing computers to do the heavy lifting that people used to do in the fraction of the time and at the fraction of the cost.
Courtesy Fundata Canada Inc. © 2017. Mark Taucar, CFA, manages discretionary client assets through Bespoke Discretionary Service for Accilent Capital Management Inc. Securities mentioned are not guaranteed and carry risk of loss. This article is not intended as personalized investment advice.