Good reads from around the Web.
One issue with chasing the so-called return premiums – that historical tendency for certain kinds of shares to deliver above market returns, even to passive investors who simply tilt their portfolios thataway – is that you have to stick with them through thick and thin.
As my co-blogger The Accumulator has advised:
…think of your value fund like a sardine net. You’ll catch some of the shoal but not the whole lot.
Some days (or years) you won’t catch anything, but when you do it will make for a nice, tasty lunch.
The point is all the return premiums – value, momentum, small cap – have good and bad years, or even decades.
Tilting towards these factors already means flirting with active management.
Ditching a premium that’s going through a cold spell for a hot one that is probably due to turn cold too amounts to French kissing one of the worst traits of active investors. You can expect your returns to dip accordingly.
Yet sadly, research suggests that actively courting disappointment seems to be exactly how many are using the Smart Beta funds designed to capture the return premiums.
Not so Smart, buddy
Take the study conducted by Empirical Research Partners and quoted by the fund managers behind The Value Perspective blog:
What Empirical has done is to look at two relationships – first, between past performance and where investors put their money and, second, between where investors put their money and subsequent performance.
As you can see from the chart below, for eight out of the 11 categories of smart beta strategies analysed, there is a very strong positive correlation between past performance and future fund flows, with those directing money towards yield-type exchange traded funds (ETFs) apparently the most prone to invest with at least one eye on the rear-view mirror.
Source: Empirical Research /Value Perspective
Uh oh! According to this research, investors in these funds aren’t reaching sober conclusions about the best way to add a little extra juice to their portfolios over the long-term.
They are just buying what’s gone up lately.
This wouldn’t matter if chasing hot funds produced higher returns.
But as the article goes on to show, that doesn’t happen at all – most amusingly in the case of mean reverting momentum funds!
As Kevin Murphy, the blog’s author says:
‘But guns don’t kill people, people do’ is a line less likely to settle an argument than provoke further discussion and yet it is not impossible to imagine an advocate of so-called ‘smart beta’ investments – strategies that try to build on simple index-tracking products by focusing in on a specific factor, such as growth, momentum or value – using a similar refrain.
“But smart beta products don’t make bad investment decisions, investors do,” they might tell a doubter.
To which we would reply – as we would to anyone trying the gun line – “OK, but they do make the job a lot easier.”
While it’s no surprise that these professionals argue you’re better off using actively managed strategies if you want to pursue a value strategy (well, they would say that, wouldn’t they?), I think their warning is well put.
Remember that all the academic research that backs up return premium investing talks about achieving incremental returns over time.
It says nothing about hot hands trading ETFs like George Soros on a stag do in Vegas.
The return premiums are whispering flighty things, with their real world performance already potentially set to disappoint those seduced by the academic findings.
Indeed some, such as Monevator contributor Lars Kroijer, think there’s no case for investing in them at all.
But if you’re a passive investor set on swallowing their lure, I’d strongly suggest The Accumulator’s lazy long-term fishing approach is the way to go.
