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Weekend reading: Smart Beta ETF investors seek the next big thing

Weekend reading

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.

Happy reading!

From the blogs

Making good use of the things that we find…

Passive investing

  • FOMO and the art of not caring – Abnormal Returns
  • Socially responsible investing [US but relevant]Can I Retire Yet?
  • Quick review of the Vanguard All-World High Yield ETF – DIY Investor
  • China to be bigger share of indexes [Canadian but relevant]CCP

Active investing

Other articles

Product of the week: I was reminded about Abundance by an article in this morning’s Guardian on green investing options. Abundance brings local renewable energy projects to the notice of investors who buy debentures paying around 7-9% a year. It acts as matchmaker and middleman, and also takes care of the post-investment administration. I like the idea and motive, but the disparate nature of the projects increases the already notable risks. Can the average investor (i.e. you and me) really calibrate the differences between a ‘variable return debenture’ backed by a wind turbine in Gloucestershire and an ‘income growth debenture’ that’s backed by a solar project in the North East?

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

Active investing

  • Bond proxies: Can you afford not to own them? [Search result]FT
  • Luck: A fund manager’s dirty little secret – MarketWatch
  • Jim Rogers sounds irritated that we still haven’t crashed – MarketWatch
  • Howard Marks: The ‘uncomfortably idiosyncratic’ billionaire – Observer

Other stuff worth reading

Book of the week: Richard Beddard wrote a belated review of Money, Blood and Revolution this week, so here’s a belated pointer to what sounds like a decent thesis. Author George Cooper likens the economic system to the body’s circulatory system, and blames the slow recovery and rising inequality on money clogging up in the wrong parts – principally with the rich and their assets and bank balances – while failing to reach the poor and young.

Like these links? Subscribe to get them every week!

  1. Note some FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. []
{ 12 comments… add one }
  • 1 dearieme June 27, 2015, 12:19 pm

    The Crown Estate

    To call it “The Queen’s” crown estate is bonkers. Looked at that way, it boils down to the Queen paying tax at 85% and then having to use part of her post-tax income to defray those running costs that ought legitimately to fall on the State. That would be a funny old system.

    Better to be accurate and call it the Government’s Crown Estate: mind you, it remains an odd system for defraying the costs of the Head of State job. Still, it’s probably substantially cheaper than some comparators. I understand that the Italian Presidency costs an arm and a leg. No doubt if accounted for accurately so would the French and US posts. The “security theatre” surrounding the US president must alone cost a bloody fortune.

  • 2 John Kingham June 27, 2015, 12:34 pm

    Blast! You posted this too late to make it onto my (not so) weekly link-fest. I’ll edit and add you in old chap.

    Thanks for all the links, etc.


  • 3 Gregory June 27, 2015, 1:57 pm

    There are some good stuffs about why the premiums won’t disappear. There is an another point. I mean the DALBAR effect that explains why an average investor doesn’t achieve much of the gains. As You wrote premiums sometimes don’t work so if an average investor buys and sells a simple fund at a wrong time how can he or she endure the long periods when premiums don’t work? Answer: more badly. This explains too why premiums will work. I think.

  • 4 MyRichFuture June 27, 2015, 7:20 pm

    Nice to see Vanguard All-World High Yield ETF being discussed. It’s one of my favourite ETFs and can suit a range of investors.

    But there are not enough recent articles on it when you do a Google search. Most focus on its launch a couple of years ago.

  • 5 Gregory June 28, 2015, 11:26 am

    Vanguard All-World High Yield ETF. According to the factsheet http://www.docdroid.net/14uqq/loadpdf-42.pdf.html the dividend yield is 3,6% but according to the Vanguard’s distribution page – https://www.vanguard.co.uk/uk/portal/detail/etf/overview?portId=9506&assetCode=EQUITY##pricesanddistributions
    the dividend yield is just 3,2%. Why is this difference? Is it about taxation?

  • 6 Minikins June 28, 2015, 2:22 pm

    I like the fishing analogy for returns, there must be so many good ones out there to take inspiration from. The old Sea of Galilee parable comes to mind when despite days and nights of fishing, the disciples caught no fish and were directed by Jesus to cast their nets on the right side of the boat rather than the left which they had always favoured. They finally made an enormous catch. As long as it is done in good faith and with some humility, trying from another angle often brings results. Ultimately though you have to cast your net where the fish are and the fish are often closer than you might think. And this was advice from a carpenter to hardened fishermen!

  • 7 Mathmo June 28, 2015, 8:33 pm

    TI – another good set of reading, thanks. I do enjoy the non-financial ones. The New Yorker on reading I found resonant, and AWOCS on time not money.

    @gregory — using the Vanguard data you can add up the last 4 dividends as at 31/5 to get $1.70345 on a NAV of $53.1955 for a yield of 3.20%. Do that today and you get $1.566 on $52.3686 for a yield of 2.99%.

    I can’t immediately come up with the 3.6% number, but the definition does say it’s the underlying yield of the fund not the ETF itself. The difference could be costs/distribution policy?

    Do the same calculation in sterling (taking the exchange rate at the dividend record date) and you get sterling yields of 3.01% at end May and 2.98% today.

    As always the lesson is DYOR.

  • 8 Mathmo June 28, 2015, 8:47 pm

    Sorry it was Ermine, not AWOCS with that lovely article on living time not money.

    Also: worth checking what your broker actually pays you (and when!) in terms of USD dividends. I checked my VHYL and it was 0.5% lighter on the exchange rate and also several weeks later than advertised. The hidden costs of the low cost broker!

  • 9 Naeclue June 29, 2015, 10:56 am

    I agree with Mathmo about doing your own research. A quoted yield of an investment can be very misleading. It could be historic yield or projected yield for example. For foreign stocks it may not include deductions for withholding taxes (typically 15%). Fees may be deducted from dividends or capital and if from dividends, the yield may be before the deduction.

  • 10 Harry June 29, 2015, 11:50 am

    Hi – newbie investor here. Have been reading your blog from the start and it has been fantastic to read. That and Mr money moustache. Complete different but oh so helpful.

    I have a question ref chasing premiums.

    I have set up what I consider to be a portfolio that suits my risk/timescales and they are in the main five vanguard ETFs.

    I invest around £250 per month in a bank account then every four months buy £1000 worth.

    My question is that I have thus far been buying the ETF that is lowest relative to its 52 week high.
    My rationale is that I willbe buying all of them anyway so why not get a few more percentage that way.

    What would your thoughts be on this? Or would it be too much like active investing?

  • 11 Naeclue June 29, 2015, 1:25 pm

    @Harry, does sound like market timing but IMHO what you are doing is still sensible because it saves on trading costs. I think you would be better off simply purchasing the ETF that is most underweight in your portfolio. In the short term this will mean that you over-allocate the ETF on each purchase, but in the medium term it will mean you are keeping your ETFs inline with your chosen asset allocation. Whether the asset allocation is sensible is another matter 😉

    In the long term you will find that the dividends produced by your portfolio overtakes your contributions, so at some point you might want to line up your purchases with the dividend payment dates, say to invest quarterly. Even then you are likely to find that the portfolio goes out of balance and might need to sell one or more ETFs to rebalance. Opinions differ on this, but I do not rebalance more frequently than once per year.

  • 12 Naeclue June 29, 2015, 1:37 pm

    Regarding “Smart Beta” ETFs, I think these are a weekly disguised fightback by the active fund management industry against simple cap-weighted index investing. I think most investors will be better off not being distracted by all this and sticking to cheaper bog-standard trackers.

    Having said that, there might be something to be said for investing in small cap trackers and value trackers, but only if investors are prepared to accept their higher costs and are prepared to stick with them when they under perform.

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