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),
Many of these inherent psychological aspects of human behavior are the
making of our downfall – and can be observed even among professional money
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
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
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.
I’ll explore the success of some of these strategies and illustrate how to
put them to work in your own portfolio.
Mark Taucar, CFA, manages discretionary client assets through Bespoke Discretionary
Accilent Capital Management Inc.
He has also built and managed discretionary referral platforms for
other notable Canadian money managers. Over the course of the past 10
years, he has managed institutional, pension, high net-worth and
direct-client assets. His systematic investment strategies are used
today by various firms in the industry
. Mark can be reached by phone at 905-715-2260 or by email at firstname.lastname@example.org .
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