How to choose ETFs to get better returns

Don’t expect too much from ‘smart-beta’ and other trendy new products

 

Fund investors may feel better about themselves buying exchange-traded funds built to be “smarter,” but they’re making the same dumb mistakes that shareholders have been making for decades.

O’Shaughnessy is a portfolio manager and principal at O’Shaughnessy Asset Management, and author of “Millennial Money: How Young Investors Can Build a Fortune” (Palgrave Macmillan, 2014).
While not alone in his thinking, O’Shaughnessy was virtually alone in his criticism of ETFs — and particularly “smart beta” funds — at the recent Morningstar ETF Invest Conference in Chicago, where the focus was on a slew of new issues and fund types that will keep the ETF revolution rolling.
ETFs are the clear winner in the fund world right now, attracting billions of dollars in assets while traditional funds have been shrinking. With improved trading and tax efficiency, and a lower cost structure than traditional funds, investors are increasingly attracted to ETF options.
Yet that does not mean investors are getting better returns from ETFs.

Shaughnessy says investors are overlooking that “ETFs are just stocks in mutual-fund form.” Originally built on classic indexes, exchange-traded funds — effectively a type of mutual fund that trades like a stock — now can be built around “factors,” pro-actively pursuing a low-volatility strategy, for example, or value investing, and more.
As a result, funds are becoming increasingly active, and so are the investors managing portfolios with ETFs.
John Bogle, the founder of the Vanguard Group who put the world’s first index fund on the market 40 years ago, always has been concerned that ETFs were built to be traded, fearing that investors would take the easy way out of tough times.
That lack of fortitude is the classic bad behavior, where investors buy after a stock or fund has heated up, only to panic and sell when performance is disappointing, generating “buy-high, sell-low” misfortunes.
O’Shaughnessy says this behavior is all too common among ETF investors. “The idea is ‘I want to be a value investor, so I will pick a value ETF and let it work,’” he said in an interview at the Morningstar event. “The flow data shows that doesn’t really happen. People are actively trading these more-active ETF options, treating these ETFs like they used to trade stocks. They buy when it’s the hot dot — when it’s done really well, when it has the best three-to-five year results — and they sell in the opposite conditions.
“Reams of evidence shows that’s the worst thing you can do,” he added, “yet it’s how people continue to behave with ETFs.”
When it comes to newfangled smart-beta funds, O’Shaughnessy believes investors — and fund companies — are fooling themselves about the expected results.
Smart-beta or factor investing is an effort to improve a classic index by changing the construction, or by somehow screening out bad or lesser stocks based on certain financial criteria.
“Big companies launch ETFs that … look very similar to the overall market — sort of a tilted market — and call them ‘smart beta,’ — a great marketing name for what’s a very old strategy [of trying to upgrade an index],” O’Shaughnessy said. “You get a market-like return or exposure with a little twist, and you pay a little more for it.”
O’Shaughnessy recommends a more active approach, at least when it comes to how investment portfolios are put together. He suggests that investors would be better off with small, concentrated portfolios — with closer to 50 stocks instead of the hundreds found in many index options — that don’t resemble or perform like the benchmarks.
This concentration, he suggests, truly isolates factors like quality, stability, value, growing dividend payouts, and more.
Once investors find the right ETFs to address the factors they deem important, O’Shaughnessy advocates for less activity.
At that point, he is less worried about the “smart beta” than with what I call “stupid alpha.”
Alpha is the analytical measure of what a money manager adds to returns, the edge they have — or lack — in trying to beat the market. If you buy “smart” funds but make dumb moves with them, results are short-circuited by your own bad management decisions.
It’s the factor no one at Morningstar ETF Invest except O’Shaughnessy really wanted to discuss, the idea that new funds are power tools, but that the end users often are safer with hand implements. That discussion gets buried under the argument that ETFs are cheaper.

Low costs and better tools are great for consumers, but only if they can deliver the right kind of results.
“We quibble over basis points when we should worry about the percentage points that are lost to investment mistakes,” O’Shaughnessy said. “What most people are doing is making moves that they think are smart but which really aren’t better. You won’t get improved performance out of an ETF unless you put better behavior into owning them first.”

 

What would you do if you had $10 million and 10 years to live ?

Examining the question can be valuable financial planning tool

 

If you suddenly received $10 million dollars (after-tax) and at the same time a diagnosis that you had only 10 years to live, what would you start doing? What would you stop doing?
These are two questions I love to ask groups when I’m conducting financial-planning and financial-literacy workshops for women. My objective is to help them accurately identify their deepest values and most important life goals, independent of financial constraints and the all-too-common excuse that there’s always tomorrow. I particularly like this pair of questions because they force participants to engage with the twin concepts of limited resources and limited time. This in turn forces longstanding internal conflicts (financial, emotional or otherwise) to bubble right up to the surface.
Over the past decade I’ve asked this question of women across a wide range of demographics — age, income, education, career path, religion, ethnicity, etc. Despite the diversity of participants, the answers are remarkably similar.
Start: Most people tell me they would volunteer, be more philanthropic, travel, spend more time with family and/or pursue hobbies.
Stop: Most people also tell me they would stop working (at least full time). They’d stop worrying about money. They’d stop fretting about what other people think.
While my practice is focused on women, these responses are actually widely held across genders, according to the new Life Reimagined survey from AARP.
This begs two questions. 1) If this is what we want, what’s keeping us from having the lives we truly desire? And 2) What lessons can we learn from these remarkably consistent expressions of human hope and desire?
With regard to the first question, the biggest lesson I have taken away from participants’ responses is that it’s shockingly easy to get unintentionally trapped in a certain lifestyle. And our concept of self is painfully difficult to extract ourselves from.
Let me give you an example, from my own experience. Fresh out of college, I had joined one of the traditional investment banking analyst programs at a top firm. Less than a year into it, I realized it wasn’t the career path for me and decided to switch to asset management. I thought my employer would be furious, having invested heavily in my training and having not yet gotten back much meaningful return on its investment. Instead, a number of very senior professionals pulled me aside. Quietly and almost confessionally, they told me how “wise” I was to get out before I had a family and became accustomed to the heady incomes this career path produced. I would then be unable to ever switch gears.
This memory, nearly 24 years old now, is seared in my brain. The urgency and intensity with which this advice was given to me reinforced how very many men and women were living lives of quiet desperation while wearing incredibly expensive sui
ts and otherwise leading “the high life.”
When I ask people today what’s holding them back, the answers more often than not fall into some version of the same — that is, that the web of life is too thick to trim back or alter now. I’d argue what we can learn from this is that while it may be a common feeling, it is flawed logic to think the status quo cannot be adjusted.
Clearly, it’s vital to spend the time and effort discerning what it is you truly want from life.

 

Focus on Our Country ,Our Fundamentals and Our Stocks

over the last 25 years, we have created enough value and if you pick the right stock, you can withstand volatility and end up making more money than most other asset classes in Indian equity market. Edited excerpts



I think we have to differentiate global market vis-a-vis India. In my 15 years' career, I have always read a headline that the best performing hedge fund is predicting a correction. Now even a broken watch gives time correctly twice in a day and this best performing hedge fund or the best performing market guru does not remain constant, it keeps on changing. I have also seen person who is known as predictor of gloom, boom and doom every year talking about Indian markets crashing and correcting. If I had followed his advice in 5 years, I would have probably lost my job 15 times.

Let us separate the doom sayers because it is their job to give extremely wild predictions. If there is 0.01 per cent probability of its coming correct, for life they become hero. Let us focus on our fundamentals. Is the Indian market running little bit ahead of its fundamentals? The answer is yes. If there is a steep correction in Indian market because of some global volatility like it happened in October 2008, I think it will be temporary. It will be short term and markets will bounce back very quickly after that uncertainty or volatility is over. It does not mean that we cannot have correction in this market. Certainly there could be correction, but there would not be deep, they would not be lasting.

Now in that context, let us also understand yesterday's two central bank action or inaction as you called it. The Bank of Japan after providing liquidity, after keeping interest rates in negative for years, ran up debt to the extent of 250% of GDP. After Bank of Japan becoming a significant owner in majority of Japanese stocks, now they are going into a territory where they are saying that will continue to buy government securities in a manner so that the yield curve will be as per our requirement, yield curve will be as per our need. Now these are all uncharted territory. This is where central bank probably gives a put options to the equity market. Where will this end who knows but till such time it is continuing, you have no option but to remain participant in the equity market, otherwise you will end up a significant part of rally.

On the US Fed side also, as child we were always reading that story of tiger coming, tiger coming, tiger coming, in December 2015 while raising US Fed rate after a decade, they indicated four rate hikes in 2016. Now, it will be just about one. So, clearly they also are getting data dependent, they also are trying to give put option to the equity markets to sustain growth. Probably, future of America is what the past of Japan is. So my request to viewers will be do not really go by the wildest predictions, do not really go by the extreme forecast that is unlikely to happen. Let us focus on our country, our fundamentals, our stocks. Over last 25 years, we have created enough value and if you pick up stocks rightly with right temperament and you can withstand volatility which might come on the way, I am sure you will end up making more money than most other asset classes in Indian equity market.

For equities to do well, two things have to be in place - attractive valuations and lot of liquidity. There is lot of liquidity and there will be lot of liquidity. Valuation is where the discomfort is. I mean what you want to buy is not cheap, what you do not want to buy is really cheap. Now you may buy stocks but the stocks may see a lot of time-wise correction because earnings recovery is already in the price.

It is absolutely brilliant observation. What you want to buy is not cheap and what you do not want to buy is probably available cheap. But then every day you do not get a batting pitch to bat upon. That batting pitch was available in February 2016. Now, if you were sleeping on that day, bad luck to you, the market is not going to give you an easy opportunity so that you can make money sitting idly on a beach. It does not work that way. Tendulkar became the greatest batsman by not only batting on the batting pitch but he also took the battle on the balling pitch. He took the balls on his chin, on his helmet, on his bat and that is where he became Tendulkar.

So, please do not expect markets to give you easy opportunity to make money and especially in today's market you have to pick up stocks right correctly, you have to have right temperament to withstand volatility and you have to have long-term investment horizon to make money. Making money is not easy. Who told you that it is easy to become billionaire is wrong, otherwise all of us would have become billionaires.

The common conundrum of late is that we have been hearing rhetoric and I started off our discussion the way that there could be a correction now. I take on board your point that do not get lured by or do not get bothered by a lot of what is happening but we have to admit that growth has not come back in a hurry and there is a remote possibility of a correction that may come in and give an opportunity to buy. My question to you is should people who are not SIP investors but actual stock investors wait for an opportunity right now? Could that come in or do you not foresee a chance of a meaningful correction coming in?

: I think for the stock investors even today in this market there are opportunities to buy stocks now whether they are fully priced or fairly priced. There is value as a stock picker. You can start buying stocks even in today's market. Of course your rate of expected return will be lower than what if markets correct 10-15% but if you are a stock picker you have no option but to pick up stocks depending upon your time horizon.

Now if you are not a stock picker, there is a very simple common sense technique of asset allocation. Today's fair value of market have neutral allocation to equity if your risk profile is not very aggressive. Within that risk profile if there is a correction, you can always increase your allocation to equity. No one says that being a stock investor, you have to put 100% of your net worth in stock market. If there is correction, you can always shift some allocation from debt and other portions into stock market.