I attended Morningstar’s annual ETF conference this week. Though the event is mostly attended by financial advisers, there were several topics of interest to individual investors.
One of them was factor investing, which is financial services industry terminology for taking advantage of stock characteristics associated with higher returns. Jason Hsu of Research Affiliates described factors as being counter-cyclical, meaning that when a factor becomes popular, it underperforms. This is because when too much money tries to exploit the same return anomaly, the anomaly vanishes until enough investors move on to a different anomaly. Hsu pointed to low volatility as being a current example, with low-beta stocks trading at historically high valuations.
In a different session on factor investing, one of the panelists said value is particularly unique in its persistence of outperformance. Though value does underperform at times—particularly during speculative bubbles—its periods of underperformance tend to be comparatively short. As far as pairing value with other factors, the same panelist said to pair it with quality, while another said he likes to pair it with price momentum. (I suggest combining the three factors.) The panelists agreed that patience is required when following a factor-based strategy, since periods of underperformance will occur.
Which brings me back to Hsu. He explained a fund’s alpha (outperformance due to skill) as being created by someone else having negative alpha. In other words, if a certain group is going to beat the market, another group has to lag. Hsu believes fund shareholders provide negative alpha (0.9% in negative return) through bad timing. He further said that a mutual fund’s ability to outperform is influenced by the inflows from and outflows to investors. The timing and amount of these flows can force a fund’s manager into making decisions he would otherwise not make.
Fund performance was also the subject of AQR’s Andrea Frazzini's presentation. Frazzini disputed the need for high levels of active share in order for a fund to outperform. (Active share is the extent to which a fund’s weighting of stocks differs from that of its benchmark index.) Rather, he believes that alpha is created by what the benchmark index emphasizes (e.g., large-cap stocks). Furthermore, when the alpha of the benchmark is considered, there is no statistical difference between closet indexers (fund managers whose portfolios mimic the index) and fund managers who have high levels of active share.
Charles (“Charley”) Ellis has been a long-term critic of the fees charged by many actively managed funds. His talk was not about fees, however, but rather about the retirement system. Ellis explained how a desire to prevent older railroad workers from causing train accidents was one of the reasons age 65 emerged as the targeted age for retirement in the 19th century. He then went onto explain how the responsibility for funding retirement changed from employers (meaning pension plans) to employees (meaning 401(k) plans). He described this shift as resulting in a system where people with no investment experience are put in charge of ensuring their financial security in retirement.
Ellis did have some solutions. He suggests that postponing retirement from age 62 to age 70 can increase the median retirement savings account from $110,000 to $260,000 for a person earning $60,000 per year, assuming a 6% rate of return and contributions to retirement savings equal to 12% of salary each year. In addition, Social Security benefits would increase by 8% per year over this period. He further advises constantly learning new skills, thinking young and understanding all of the choices available before making a financial and retirement decision.
A focus of the session I attended today was robo-advisers. These online platforms offer financial advice at fees well below what most traditional advisers charge. A panel of three industry experts did not view them as a threat, however, but rather as agent of change. Jim Crowley of Pershing said the growing popularity of robo-advisers greatly reduces the value of simply providing a portfolio allocation and doing an annual review of performance. As such, traditional advisers need to put more effort into proving their value to clients. He and the other two panelists said this can be accomplished by helping clients to understand their goals, by incorporating the entire family into the planning process and by providing financial education.
The Week Ahead
Third-quarter earnings season will “officially” start when Alcoa (AA) releases its results on Thursday. Joining it will be fellow S&P 500 members PepsiCo (PEP) and Yum! Brands (YUM) on Tuesday and Constellation Brands (STZ) and Monsanto Company (MON) on Wednesday.
The first economic report of note will be the ISM’s non-manufacturing index, released on Monday. Tuesday will feature August international trade data. The minutes from last month’s Federal Open Market Committee meeting will be released on Thursday. Friday will feature September import and export prices.
San Francisco Federal Reserve Bank president John Williams will speak on Tuesday and Thursday. Also making public appearances will be Minneapolis president Narayana Kocherlakota on Thursday and Chicago president Charles Evans on Friday.
About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)