Monday, December 26, 2016

Will ETFs (Factor Investing) Lose Popularity: Scientific Revolutions and Humility


Contrarians should always be looking for what is not present or expected. Exchange Traded Products or Funds are modern applications of traditional analytical screens. The established, top-down approach to selecting what to research in order to achieve investment success is a five step process:

1.   Economic/Political Overlay to Market Belief
2.   Segment Identification
3.   Security Selection
4.   Trading Requirements
5.   Timing of Purchase and Probable Sale

ETFs invest entirely in a segment. This can be a narrow segment such as an industry or a broad segment such as the components of a stock or bond index. Importantly, there is little to no additional cash to meet withdrawals or to provide flexibility. Components are selected by rigid prescribed rules.

The big advantage to this type of investing is that for many investment advisors, traders, and individual investors who believe them to be sophisticated, the choice is simple and takes far less time than what we do in a multi-step selection process. The brevity and decision speed makes these products attractive to individuals and organizations that can instead spend their time raising money or other worthwhile activities. In a number of global markets (largely stock markets), the gross inflows into these products is in the same range as the traditional long-only mutual funds. (Not all the purchases of ETFs are intended as a single, long-term investment. I believe a good bit of the reported net flow volume comes from trading elements as part of a complex strategy of being long or short other instruments, using ETFs as a hedging device.) 

With rare exception the use of ETFs has proven worthwhile as long as the various brokers and investment advisors’ selection, weighting of portfolios and timing has been reasonably good. I suspect that this has not universally been the case.

Real World Selection Processes

Many of us are happy with our marriage and other partners. Most of us are choosing to live in homes that were not selected solely by statistics. In many cases throughout our business careers we did not always pick the highest compensation offered. In each of these critically important choices either consciously or subconsciously we used a multi-step decision tree not too different to the five steps outlined above. I prefer to think that a multiple step process would lead to a more comfortable result than just buying the S&P500 Index fund, Financial Services fund, or a Single Country Developing Market fund.

Natural Law and Scientific Revolution

Over the Christmas holiday I had a deep discussion with our long-term family friend Mark Massa, SJ. This Jesuit Priest is working on a new book that is focused on the development of natural law relative to the evolution of scientific revolutions. Because I am a non-alumni trustee of Caltech, he asked me to read a section of the book which discusses Thomas Kuhn, an historian of science in a best seller, "The Structure of Scientific Revolutions."  Remembering discussions in my ancient school as well as Caltech about how “The Scientific Method” really worked, with most of the gains coming from "mistakes," I became sympathetic to Professor Kuhn's work. Normal science appears to rest on an agreement reached by a majority of scientists of a particular discipline, while the majority agrees there were always some contrarians. Instead of nice neat solutions, there were always some parts of the physical universe that were out of place in the picture painted by the accepted scientific law. These laws were meant to be universally predictive. Exceptions inevitably appeared so that the once the unthinkable  suddenly became thinkable.

Past Performance is Not Predictive 

While I made a reasonable living being the guardian of mutual fund performance records, I totally believed that past performance was not totally predictive of future results. Yet those advocating the use of constrained exchange traded portfolios are relying almost exclusively on their past records. To me the construction of market indices, (I created many) is a backward looking device. Most of these vehicles were created by publishers not active portfolio managers. Further, based on technological and legal/accounting evolution, narrow industry definitions change. I remember when analyzing steel companies, the steel company in Chicago was worth more than those in Pennsylvania, as Chicago was in a steel deficit region. Due to the cost of transportation, the Chicago steel producer could get premium prices and margins. Over time that advantage disappeared. Often just looking at financial statements one would miss a critical change such as at one point the profitability of color television tubes was the key to the profitability of TV set manufacturers.

Possible changes to the deductibility of expenses and different levels of tariffs, bring into question the predictability based on the past. In some cases, changes of reported earnings could be substantial because of changes in accounting and court settlements. An investment advisor who does not consider these and other changes is not only putting his client in a potentially risky situation, but also possibly his or his/her company's practice.

How Little We Know

In addition to the normal cautions about survivability, is the less mentioned historic truism: that the only guaranteed product of investment is humility.  Marathon Global Investment Review has a useful quote from Daniel Kahneman, "We have very little idea of how little we know." One of my concerns for high reliance on the use of ETFs is that there is no built-in flexibility to be able to change the portfolio. Actually the only thing that I promise my accounts is that I will make mistakes, but hopefully recognize them quickly and begin corrective actions soon.

Too Much of a Good Thing
I worry about “too much of good thing.” The current level of market enthusiasm is too high and suggests very little can go wrong. Many professionals have been trained to view the VIX measure from the CBOE as a fear gauge. The peak reading was 80, and averages about 20, and on December 22nd it dropped to about half of the average. Just on general principle, when others are not worried, I am concerned.

To my readers, their friends and family, I wish a Merry Christmas and a Happy New Year.  This next year may prove to be quite different from what we have experienced.

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A. Michael Lipper, C.F.A.,
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