ETFs and Bear Markets: Unsuitable Bedfellows?
Buy and hold!, shout stalwart indexers, with many more on Wall Street joining the chorus. But is it appropriate investment advice for all market climates? Can risk not be systematically analyzed and portfolios adjusted to mitigate market declines? And, importantly, are indexed investment vehicles such as exchange-traded funds still suitable for downward trending markets?
With recent heightened volatility in financial markets and a murky 2008 upon us, it is certainly a question worthy of attention. And, it is always a good time to review some prudent investment principles.
Our own view flatly disagrees with the "buy-and-hold" philosophy. Instead, we advocate a primary focus on managing overall portfolio risks ... and allowing portfolio returns to follow. That means a concentration on asset allocation while tactically adjusting different investment classes in varying market environments ... and less emphasis on individual investment performance.
The proliferation of ETFs, now covering most types of asset classes and risks -- including those that exhibit low or even negative correlations to broad markets -- has been a big win for investors. ETFs not only meet longer-term asset allocation needs, but also allow portfolio risks to be more easily managed during inclement market periods.
"Buy and Hold" Not Always Sound Advice. Two key supporters spread the buy-andhold- forever approach. Of course, the first is the financial industry's marketing machine. The drumbeat of bullishness never seems to stop. And it's always a good time to buy.
One often cited reason for continuous market exposure is the theory that the largest market advances will occur only on very few days of the year. And, since one cannot possibly know in advance which days those will be, it is reasoned that it is best to stay fully invested. But, what about the opposite? Shouldn't one be out of the market for the biggest negative days also?
There are times where negative days are particularly damaging. For example, 2000- 2002 was one of those periods where reduced equity exposure was critical in avoiding large losses.
Limiting exposure during riskier periods becomes even more important with higher beta markets such as emerging equities. The reason is that they tend to have negatively skewed return distributions - that is, a higher probability of a large negative return than inferred from a normal distribution. And volatility tends to cluster. During broad market declines, these asset classes can lose considerable amounts in short periods. (In the latest market decline, the iShares FTSE/Xinhua China 25 ETF has lost more than 4% on 10 trading days since the end of October).
The second camp of "buy-and-hold" cheerleaders may be classified as "indexing purists", a group often associated with the Efficient Markets Hypothesis (a theory stating that security prices fully reflect all currently available information). Since the market is supposedly "efficiently" priced one cannot expect to beat the market. Better to maintain a static asset allocation suited to the client's risk tolerances and return needs, EMH proponents would say.
While we don't want to spend time refuting the EMH (which has already been largely discredited both empirically in investment circles and academically), it is clear that markets are not always rationally priced. In fact, they may never reflect fair value. The key reason? Investors are emotional animals, complete with analytical failures. Their collective emotional biases driven by fear, greed, impatience and faulty logic distort market prices. (With a trailing P/E ratio of over 60, the Chinese domestic A-share market is not "rationally" priced!).
In late stage bull markets, market participants tend to buy regardless of basic fundamentals. Investors are similarly irrational in bear market bottoms. Not logically assessing long term value, they blindly sell. These are the great opportunities for rational investors.
To be sure, market timing is difficult. And markets can remain illogical for long periods. But risk can be managed. Portfolio strategies need to be proactive, adaptable and forward looking. Having a disciplined, methodical framework for managing portfolio risk and opportunity is paramount.
Dodging Human Hazards. Make no mistake, we are not arguing that everyone quit their jobs and start day trading. Just the opposite. Emphasizing material strategic shifts, maintaining low costs and taking measures to eliminate emotional biases can ensure long term success much more than market timing.
Studies show that over-activity in individual investor portfolios virtually guarantees sub par performance. Dalbar Inc., a financial services market research firm, releases its annual Quantitative Analysis of Investor Behaviour that reaches the same conclusion every year: despite broad market indices posting large gains, the average investor earns only a fraction of these market returns.
According to Dalbar's 2007 report, the S&P 500 has returned 11.3% annualized over the last 20 years. Comparatively, the average equity fund investor has earned just 4.3% annualized during the same period - a full 7 percentage point difference. The average fixed income investor shows an equally horrific track record - 1.7% versus 8.6% for a US long-term government bond index.
Why the consistent underperformance? In short, investors are performance chasers, motivated by greed and fear. Often their own worst enemies, they have a history of buying high and selling low. To illustrate this, Dalbar tracks mutual fund flows and identifies a long running correlation: inflows surge after market rises, while outflows increase immediately after market declines. Reactive emotions again drive decision-making, suffocating analytical faculties and setting investors up for failure.
Look Ma, No Cash! Critics will point out that actively managed mutual funds are more insulated during bear markets. To be fair, yes, a few funds will provide protection during market corrections. But these funds are often ones with the highest cash levels. In other words, these funds are managing their risks and asset allocation prudently - and not outperforming due to superior stock selection.
Mutual fund cash levels also tend to behave similarly to individual investors. On average, lower cash balances (therefore more downside risk) are seen at the top of bull markets and high cash balances at the bottom of bear markets (yes, even professional fund managers are guilty of performance chasing). When major market indices were hitting multi-year highs in July 2007, cash levels in US equity mutual funds were at historic lows of around 3.5%. The latest data continues to show record low cash levels.
What about hedge funds providing protection? A few are certainly delivering on their promise of absolute returns and low correlations to traditional asset classes. But measured broadly, hedge fund correlations are extremely high with major market indices.
In fact, correlations have increased dramatically in the last few years. According to data compiled by Bridgewater Associates for the 2 years leading to June 2007, broad hedge fund returns have been 67 percent correlated to the MSCI EAFE index and 87 percent correlated to unhedged emerging equities. In the "equity longshort" category (a plain vanilla hedge fund strategy) returns had an enormous correlation of 84 percent to the S&P 500.
Stock Picker's Market? The common Wall Street mantra during downward trending markets is "it's a stock-pickers market" (our least favourite Wall Street spin). But individual stocks within sectors tend to move in packs and have very high correlations among each other. Outperforming merely by selecting better stocks within a particular asset class is difficult at best.
As worldwide capital markets become more linked, being in the right sector rather than the right stock is becoming increasingly important. This publication has urged caution in certain sectors during 2007. Based on our assessment of risk, we have advocated an avoidance of financial companies and emphasized exposure to large cap multinationals -- a strategy which has protected portfolios much more than picking the right stocks ever could have.
Institutional Adoption. Increasingly sophisticated investors are using ETFs for all market climates. With over 300 new offerings year-to-date (bringing the total to over 1,000 with approximately USD 750 billion under management), ETFs are no longer synonymous with pure indexing. They are more closely aligned with asset allocation - the most important driver in the variation of returns.
Professional money managers are also using ETFs for tactical and strategic exposure. Morgan Stanley reports over 2,200 institutional investors using ETFs globally - an increase of 1,242% in the last nine years. As of Q3 2007, the number of hedge funds using ETFs over the last year has increased by a full 36 percentage points. And according to VanthedgePoint Group's annual Emerging Hedge Fund Manager Sentiment Survey, 62% of emerging hedgies report using index products. Ned Davis Research reports a record USD 19.9 billion flows into ETFs by hedge funds during September 2007.
Active mutual fund managers are also using them (many fund managers have been accused of "closet indexing" ... recent evidence of ETF holdings in mutual funds certainly furthers that case).
Risk Management Critical. Commenting on the product driven orientation of the wealth management industry, venerable financial editor James Grant once lamented that "'buy and hold' have replaced 'I love you' as the three most popular words in the English language". That strategy should have worked during the massive bull market of the 1990s, a decade when the Dow rose more than 300%. Even then, that was not the happy experience for most investors. But with increasingly complex and interlinked global financial markets, a more apt 3-word phrase for 2008 might be "manage portfolio risk."