Patrick O’Shaughnessy says that 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.
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O’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.”