These days, nobody explicitly denies the theories behind
behavioral finance. What began as a trickle of academic papers in the late
1970s has now well and truly entered mainstream thinking. Homo Economicus has joined the ranks of the unemployed and even
traditional text-book economics now comes with built-in disclaimers.
Governments have even gotten in on the act. UK Prime
Minister David Cameron established a Behavioral Insights Team (´the Nudge
Unit’) in 2010. It subsequently became a semi-state organization. Three years
later, in 2013, US President Barack Obama attempted to set up a similar office
in the US.
The irony of all this is that, despite everybody
acknowledging the veracity of behavioural finance, we fail to heed the lessons
it provides us. Anomalies and ineffective investment patterns persist. Just
look at the Shanghai Composite Index: After trading to record highs, it lost
20% in a couple of days and suddenly the short-traders were out in their
numbers.
As humans, we’re simply not hardwired for the
rationality required for sensible long-term investing. Professor John Coates
showed in some detail in his book, The
Hour Between Dog and Wolf, that success in the markets only serves to
provide us with the fuel to take more risks and ultimately become reckless in
our trading and investing.
Another author who touches on this is Joe Peta. In
Peta’s book, Trading Bases, he talks
about how as a trading manager at Solomon Brothers, he witnessed traders rack
up huge profits only to blow most of them because their success led them to
take irrational risks – they became overconfident and continued trading even
after the opportunities had dried up.
In short, they failed to follow the mantra, “don’t just
do something, stand there.”
How does the average investor avoid the pitfalls
mentioned above? Well, not easily but it is possible. The most successful
investors are the ones who are able to control their ‘animal instincts’ to find
alpha at the other side. It’s generally a combination of long-term investing
(in value or growth stocks) and riding out waves the inevitable peaks and
troughs experienced by financial indices.
The reality is, however, that these investors are rather
short on the ground. And when they do exist, they’re oversubscribed with people
looking to get on board. Active fund managers generally just aren’t that good.
If they were as competent as they claimed to be – at the end of the day, why
would they need to invest other people’s money?
Enter ETFs
Exchange Traded Funds (ETFs) allow investors to take an
overall view of a sector, an index or even a country and as such, dampen many
of the behavioral issues that characterize investing in individual shares. The
broader a view an investor takes of their investments, by definition, the less
risky the investment becomes.
The diversification offered by broader ETFs also lowers
the risk profile of the investment. To take just one example, energy-based ETFs
performed well in 2010, while one of the traditional top performers in energy,
BP (LON:BP) had a dismal couple of years after a colossal oil spill in the
Mexican Gulf. And there is talk of further reparations still.
The range of ETFs is constantly growing. An Economist article from 2014 noted that the
global ETFs industry grew from $416 billion in 2005, to over $2.5 trillion
today. If this seems like a systemic worry, it doesn’t necessarily have to be:
In the 2008-2009 period, ETFs were one of the save havens of the financial
industry – barely registering a downturn, and only for one year at that.
Could it be that private and institutional investors are
finally grasping on to the fact that the active manager is really just an
expensive manager? As John C. Bogle, a pioneer in ETFs back in the 1970s,
recently said, ‘more than anything, it’s the experience of investors and the
power and logic of my ideas, which aren’t earth-shaking. It’s gross return
minus costs equals net returns.’
Simple thinking can yield extraordinary returns
There’s a paradox to all this, of course: active
managers, armed with sophisticated analyst reports often don’t even hit their
benchmark return. And yet, we’re paying them more. ETFs, by definition, hit the
benchmark every time… and they cost far less. ETFs have performed particularly
well in 2015 as well, making the case for active fund management even more
baffling.
To take one example, one only has to look at Vanguard’s
range of stock-based ETFs and how they’ve performed in 2015. Literally not one
of them has provided a negative return so far in 2015, with the best performing
of them, Growth (ticker: VUG) yielding over 7.26% so far this year.
Vanguard’s ETFs are not alone in this regard. State
Street’s ETFs are also having a good year. The SPDR S&P Biotech (ticker:
XBI) has yielded an impressive 45% to date in 2015. In fact, not many are down;
as one might expect, indices covering China and Latin America have performed
poorly, but the experience of the Market Vectors Russian ETF (ticker: RSX),
which has rebounded strongly this year, suggests China- and Latin America-based
ETFs will return to positive yields shortly.
ETFs are the best way to guard against the patterns of
human behavior which we now term behavioral finance. Their growth is
testament to the fact that individuals may be cottoning onto the fact that the
foundation of most wealth and asset managers’ careers is based on one four
letter word - ´fees.’ There’s a far more effective way to invest provided by a
three-letter acronym: ETFs.
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