"I can calculate the motion of heavenly bodies," Sir Isaac Newton once observed, "but not the madness of crowds." Newton was writing during the rise of the South Sea Company in the early 18th century, where the British government had granted a trading monopoly with the Spanish colonies in South America. With great promise of sizeable returns, investors started snatching up shares and quickly drove the stock price to irrational levels. It was a time of unfettered optimism as fortunes were made overnight.

Yet, as history regularly reminds, easy winnings are a fleeting occurrence. Sustainable wealth creation is a slow, steady process. As the story goes, the company ultimately proved to be more sizzle than steak and the stock price plunged. In hindsight, movements in the share price of the South Sea Company became divorced from the underlying fundamentals ... a hot investment story once again replaced prudent investment analysis. Even the great Sir Isaac, inventor and master of many disciplines, was unable to resist the collective euphoria and lure of quick riches. Reportedly, the drop dealt a devastating blow to his personal portfolio.

Gambling or Legitimate Investment? Is there evidence of a similar "casino mentality" (in the words of John Bogle) in any financial markets today? And -- perish the thought -- can this phenomenon even extend to ETFs? Consider that with over 2,000 ETFs worldwide (and over 3,900 listings on 40 exchanges around the world as of January 2010), the "hot investment" lure of the South Sea bubble is sure to find expression at least somewhere in our favourite domain.

We think we may discern some of its traces. Not infrequently, investors today are enticed with speculative ETF picks or hyped stories, persuading them to chase the latest trend. Make no mistake. ETFocus is not about to scream "bubble!" at every sign of market exuberance. Far from it. Identifying undervalued, profitable investments -- even if they become popular at some point -- is a critical component of portfolio investing. And, the expansion of ETF listings is an indisputably positive step forward for investors, re-shaping investor economics and the global portfolio-building process.

But let's be clear. Chasing the investment idea du jour is a strategy that regularly leads to disappointing results. A recent study provides solid support. Researchers Meir Statman, Kenneth L. Fisher, and Deniz Anginer analyzed the performances of "admired" and "despised" stocks in Fortune Magazine's annual survey from 1983-2006. Their conclusion? Returns from the admired stocks were consistently lower than returns of the despised stocks. The researchers determined that investors prefer stocks with a positive emotional "affect" (i.e. perceived attractiveness, a good story, etc.), thus driving up the stock price and decreasing their longer term returns. Of course, the reverse holds true in shunned stocks. Indeed, it's not the celebrated investments that make money -- it's the undiscovered ones. It's no different in the world of ETFs.

Turning to recent events, is there evidence of positive "affect" taking root in any investment areas? Actually, yes. In fact, human nature ensures that short-lived speculative episodes will be recurring features of the investment landscape. Let's look at one recent example to illustrate specific risks.

Don't Believe the Hype. "Investments are sold, not bought," an old investing adage goes. In the case of the so-called emerging markets, investment promoters have sunk their teeth into this one. Through masterstrokes of marketing brilliance, many emerging market assets have been packaged and distributed with flashy labels. Many of these emerging market ETFs are regularly touted as "top picks". "Most Promising Emerging Market ETFs for the Next 3 Months", blasts one recent headline.

To be sure, we have long supported investing in the developing world. (And, for the record, the term "emerging" is both pejorative and outdated). Currently, many emerging markets are proving their economic resiliency through a challenging global economic landscape. Compared to Western markets, many emerging countries have not witnessed epic credit booms during the last two decades. That means consumer leverage is much lower, and debt overhangs will not act as structural drags on future economic growth. Many ETFs provide excellent exposure to this asset class.

As always, however, it is important to separate facts from hype. In this case, it's critical to note that broad economic growth does not always translate directly into investment profits. In a 2009 book by James Montier called "Value Investing: Tools and Techniques for the Intelligent Investor", the relationship between emerging market real GDP growth and stock returns were analyzed for the period 1988-2007. The results may be surprising to many. The relationship between the two variables actually displayed an inverted bias. In other words, the fastestgrowing markets generally delivered the lowest stock returns.

Why the odd relationship? After all, intuitively, higher growth should offer higher returns. But consider that emerging markets -- like the admired stocks in the study cited earlier -- face the same issues. Often, hot country ETFs with hyped stories also come with higher stock market valuations, decreasing their long-term returns. "The growth was already discounted," a wise head will say.

What About Value? Take the emerging Asian region as an example -- see the SPDR Emerging Asia ETF (NYSEArca:GMF). In the run-up to the Global Financial Crisis of 2008, investors became enamored with the concept that emerging markets -- particularly China -- could "decouple" from a slowdown in the developed world. It was a catchy story. Unfortunately, the facts did not square with economic reality. In an increasingly globalized and interconnected world financial system, individual markets remaining insulated from global systemic shocks was a tenuous argument.

And, the price wasn't right. Valuation levels for emerging Asian stock markets during that time were in nosebleed territory (see chart 2). Yet, many investors ignored the risks. The great value investors, like Graham and Dodd, knew that paying 50 cents for a dollar bill was better than paying more ... providing a "margin of safety" against unforeseen events. But in times of speculation and promotional hype, value can be overlooked ... with the typical result of overpaying for hopeful outcomes. Like most investors, ETFocus is drawn to high-growth investments -- but not without losing sight of risk and value. (A little known fact is that investment valuations are the best predictor of longer term returns).

As we write, investors again seem disposed to repeating the same mistakes made in the period up to the 2008 global stock market decline -- broadly underestimating risk levels and supporting the decoupling hypothesis. Many equity ETFs in the emerging world (and other "growth" segments of the stock market) are again trading at premium prices. And, the hope that the developing world will lift the worldwide economy out of its low-growth phase persists despite evidence to the contrary. Needless to say, there are many competing opinions on these points. We will return to the China and emerging markets theme in future issues of ETFocus. For now, a cautionary stance on emerging stock markets and other "growth" stocks is recommended -- many high-quality and value-oriented assets are now underrated.

Focus on Investment Process. How can investors protect against the above risks? After all, the seductive allure of a quick gain is difficult to resist. Consider the record of initial public offerings (IPOs). James Montier in the aforementioned book points out that IPOs -- with their characteristically hyped stories -- have a horrific track record. During the period 1980-2007, the average IPO in the United States underperformed the market by some 21% per annum in the 3 years after listing. Despite the evidence, investors seem to replicate the same errors ... chasing momentum and getting sucked into hot stories.

Is there hope for investors? Fortunately, yes. A variety of approaches can mitigate against these errors. Generally, the best defense is having an investment process -- one that identifies both opportunities and risks, and extinguishes the emotional impulses that lead to poor investment results. To be sure, creating a reliable investment framework is a formidable task (indeed, we have spent years working on ours). But there are critical components that should be included in every investment process. Without one, investors are analytically rudderless and all too susceptible to being swept up in the whims of investment fads.

Newtonian Lessons. Newton expressed frustration that the "madness of crowds" could not be mathematically modeled. That's true. We can't know where speculative action or "groupthink" will take a vice-like hold on certain markets. There is no elegant formula here. For many fundamental-oriented analysts, these times can be an exercise in frustration as investor exuberance temporarily allows price levels to detach from fundamental underpinnings. ETFocus understands this all too well. Yet, history is clear that chasing the latest investment fad and other strategies of financial brinksmanship does not lead to long-term success. A better approach is to remain anchored to a balanced, risk-sensitive investment process.