"The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent ... might be a useful remedy for our contemporary evils," Keynes wrote in 1936. "For this would force the investor to direct his mind to the long-term prospects and to those only."
In today's trade-frenzied investment environment, Keynes would be even more dismayed ... certainly shocked at the rapidity at which incoming data is analyzed and acted upon. Commentaries are released almost instantaneously on every market uptick, down-tick and more. What's more, investors experience a persistent showering of new investment options. (The ETF space is no exception -- according to Morgan Stanley, 457 ETFs were launched in 2007 with another 547 planned). It's no wonder investors are often confused.
What then are investors to make of the contemporary investment environment? And, importantly, what are the implications for managing portfolios? The last issue of ETFocus commented on the dangers of a rigid "buy-and-hold" philosophy. This article intends to shed some light on the hazards of myopic, short-term thinking in the context of today's markets.
Shifting Investor Psychology. With a volatile start to 2008 (and the worst year-todate S&P 500 performance since 1939), fear has gripped many investors. In fact, "bear-market" sentiment levels are firmly entrenched both in credit markets and investor behaviour. Asset-backed securities issuance (the epicenter of the current credit revulsion) is down approximately 60% over comparable levels a year ago. Institutional and retail investors have also run for the hills. According to the Investment Company Institute, total US money market mutual fund assets have now increased to USD 3.361 trillion - an increase of approximately USD 1 trillion over last year.
Many markets have seen steep declines since October highs. One high-flying ETF, the iShares FTSE/Xinhua China 25 (NYSE:FXI), is down over 35%. Market headlines are equally pessimistic: "G-7 Says Global Growth May Deteriorate, Market Turmoil to Persist." "Paulson Says Global Economy Faces Serious, Persisting Risk From Markets."
How should we react to such swift changes in the investment outlook, such as now? After all, only a few months ago all seemed rosy. Fourth-quarter earnings growth estimates for the S&P 500 were still hovering around 11.5%. Markets shrugged off mounting evidence of slowing economic growth and appeared completely indifferent to growing credit market risk.
Investors should acknowledge that emotions tend to drive decisions even more through periods of episodic risk. Monumental mistakes are often made during those times. Most often, the best reaction is to do nothing at all. Yet, other times can be great opportunities.
Short-Termism Rampant. During periods of shifting sentiment many market participants tend to over-transact, attempting to "trade" their way out of broad declines -- a sure way to worsen returns even more. In 1998 two researchers, Brad Barber and Terrance Odean, analyzed the trading habits of over 60,000 investors over a six-year period. They concluded that there was a direct correlation between trading volumes and performance: those who traded the most fared the worst. Specifically, the investor group with the highest trading volumes underperformed the index by 500 basis points.
John Bogle, founder of the Vanguard Group, has also published excellent research on the damaging effects of excess churn in portfolios. In a 2005 article in the Financial Analysts Journal, Bogle looked at turnover rates in US equity funds from 1995 to 2004. An alarming trend becomes clear. Rates increased from around 24% in 1945 to 112% in 2004 (see chart above). That implies a decline in the average stock holding period from over 4 years in 1945, to just 11 months in 2004.
Moreover, holding periods of fund holders have also decreased, exacerbating total turnover rates experienced by investors. According to Bogle, during the 1950s, shareholders typically held their funds for 16 years. From that decade, a steady descent in holding periods ensued. By 2002, the figure had dropped precipitously to only just over 3 years.
ETF Investing Immune? We are seeing short-term focused behaviour proliferate in ETF investing as well. Bogle estimates that only about 20% of assets in the more broadly diversified ETFs belong to long term investors. The remainder is held with high-turnover hedge funds, electronic trading programs, and other speculators.
Annual turnover for ETFs often exceeds thousands of percent (turnover for the popular NASDAQ Qubes is reported to exceed 6,000% per annum). State Street's flagship ETF, the "Spider", typically has a daily turnover of more than USD 10 billion ... likely the world's most actively traded security. Fortunately, ETF unitholders are insulated from the tax impact of the trading activities of other shareholders (since they are exchange listed).
Used appropriately however, ETFs can help mitigate many behavioural errors and introduce a more disciplined framework for the implementation and rebalancing process. Holding a diversified basket of securities -- where single company risk is reduced -- can decrease monitoring and trading frequency, and will help investors focus on more important drivers of long term performance such as asset mix. ETFs also achieve instant diversification, remedying another typical investor snare of holding too few stocks (and underestimating the individual stock's beta with the broader market).
Portfolio Defenses and Opportunities. What else can we do to protect portfolios against short-term thinking or our own behavioural errors in the current volatile environment? The first line of defense is maintaining overall diversification. That doesn't mean holding a "batch of lottery tickets" (in the words of fund manager, John Hussman). Rather, holding non-correlated assets with reasonable valuations, a claim on reliable income and those that can maintain their real values in higher inflationary environments is paramount. ETFs are democratizing many areas of investing by providing access to previously unavailable asset classes. As a result, investors are better equipped to build more diversified, lower-volatility portfolios.
We can also shut out the drumbeat of market "noise." Shortsightedness and decision-making biases plague not only individual investors but also investment committees - undoubtedly, to the detriment of long-term performance. The fund industry has become focused on quarterly earnings, shortterm results and tracking-error. But long-term investment returns are much easier to forecast than those based on short horizons. For one, valuations are the best predictor of longerterm returns. Perhaps more surprisingly, most of longer-term returns come from yields and not valuation changes (over twothirds, according to some analysts). Indeed, WisdomTree has launched a whole suite of ETFs based on high-yield or dividend-weighted indices to capture this phenomenon.
The short-term shouldn't be neglected, however. Often, key inflection points offer opportunities -- periods where valuations become compelling or investor psychology reaches such pessimism that one can buy assets cheaply. In fact, the near future may be one of those times. Risk is rapidly being repriced and we are witnessing key sentiment levels deteriorate. For now, a cautious approach is still recommended although buying opportunities will likely present themselves in the next few quarters.
Avoiding performance chasing and sticking to a disciplined, riskfocused investment process is another important recommendation. The emerging field of behavioural finance warns against many of these pitfalls, pertinent also to investment professionals. James Montier, a leading expert in the psychology of investing, classifies these behavioural biases into three groups: (1) "self-deception" biases limit investors from learning from previous mistakes; (2) "heuristic simplification" causes us to make information processing errors; and finally, (3) "social" biases encourage herding behaviour. We will be examining these in more detail in future columns of ETFocus. Needless to say, behavioural biases lead to sub-par investment performance.
Keynesian Insight. 72 years ago Keynes observed that speculation had come to dominate true investing. In today's hyper-active trading environment, Keynes' lament rings all the more true. Finding a balance between focusing on long-term investing and capitalizing on short-term opportunities -- while controlling emotions -- is vital to successful investing.