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Tuesday, August 15, 2017

Meanwhile Over at Betterment They Reject Smart Beta Completely.... and at Schwab they use it Extensively

 In another post I wrote about Wealthfont's adoption of "smart beta" in its Passive Plus strategy. At Betterment the other major independent robo advisor they reject the use of Smart Beta completely

Is ‘Smart’ Beta Just Expensive Beta?

Are ‘smart’ beta funds good for investors? So far, the answer is no.

Over at Schwab in their Intelligent Portfolios they make extensive use of Smart Beta (fundamentally weighted) ETFs

Why do you include both market-cap and fundamentally weighted ETFs in your portfolios?
Fundamentally weighted and market-cap weighted ETFs both track indexes, but their performance can vary widely. 

Given their unique construction, fundamentally weighted ETFs can complement traditional ETFs in a portfolio. While traditional market-cap ETFs often provide low cost diversification, fundamentally weighted ETFs provide a value tilt in the portfolio construction. To help ensure that our portfolios are truly diversified, Schwab Intelligent Portfolios invests in both types of ETFs with the goal of helping to reduce volatility and provide better risk-adjusted results over time. 

Bottom line: the portfolios of Robo Advisors differ tremendously. I would assume few investors have the skills to evaluate the pros and cons of the growing number of Robo Advisors. Will human advisors who now advise on which robo portfolio to choose...or will independent advisors only recommend the robo advisor they can offer to clients (advisors linked to the Schwab advisor platform recommending the Schwab portfolio and Fidelity to Fidelity) ?

As I expected we are now beginning to see newsletters and articles evaluating the short term performance of robo advisor portfolios. I have little doubt that will lead to investors swapping between robo advisors based on short term performance just as they have done with mutual funds and ETFs..defeating the whole purpose of these programs.

At the end of the day will investors be better off not only with a human advisor but unlike with the robo advisors not wedded to a one size fits all portfolio allocation?

 The robos moderate portfolios based on risk appetite but then put them into a one size fits all portfolio. A human advisor might lower the exposure to --for instance emerging markets-- in a portfolio of a low risk tolerance portfolio along with altering the stock bond allocation, in addition to tax management across all accounts including those not managed by the advisor such as 401ks,

One Robo Does an About Face on "Smart Beta" and Offers Its Clients a Black Box Version

Wealthfront--one of the larger and earliest robo advisors-- has introduced a new program called advanced indexing which combines several of the factors used in factor ETFs such as momentum(availabe in MTUM ), dividend minimum volatility(USMV) and quality (QUAL) and dividend (such as Schwab's Dividend Equity ETF(SCHD).

The strategy which they call PassivePlus®.  is based on proprietary research --in other words unlike the momentum, quality and value strategies available there is no library full of academic research backing up their choice of strategy. It is impossible to know their methodology for categorizing stocks as they do, nor of their chosen proportion of each characteristic, and there is no regular listing of holdings,p/e price to book and other characteristics of the portfolio,

Wealthfront's description

Constructing the Modified Index


After constructing the single-factor strategies we combine them to produce a multi-factor “overlay” portfolio, which includes securities with good value, strong momentum, high dividend yield, low market beta, and low volatility. This overlay portfolio is blended with the cap-weighted index to produce a modified index, which serves as the benchmark relative to which the stock-level tax loss harvesting algorithm will seek to minimize tracking error. The goal of this construction is to overweight securities with high expected returns, while ensuring the modified index remains close to the cap-weighted benchmark, thus keeping overall portfolio risk unchanged.

The Smart Beta Flip Flop at Wealthfront

To say the least ironically top executives from Wealthfront have been outspoken critics of "smart beta" 2015, former Wealthfront CEO Adam Nash wrote a scathing article criticizing Charles Schwab’s robo advisor for, among other things, allocating users to smart beta ETFs.
“The average smart beta ETF that Schwab has selected not only has 3 times the management fees of the average Vanguard ETF, but not surprisingly, all are either proprietary Schwab ETF products or ETFs from issuers that pay Schwab to use them,’ Nash said. He included a quote from John Bogle saying “smart beta is stupid” and referenced Malkiel’s feelings about smart beta. “Last year, Burt Malkiel, our CIO, explained why smart beta products are not smart investments.”
Just a year ago, Malkiel reiterated his disdain of smart beta to the Wall Street Journal, saying they are riskier than index funds and just a new way for managers to justify fees. In a 2016 update of his book, “A Random Walk Down Wall Street,” he devotes a chapter to arguing why smart beta isn’t good for individual investors.
I must say I find it disappointing that Malkiel long a pioneer in advocating straightforward low cost capitalization weighting indexing now puts his name on these strategies.
Here is his flip flop

Burton Malkiel Is Still an Indexing Fan, but a ‘Smart Beta’ Skeptic

The author of ‘A Random Walk Down Wall Street’ says smart-beta strategies are riskier than index funds and not right for individual investors

Mr. Malkiel, the economist known for being one of the biggest proponents of index investing, continues to be among the skeptics of these popular mutual funds and exchange-traded funds, which blur the lines between active and passive management.
The “beta” part of the name refers to an index, or an index fund’s, return. The “smart” part means that the funds weight stocks in an index based on factors such as low volatility, high quality or high momentum (rather than on market value like a typical index fund) in a bid to produce better returns....

And here is the flip flop a little over a year later..not coincidentally of course Malkiel is Chief Investment Officer of Wealthfront. To the best of my knowledge he has never done data driven research on finance and certainly not on factor investing..of which he has been skeptical his entire carerr up till now (he is 84) and through 44 years and 9 updates to his classic Random Walk Down Wall Street:
NYT June 22, 2017

An Index-Fund Evangelist Is Straying From His Gospel

In his classic 1973 book “A Random Walk Down Wall Street,” Burton Malkiel, a Princeton economics professor, made an assertion that was startling at the time: that “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.”

Three years later, Vanguard, the asset manager where Mr. Malkiel served on the board for 27 years, started the first passive index fund, an innovation that has swept the financial world.

Now, at age 84, Mr. Malkiel has had a remarkable change of heart: Maybe the experts can beat the monkeys after all. That is, if the experts are software engineers writing sophisticated algorithms for computer-generated trading.

Mr. Malkiel is chief investment adviser for Wealthfront, a pioneering automated investment manager that last week adopted a new approach it calls Advanced Indexing. The strategy aims to exploit market inefficiencies and beat the passive approach, based on an index weighted by stocks’ market capitalization, which Mr. Malkiel has long championed. This falls within a broad investing category known as “smart beta,” beta being a measure of the volatility of a security or a portfolio in comparison to the market as a whole.

“I have been a critic of smart-beta funds because they have typically been sold with high expense ratios and have ignored tax consequences,” Mr. Malkiel told me this week. “Smart beta has in effect been expensive beta.” But decades of academic research into efficient markets and Wealthfront’s ability to deliver a smart-beta approach at low cost, coupled with tax efficiency, finally won him over, he said.

I find the argument about expensive beta a bit specious the ishares USM,QUAL and MTUM have  fee of 15%, Vanguards Value ETF has a fee of .07%, Schwab's Dividend ETF has a fee of .07%. Wealthfronts fee (which to be fair includes other services) is .25%.

I addition to value and momentum factors, Wealthfront’s approach embraces stocks with high dividend yields, low market beta and low volatility, all factors that “have proven robust across long time periods, geographies and asset classes,” Mr. Jurek said. (Wealthfront excluded another widely cited factor, small market capitalization, because its investment universe is limited to large-cap issues.)

Wealthfront’s testing against historical data indicates its multifactor approach outperformed a strict index approach by an average of 1 percentage point per year over the past 50 years, and even more since 2000, without any increase in volatility. As would be expected, there were some periods in which it underperformed.

1% excess return based on historical data is a very slim advantage. Backtested data does not take into account trading costs involving the bid ask spread or intraday moves it is based in almost all cases on closing data.

Interestingly Robert Arnott whose Fundamental Indexing book and researh pioneered the field has recently raised questions about some strategies particularly due to valuations.

From the NYT article
Smart beta has its critics, including Mr. Arnott, viewed by many as the godfather of the field. “Smart beta can be smart, and then it can be not so smart,” Mr. Arnott said. “There are tons of strategies being offered now based on nothing but back tests. Anyone can create a brilliant strategy with benefit of hindsight. But does that mean anything for future returns?”
“Pretty much everyone is looking at the same factors, which is a danger,” he added. “It’s a very crowded space. If 10,000 quants are all looking at the same data and trading on it, the chances are that it’s not going to work.”

Mr. Jurek (director of research at Wealthfront) responded that “at a very general level, you could say that every back test is problematic.” But he stressed that “when designing Advanced Indexing, we relied on decades of peer-reviewed research to select factors that have stood the test of time” 

The above is a bit of intelletual sleight of hand. Although it is true thst there is pee reviewed research on the factors, the lack of transparencey means there is no peer reviewed research on the Welthfront criteria for characterizing stocks and the proportions they use.

One more note..Wealthfronts strategy only includes large cap stocks although the largest outperformance found in research dating back to Eugene Fama's nobel prize winning work was in small value stocks.

Investors wanting to incorporate smart beta strategies in their portfolio may well be better buying the individual strategy ETFs rather than the "black box" of Wealthfront's "Passive Plus".


Monday, August 14, 2017

Pick Your Market Expert to Follow..Or More Productively Ignore Them All

This is an entertaining one:

Two of the most well known finance Professors in the a nobel prize winner --disagreeing on almost everything….making the argument for ignoring gurus even if they have a nobel prize

Interestingly they agree on this one:

Both Shiller and Siegel said they agree on the relative value of investment opportunities outside the United States, where valuation is lower.
“We have the highest CAPE ratio in the world of all major markets,” Shiller said. “You don’t have to invest in the United States. Most of your listeners are probably—if they’re from the US—over-concentrated in the US….People should diversify and international diversification is a good thing.

Tuesday, August 8, 2017

Here We Go Again...."it's Time For Active Stock Picking"

Of course this one is a perenial in the financial press. After all who would read Barrons if it eschewed market timing and stock picking

Barrons August 5


Is It Time to Return to Active Stock-Picking?

As the major market averages keep rising, some folks think it’s time to ditch the passive-investing trend.

But even Barrons in the text of the article has to acknowledge

Passive investing is in danger of devouring capitalism,” Paul Singer wrote in the second-quarter letter to his Elliott Management hedge fund investors.
That recalls last year’s rather histrionic paper from Bernstein, “Why Passive Investing Is Worse Than Marxism.” The gist of both attacks on index funds is that, without active investors diligently working to allocate capital and to hold managements accountable, our economic system would be in peril.
“What may have been a clever idea in its infancy has grown into a blob that is destructive to the growth-creating and consensus-building prospects of free market capitalism,” Singer is quoted by Bloomberg News as having written.
To be sure, we at Barron’s extol the virtues of ferreting out superior investing ideas, as we seek to do each week in these pages and daily at Yet for fiduciaries charged with managing millions and billions of institutional money, the cost of actively managing stocks hasn’t translated into superior results for the median investor, let alone those on the left side of the bell curve.

Friday, August 4, 2017

The Perils of Capitalization Weighting: Teva and the Tel Aviv 35 Index

Yesterdays action on the Tel Aviv stock exchange demonstrates the perils involved in capitalization weighted indices. Even after expanding the index from 25 to 35 stocks Teva still carries a weighting of 5.58% in the index thus the 17.5% drop in Teva produced a large 1.5% drop in the index.The sharp decline of Teva over the last year has held back the TA 35 index despite the global rallies in stocks and the appreciation of the Israeli Shekel vs the dollar,

Teva One Year Chart

Tel Aviv 35 Index One Year

As a basis of comparison the highest weighting in the S+P 500 is Apple at 3.8%.

The perils of small indices can be seen in the popular technology index ETF XLK where Apple has a 15% weighting and Microsoft a 10% weighting, It is not hard to calculate what a large drop in one of these stocks would do to the value of the ETF

Thursday, August 3, 2017

Mixed Messages

There can be long debates about whether or not political developments are important to the stock market, But the dichotomy between the performance of the US stock market and the dollar is attributed by many analysts to weakening confidence in the President. The dollar has experienced its largest decline since 2010-2011

Here is the SP 500 and the Dollar Index not that the dollar participated in what was called the "Trump rally" from election day through the end of 2016 but that the two have diverged completely since the beginning of this year. Ironically the stronger foreign currencies benefit US companies with a large percentage of sales abroad (weaker dollar/stronger foreign currency) which boosts profitability for companies with significant earnings abroad--generally large cap stocks.

SPY (brown) US Dollar Index (black)