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The Difference Between Investing And Speculating

Investing isn’t always easy, and 2016 has certainly proven that volatility in the stock market can lead to significant shifts in investor sentiment and philosophy. A correction of this nature should be viewed as an opportunity to analyze your current strategy to ensure it is measuring up to your expectations. What it should not do is cause you to deviate from a sound philosophy of investing to a gambler’s streak of speculation. Let me explain what I mean. Investing is when you create a rational plan to grow your earned capital through a systemic process of investment in multiple securities or asset classes. It may include converting your cash to stocks, bonds, commodities, mutual funds, or ETFs in a manner that conveys a disciplined approach to risk management alongside a defined process and time horizon. For most investors, this simply means building a balanced portfolio that takes into account their specific risk tolerance, experience, and goals. That plan will then be subtly adjusted over time as your life changes, you accumulate or redeem capital, or your philosophy takes on a different form. The themes change, yet overall, the basic building blocks of investment in the stock and bond markets have been similar for generations. Speculation , on the other hand, is a completely different mindset that is more akin to gambling than true investing. You don’t wake up one day and put $5,000 in the Direxion Daily Gold Miners Bull 3x ETF (NYSEARCA: NUGT ) as a long-term investment opportunity — you do it because you think you can make a killing in a short period of time. This chart should illustrate that point distinctly: Click to enlarge Sometimes that opportunity pays off through timing, and maybe a bit of skill in reading the fundamental or technical tea leaves. Other times, you get scorched, and end up selling at a loss, with a big helping of regret and earnest promises to never to do it again. The former is honestly far more damaging than the latter. Bear markets bring about a sense of frustration with the fact that the “normal” system you have relied on for years is not working. But you keep hearing about those guys trading gold stocks, volatility futures, Treasury contracts, leveraged ETFs, bear funds, and options bets that are making a killing. Naturally, you ask yourself, why can’t I do that too? I can own all those types of investments through an ETF in most of my retirement or brokerage accounts. So you buy a little NUGT or ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ), and BOOM! in a matter of a few days, it jumps 15%. You sell, bank the profits, and all is right with the world. Suddenly this speculating stuff doesn’t seem so hard. In fact, you can probably fire your advisor or redeem your basket of diversified stocks and bonds. Timing the market is easy when you only have to hold for a couple of days and can magnify your returns! No more riding through those pesky bear markets or fretting over rising interest rates. It’s a whole new world. Of course, that last paragraph is totally sarcasm in contrast to my true beliefs. Speculating in high-risk investments is one of the last things you should be doing as volatility expands. Even though you may hit a few singles with some well-timed trades, the same correlations and patterns you are using to time the market may look completely different a few weeks from now. To state the obvious, it’s just as easy to experience a double-digit percentage drop in leveraged or inverse funds, as it is to make that much on the upside. This same mantra holds up for individual stocks too. There is a big difference between buying Yahoo! Inc. (NASDAQ: YHOO ) because it has fallen 50% and you are hoping for a face-ripping bounce or buyout offer rather than because you love the platform and think it’s a solid company to own long term. Make sure you consider your motives before putting money to work, as unintended price action can have deleterious effects on your decision-making process once you are committed. I think it’s also worth noting that trading does not automatically equate to speculating . There are some very methodical traders with short-term time horizons and a risk-aware approach that are candidly investing in a more active manner. The difference is that they have time, tools, and discipline that have been honed by experience, and the most successful stay within their refined process. Remember that volatility is not a transient event. It is something that is constantly with us and causes the market to move both up and down in unpredictable ways. If you have found yourself straying from a sensible portfolio strategy, take the time to evaluate your decisions to determine if you are making changes for the better or possibly worse. Sometimes that simple exercise is all you need to snap back to reality and re-focus on a plan that makes sense to reach your goals. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.

How Long Will You Wait For Smart Beta To Work?

In my last post I shared some insights from Ben Carlson’s A Wealth of Common Sense , which argues that investors are generally better off keeping their portfolios simple and straightforward. This idea has little appeal for index investors who hope to improve on plain-vanilla funds by using so-called smart beta strategies. “Smart beta” refers to any rules-based strategy that attempts to outperform traditional cap-weighted index funds. Now more than a decade old, fundamental indexing is the granddaddy of smart beta, while factor-based strategies are the newer kids on the block. In each case, the goal is to build a diversified fund that gives more weight to stocks with certain characteristics (value, small-cap, momentum, and so on) that have delivered higher returns than the broad market over the long term. Many proponents of passive investing see huge potential in factor-based strategies because they combine the best features of indexing-low-cost, broad diversification, and a rules-based process-with the potential to overcome the shortcomings of traditional cap-weighting. Indeed, many of our clients at PWL Capital use a combination of traditional ETFs and equity funds from Dimensional Fund Advisors (DFA) , which have greater exposure to the small-cap, value and profitability factors . The academic research on factor-based investing is robust and convincing, and building your portfolio using these principles may be rewarding over the long term. Ben Carlson thinks so, too, despite the emphasis he puts on simplicity. But he has some cautionary words for those who are ready to jump on the smart beta bandwagon. “I think these strategies can make sense as part of a broadly diversified portfolio if you know what you’re getting yourself into,” he writes. A costlier, bumpier ride Let’s start with the most obvious caveat: smart beta is cheap compared with active strategies, but it’s significantly more costly then traditional ETFs. Cap-weighted ETFs carry almost negligible costs these days, with fees as low as 0.05%, while factor-based funds tend to have MERs in the range of 0.40% to 0.80%. That means they need to deliver significant outperformance before fees to simply break even on an after-cost basis. Second, any outperformance is probably going to involve a rockier ride. While it’s not true over every period, small-cap and value stocks are typically more volatile than the broad market, so their excess returns may require you to endure more swings in your portfolio. Over the last five years, for example, that standard deviation (a measure of volatility) for both value and small cap stocks was higher than that of the broad market in Canada, the U.S. and international markets. And as Carlson notes: “One of my common sense rules of thumb states that as the expected returns and volatility of an investment increase, so too does poor behavior.” Which brings us to the biggest challenge for investors who use smart beta strategies. The waiting is the hardest part Investors who embrace smart strategies are usually familiar with the research showing that small-cap and value stocks have outperformed over the very long term in almost every region. But few appreciate that to those premiums can take a long time to show up-and were not talking about a mere five or 10 years. In his book, Carlson explains that from 1930 to 2013, small-cap value stocks in the US delivered an annualized return of 14.4%, compared with 9.7% for large caps. However, small-cap value lagged the S&P 500 for a 15-year stretch in the 1950s and 1960s, then for seven more years from 1969 to 1976, and finally for a gruelling string of 18 years in the 1980s and 1990s. “Eventually they paid off, but that’s a long time for investors to wait. Patience is a prerequisite for these strategies.” That’s an understatement. It’s not uncommon for investors to lose faith in a strategy after a year or two. It’s hard to imagine many will hang on to an underperforming smart beta fund as it lags the market for even five years-let alone 18-because they’re confident it will outperform over a lifetime. Almost no one has that kind of patience-with the possible exception of Leafs fans . “You have to commit to these types of strategies, not use them when they feel comfortable,” Carlson says. “The reason certain strategies work over the long term is because sometimes they don’t work over the short to intermediate term.” Tracking error regret Just this week, Larry Swedroe expanded on this idea by looking at the probability that the small and value premiums will be negative over various periods. He demonstrates that there’s a significant chance of underperformance over even a decade or two. “My almost 20 years of experience as a financial advisor has taught me that even the most disciplined investors can have their patience sorely tested by as little as even a few years of underperformance,” he confirms, “let alone a 10-year period without higher returns for value (or small, or international, or emerging market) stocks.” Swedroe goes on to coin a brilliant term for the anxiety indexers feel when their smart beta strategies go awry: tracking error regret . “These are investors who regret their decision to maintain a portfolio that performs differently than the market. Tracking error regret causes many investors to abandon their well-thought-out, long-term plans.” The point here is not that you should ignore alternatives to portfolios built from traditional index funds. Smart beta strategies may indeed reward the patient, disciplined investor over the very long term. But no investors should ever feel they’re settling for second-best with a simple solution. In the end, these traditionalists will likely find it easier to stay on course, and may just end up looking like the smart ones.

Understanding Liquid Alternatives: Ask The Right Questions

Financial advisors and other professional investors often have a lot of questions about liquid alternatives, and for good reason. The investment strategies used in alternative mutual funds and ETFs are not straight forward by any means. Many use some form of leverage. Most utilize the ability to short securities, while others use a variety of derivative instruments to efficiently gain exposure to certain assets classes or securities. But when used properly, liquid alternatives can be an effective tool to mitigate risk, increase diversification and/or enhance returns. So what questions should advisors be asking? To answer that question, Cognios Capital , managers of the Cognios Market Neutral Large Cap Fund (MUTF: COGIX ), has produced a handy guide, “FAQ: Liquid Alternatives.” The eight-page white paper answers the following frequently asked questions: What is the difference between traditional alternative investments and liquid alternatives? What is the benefit of adding alternatives to my portfolio? How many different alternative strategies do I need? From where should I fund my alternative allocation? Are there risks that are unique to alternatives? Why not just invest in a multi-strategy fund? Why is there such a large difference in returns among the different types of alternative strategies? What does it mean to be Beta Neutral? How are fees and expenses reported for alternative mutual funds? Cognios’s white paper answers each of the above queries in great detail, devoting nearly a page to each answer. What follows is an abbreviated summary of the report. Traditional vs. Liquid Alts Alternative investments include assets such as commodities, currencies, and private equity; as well as public-equity strategies such as long/short equity, market neutral, and equity arbitrage. Traditional alternatives are subject to less stringent regulation by the SEC, have less liquidity and transparency than liquid alts, and are open to wealthy individuals and institutions only. Liquid alts offer similar exposures but through SEC-regulated mutual funds and ETFs, with daily liquidity and greater transparency. Benefits of Allocating to Alts Alternatives present many potential benefits, but perhaps the most obvious is their potential to improve the risk-adjusted return of portfolios through exposure to assets and strategies with low correlation to traditional stocks and bonds. How Many Alts are Needed? According to Cognios, a 10% to 25% allocation “may be an optimal range” for individual investors. As for the optimal number of different alternative strategies, this depends on investors’ desired outcomes. Alternatives aren’t a single “asset class” – a variety of strategies pursue a variety of different outcomes. Funding an Alts Allocation Should alternatives be funded from the equity portion of a portfolio, the fixed-income sleeve, or a separate “alts” sleeve? According to Cognios, there is no one right time to add alts to a portfolio – and similarly, there is no one right way to fund them. Unique Risks Cognios cites the following as unique risks to investing in alts: Insufficient manager experience Limited track records Difficult-to-understand strategies Multi-Strategy Funds Investing in a multi-strategy fund leaves the decision of which strategies to invest in and how much to allocate to each strategy up to an outside manager. While this can be beneficial, multi-strategy funds sacrifice customization for ease. Furthermore, multi-strategy funds aren’t always fully diversified within the alts space, so certain single strategy funds may be needed to complement multi-strategy holdings. Dispersion of Returns Since alts aren’t a single “asset class,” it makes sense that there would be a wide dispersion of returns across the different alternative assets and strategies. But even within a given strategy, wide dispersion between the best and worst performers is common, since many funds operate different sub-strategies and most are unconstrained by benchmarks. Beta Neutrality A “beta” of 1.0 indicates 100% correlation with a given benchmark. Equity market neutral funds pursue “beta neutrality,” meaning a beta of as close to 0.0 as possible. This way, their returns are isolated from the fluctuations of the broad market. Liquid Alts Fees While alternative mutual funds certainly have lower fees than their hedge-fund counterparts (in most cases, at least), their fees aren’t necessarily as straightforward as those of traditional mutual funds. This is because strategies that engage in short-selling incur related costs, whereas traditional mutual funds don’t sell short, and thus don’t incur these added charges. Download the full guide for complete answers to the nine questions (linked above). Jason Seagraves contributed to this article.