Tag Archives: nasdaq

My ‘Wisdom’ On Smart Beta And Factor Investing

The latest installment from Tadas Viskantas’s series on “financial blogger wisdom” (is that an oxymoron?) asked a bunch of smart people (and also me) about smart beta. I was short: Smart beta and factor investing are the newest versions of high(er) fee active management promising the fairy tale of “market beating” returns in exchange for higher fees and usually delivering lower returns (after taxes and fees). Regulars know I am not a big fan of Smart Beta and Factor Investing (sorry to all my friends in the industry who love these approaches!). For the uninitiated, Smart Beta basically involves taking an index fund and changing it so it captures a “smarter” type of return. For instance, you might take a market cap weighted index fund like the S&P 500 and equal weight it so that it doesn’t expose you to the procyclical tendencies of the market cap weighted fund which will tend to be overweight the riskiest stocks at the riskiest points in the market cycle. The evidence that this is countercyclical is weak as Vanguard has shown and as I expressed in my new paper . Further, you will generally pay higher taxes and fees in these funds without a high probability of better results. For instance, the equal weight S&P 500 has a pretty mixed performance versus the market cap weighted S&P as it’s performed better on a 10-year basis, but underperformed on all periods shorter than 10 years. The nominal returns are slightly better over longer periods, but that’s only because the equal weight fund has a much higher standard deviation with 95% of the total correlation. So, the intelligent asset allocator has to ask themselves why they’d pay for 95% of the correlation while guaranteeing higher taxes and fees without a reasonably high probability of better risk-adjusted performance? Should you really pay higher fees for the empty promise of “market-beating returns”? I say no. The same basic story can be laid out for factor investing. There’s a great irony in the idea that the founder of the Efficient Market Hypothesis says you can’t pick stocks that will beat the market, but you can construct index funds that will be comprised of the stocks that will beat the market. The problem is no one knows what are the right stocks to put in a “momentum” index before they earn the momentum premium. And just like active mutual funds, no one should pay a premium for an asset manager who claims that they can construct an index that will be comprised of stocks that will benefit from “market beating” returns in the future. You just end up guaranteeing higher fees and taxes in exchange for the empty promise of market-beating returns. To me, these are just the new forms of “active” investing charging people higher taxes and fees for indexing strategies that won’t outperform.

Peak Oil And Runaway China: A Dangerous Combination Of Memes

By Ron Rimkus, CFA Back in 2005, investors heard an endless chorus in the financial media around two memes: the end of oil, and the growth of China. Oil production was supposedly hitting its upper limits. In 2005, the US Department of Energy published a study on the peaking of world oil production (.PDF) that stated: Because oil prices have been relatively high for the past decade, oil companies have conducted extensive exploration over that period, but their results have been disappointing [….] This is but one of a number of trends that suggest the world is fast approaching the inevitable peaking of conventional world oil production [….] The world has never faced a problem like this [….] Previous energy transitions (wood to coal and coal to oil) were gradual and evolutionary; oil peaking will be abrupt and revolutionary. The peak oil narrative was reaching a fever pitch around the same time as China’s “runaway growth” meme. A BBC report on ” 2004: China’s Coming Out Party ” highlighted how China’s increasing appetite for oil was affecting global prices. Other articles made eye-popping comparisons of China’s cities before and after the country’s economic changes (decades apart). For instance, Shenzhen transformed from a sleepy fishing village in 1980 to a bustling urban empire by 2006 . Shenzhen had grown at an annual pace of 28% per year during this 26-year period. Yes, you read that right. The pair of memes led some investors to embrace the notion that oil supply was peaking just at the moment that oil demand was accelerating- a recipe for higher and higher oil prices. Then, we all marveled as the price of oil rose from $30 per barrel in 2003 to well over $100 by 2008 . In subsequent years, both memes were proven wrong. There was no “abrupt and revolutionary” oil peaking, and China’s energy demands would not keep growing forever . But higher oil prices created an umbrella of opportunity for capital formation, and much of that capital flowed into US shale oil projects. Between 2009 and 2015, total US oil production nearly doubled from 5,000 barrels per day to just under 10,000 barrels per day , thanks largely to shale oil. The shale revolution, which took place because high prices stimulated investment and innovation, blew apart the notion that the world had reached peak oil. By the end of 2014, it became apparent that oil output would satisfactorily meet demand growth. Blindly following popular investment memes is a recipe for disaster, and investors who convinced themselves that oil prices would remain above $100 per barrel were blindsided by the return of oil priced under $40 per barrel – even though it was a function of price signals directing capital investment as a normal part of the business cycle. One person who correctly identified the business cycle as it played out was Amy Myers Jaffe , executive director for energy and sustainability at the University of California, Davis. “When I would talk about this boom and bust cycle in 2005 and 2007,” Jaffe said in a 2013 issue of The Planning Report , “people would heckle me off the stage because it looked like the price of oil was going to be high forever.” But time has a way of vindicating truth, and now her perspective looks quite prescient. Jaffe will be sharing her views on current events in global energy markets at the 69th CFA Institute Annual conference in Montréal. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.