Field of play
Memo to wife and kids
I like to think I have a simple and straightforward approach to investing. I invest in an actively managed small portfolio of individual stocks. So far it has worked for decades. But in the last ten years ETFs have crept into my life. Let me explain. To do so I need to go back to the beginning.
A little history
When I started saving for retirement many decades ago I put all our money in a lawyers’ pension fund. I soon realized that the returns from the fund would not be high enough to allow me to retire. I read that stocks outperformed bonds. So I cashed in the pension fund and put all the money in an actively managed mutual fund. ETFs did not exist at the time.
Over the next ten years I added further savings to the mutual fund. At the same time I opened a small brokerage account and practiced my hand at various investment strategies. I ultimately concluded that a self-managed stock portfolio was the way to go and opened a discount brokerage account. That same discount brokerage account is still open today.
Today I would use an ETF
If I were starting today, I would have used an index ETF rather than a mutual fund. I was lucky with the mutual fund. It gave me a good return. But the simple fact is, you have no way of knowing with an actively managed mutual fund how it will perform. One, three, five or even ten years of great performance by an actively managed mutual fund or actively managed ETF does not mean it will perform well in the future. The outperformance could be pure luck. Or there might be a change of fund manager.
Today I have three discount brokerage accounts, two of which are tax advantaged registered accounts and one is a normal taxable account. My wife has the same three types of accounts. The six are managed by me as a single portfolio. They contain three ETFs which together make up .8% of the portfolio. These miniscule holdings are there for a reason.
A few years ago I realized we needed a plan in the event I predecease my wife. We also needed a plan for our children for when both I and my wife are gone. This is where ETFs come in. Neither my wife nor our children have any interest in actively managing money. The vehicles I came up with would have to allow completely passive holding.
I realized I would need to learn more about ETFs. Since half our investments are in individual U.S. stocks which are denominated in U.S. dollars, the U.S. side was easy: an S&P 500 index fund. I chose VOO – VANGUARD S&P 500 ETF.
The Canadian side was more complicated. The Canadian stock market is seriously unbalanced. It is highly concentrated in banks, oil companies, mining companies, telecoms and railways. Thus a Toronto stock exchange index fund would suffer the same lack of diversity. I elected a two pronged approach. One half of the Canadian side would go in XIU – ISHARES S&P/TSX 60 INDEX ETF. This ETF invests in the largest 60 Canadian stocks. And, of course it reflects the lack of balance of the Canadian economy and stock market.
My second choice was a factor or smart beta ETF which by its design essentially side steps the imbalance of the Canadian economy. It is WXM – CI MORNINGSTAR CANADA MOMENTUM INDEX ETF. The fund is described as following a methodology that “rank[s] stocks based on above average returns on equity, with an emphasis on upward earnings estimate revisions and technical price momentum indicators. The constituents…. are equally weighted and… rebalanced quarterly, providing targeted exposure to the momentum factor.” This sounds clever and it makes me nervous. But, it has a billion dollars in assets and has performed well over the last ten years. It has slighty outperformed the S&P TSX composite index over this time period.
The detailed memo to my wife sets out that if I predecease her, all the stocks in the various accounts should be sold and the U.S. dollar proceeds invested in VOO. On the Canadian side the proceeds are to be split 50/50 between the two Canadian ETFs.
We have also started to transfer financial assets to our children. They have all the same types of discount brokerage accounts as my wife and I. Their financial assets are invested with the same U.S./CAD split as our assets and are already in the three ETFs described for my wife. The added benefit regarding our children is that there are no income attribution rules for adult children in Canada. Thus, income and capital gains from their taxable accounts are taxable in their hands and this allows income splitting with them.
Is Alpha shrinking?
Part of my due diligence in coming up with the above plans has naturally been to learn about ETFs.
I read a book written by Larry Swedroe and Andrew Berkin titled The Incredible Shrinking Alpha. The second edition was published in 2020.
The book is particularly helpful in understanding factor funds or smart beta as they are also called. The word ‘alpha’ in the title is the investment industry’s term for a return that exceeds a broad stock market index.
While I agree with most of what the authors say about the merits of ETFs, I do disagree with their main thesis. This thesis is captured in the title The Incredible Shrinking Alpha.
Alpha and market efficiency
The investment industry for the most part believes that the stock market is highly efficient in processing new information and that prices fairly reflect value. It’s called the Efficient Market Hypothesis (EMH). It holds that alpha is virtually impossible to achieve.
Messrs. Swedroe and Berkin are firm believers in the EMH. It is my view that the EMH is baloney. In my investing I have seen little evidence that stock market prices usually reflect fair value. Here is a post I have written on the subject: The conventional view of market efficiency is badly mistaken
Warren Buffett offered his view of the EMH, writing in his 1988 Berkshire Hathaway Chairman’s Letter: “This doctrine [the efficient market hypothesis – here EMT for Efficient Market Theory] became highly fashionable – indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but also by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”
A full-on refutation of the EMH is contained in Andrew Smithers’ 2009 book, Wall Street Revalued, Imperfect Markets and Inept Central Bankers. (Smithers, 2009). Smithers is British and an economist by training. He has had a long career in investment management and currently runs a consultancy on international asset allocation.
In a forward to Smithers’ book, Jeremy Grantham, Chief Strategist and Chairman of Grantham, Mayo, Van Otterloo, now known as GMO, writes: “The EMH ruled the academic waves for 50 years, and for the majority of the time – say, 1968 to 1998 – it was found to be nearly impossible to get tenure or peer reviewed articles published in prestigious journals if you espoused views deemed heretical by the high church of ‘rational expectations!’ (Smithers, 2009)p.vii. Grantham takes pleasure in describing EMH as the ‘most expensive mistake – or simply the biggest mistake – in the history of finance.” (Smithers, 2009)p.vii.
Is the market becoming more efficient?
Smithers and Berkin say not only is the market almost impossible to beat, but that it is becoming even tougher. They have four principle arguments.
First, they say that “today’s active managers are more highly skilled than their predecessors”. Second, they suggest “the pool of victims has been shrinking”. Third, they suggest that the industry has been “busy converting what was once Alpha into Beta.” And fourth, they say the amount of dollars chasing alpha has increased leading to more competition for a shrinking pie.
We can deal with the second point quickly. Only 14% of stocks in the U.S. are held in passive funds. The balance, some 86% is actively managed by pension funds, hedge funds, insurance companies, family offices, and retail investors. The pool of ‘victims’ is definitely not shrinking. See here.
The authors suggest the skill of active managers today is higher. They present not a shred of evidence to support this. They rely on a sports analogy. Analogies are a doubtful proof of anything. No doubt in most sports the level of fitness and skill is increasing. They mention tennis. But in spite of higher skills and fitness, in recent years, mens’ pro tennis has been dominated by a few individuals. The alpha tennis players still seem to be dominating.
The third point made by Swedroe and Berkin is the rise of factor funds or smart beta. Again the authors present no evidence that these funds are making it more difficult for active investors to generate alpha. Let me make two observations. First, ETFs based on factors are price acceptors and people who invest in those ETFs are also price acceptor. By definition they cannot invest with a margin of safety which is critical to intelligent investing. Furthermore, the factor fund industry relies on factors like p/e, p/b, ROC, ROE and other metrics. The world has changed in the last 50 years. We live in a world of intangibles rather than tangibles. These metrics are having a hard time transitioning. The problem as he points out is that you can’t simply capitalize all R&D spending. See Swedroe’s recent report here.
Their last argument is that more and more money like hedge funds are chasing alpha which is in limited supply. This is really a repeat of their first argument. And frankly, hedge funds don’t have the best track record.
It is my observation that the stock market is as inefficient as it has always been. I suspect the leading cause of stock market inefficiency is human psychology. This includes things like herding, group think, career pressures, peer pressure, client pressure, anchoring and so on. We have recently seen it in individual investors like with meme stocks and we see it in professional money managers with tech stocks.
There is no doubt that ETFs are useful investment products. They allow completely passive investors to capture the outperformance of stocks over bonds at very low cost. If you are lucky you might even be able to capture a tiny bit of alpha with a good factor fund. Only if you are lucky.
Sector and themed ETFs are an invitation to treat and to disaster. They encourage market timing which will surely upset the apple cart.
The only thing you can’t do with ETFs is generate the serious alpha that is available to a serious investor in individual common stocks.
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