ETF investors over the years have been schooled in their benefits compared with traditional mutual funds. Low management-expense ratios (MER) and tax efficiency are among the main attributes. But the biggest cost to any investment is your ability to handle the ride. The investment industry does not go far enough in educating investors about the risks. While most investors just look at the past returns when they choose investment funds, I consider the risk of investing before the return.
Every document ever produced in the financial-services business says in very small print that past returns are no guarantee of future returns, yet the majority of investors use past returns as their sole guide for choosing investments – and this is absolutely backward. Investors must understand the expected future return and the risk of that return compared with taking no risk in a guaranteed investment certificate. This way of evaluating investments is called the Sharpe ratio. This ratio considers the expected excess return of holding a risky asset to the safety of a risk-free asset adjusted for its risk. Risk is defined by the standard deviation of returns – a mathematic calculation of how much your portfolio rises and declines each day. In a GIC, you have a safe return with no price fluctuation. Sadly, thanks to central banks wanting to stimulate the economy, they have made the risk-free rate almost zero – and after taxes and inflation, you are in the hole. Central-bank policy is forcing investors to take more risk. If that is the new normal, investor had better learn to assess the risks much better than looking at past returns and hoping they repeat.
The past return and risk of the SPDR S&P 500 ETF Trust (the longest standing ETF; ticker SPY) dating back to inception in 1993 is 9.02 per cent, with a standard deviation of 18.74 per cent. That means that you would have had to sit through two major bear markets when that ETF was down more than 50 per cent to get that average return and several more 15-per-cent to 20-per-cent declines. According to Dalbar research, a U.S.-based firm that tracks investor behaviour by looking at buy and sell decisions of mutual funds, the average return for investors holding S&P 500 benchmarked funds have experienced a return of about 3.66 per cent while the buy and hold ETF return would have been 10.35 per cent over the past 30 years. The difference in part can be explained by the MER, but the vast majority of poor active performance is the emotional buying and selling when markets are volatile – that is your ability to handle the ride. This is why passive investing works in the long run and equities offer a very good long-term return. Bottom line is that we panic at the wrong time. Emotionally, people are not equipped to ride the ups and downs – it’s the biggest irony in the investment world and not well understood by investors.
The closer you are to retirement, the more likely you are to panic when you see your savings fall. The low rate of interest no longer provides the lower volatility, safer return in your portfolio. The market risk for stocks and bonds have never been higher and yet the parade of Trump-eters continues to suggest stocks are the place to be. Frankly, the higher the risk goes, the more nervous I am about what the next recession will bring.
For my clients, when I look out over the next year, my U.S. market exposure is not in the (more volatile) S&P 500. I own an equal combination of the BMO U.S. Put Write ETF (ZPW) and BMO U.S. High Dividend Covered Call ETF (ZWH) that together yield about 6.5 per cent and have about 35 per cent of the downside risk of the S&P 500. If I’m wrong and markets keep rising, I’m quite happy with a 6.5-per-cent yield out of the U.S. market with about a third of the capital gain over the next year while I wait for better valuation to buy the riskier and lower yielding SPY.
Near the top of a market cycle, you want a higher expected return and a lower risk – a superior Sharpe ratio. Sharpe won a Nobel Prize in 1990 for his contribution to portfolio construction – learn how to incorporate this thinking into your portfolio for a sleep-at-night portfolio.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.Report Typo/Error
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