Replace the word “stocks” with “ETFs” in Mr. Buffett’s quote. “The dumbest reason in the world to buy an ETF is because it’s going up.”Getty Images/iStockphoto
Warren Buffett says, "The dumbest reason in the world to buy a stock is because it's going up." He looks for stocks with strong business fundamentals. Then he buys when they're selling at a really great price. A stock's price might be falling when he buys it. It might be rising. But he always wants a stock to be a good deal, compared to its business earnings.
Robin R. Speziale profiled 26 great stock pickers in his new book, Market Masters, Proven Strategies You Can Apply. None of the experts simply bought stocks because their prices were rising. But that's how many investors select mutual funds and ETFs. When a fund does well, investors pile in. Investment firms feed the madness. If a fund rises quickly, they scream its story from the roof.
Smart investors have long known that they shouldn't focus on a fund's past performance. Morningstar, the world's largest fund-rating agency, says a fund's expense ratio is the best predictor of future performance: the lower, the better. Past performance is a lousy divining rod.
The Standard & Poor Persistence Scorecard proves it. Twice each year, they measure to see if top-performing funds can continue their winning ways. Twice each year, the data say no.
In their January, 2016, report, they found that 678 U.S. stock market funds were in the top quartile of performers as of September, 2013. By the end of September, 2015, only 4.28 per cent of them remained in the top quartile. Just 1.19 per cent of large-capitalization funds, 6.32 per cent of mid-cap funds and 5.41 per cent of small-cap funds remained among the top 25 per cent.
Perhaps perplexed by human behaviour, the report reads: "Due to either force of habit or conviction, investors and advisers consider past performance and related metrics to be important factors in fund selection." Unfortunately, many people select smart-beta exchange-traded funds much the same way.
Also known as factor-based ETFs, such products can focus on value stocks, growth stocks, stocks with momentum or stocks with price stability. There's no shortage of variations. It's often said that if Wall Street (or Bay Street) can sell something, they will. That doesn't mean such ETFs are bad. But replace the word "stocks" with "ETFs" in Mr. Buffett's quote. "The dumbest reason in the world to buy an ETF is because it's going up."
Rob Arnott should know. He's the father of the fundamental index. His funds don't weight stocks in an index based on market cap. Instead, his indexes weight stocks based on business profitability, book values and dividends. But he now sees a bubble in the smart-beta industry.
"Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive," write Mr. Arnott and his research team, Noah Beck, Vitali Kalesnik and John West. "We think it's reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies."
They compared six different factor-based strategies over the past 10 years, ending in the third quarter of 2015. They included value, positive-momentum, small-cap, illiquid, low-beta and high-gross-profitability ETFs. In most cases, investors fed more money into the top-performing products. But the stocks that are most heavily concentrated in those ETFs may have risen further than they should have.
Rising stock prices aren't a problem if earnings can back them up. Take Apple Inc. Its share price increased 114 per cent between January, 2011, and March 14, 2016. But the company's profit, as measured by earnings per share, increased 133 per cent during the same time period. That means Apple's shares are cheaper now than they were in 2011, when compared to business earnings.
The same can't be said for the stocks in many smart beta ETFs. That's why Rob Arnott compares many factor-based funds to bubbles.spopped
In the United States, momentum and gross-profitability ETFs, for example, have increased their price-earnings valuations, respectively, by 3.33 per cent and 4.15 per cent annually over the past 10 years. Like their southern counterparts, such factor-based funds in Canada have produced outsized returns. But if you buy them today, tomorrow could hurt.
Mr. Arnott says value-oriented ETFs are now a much better deal. Value stocks have grown 4.7 per cent cheaper per year over the past decade, relative to business earnings. That's a good reason to have a close look.
Value-oriented ETFs that trade on the TSX include iShares Canadian Value Index ETF; First Asset Morningstar's Canada Value Index ETF; First Asset Morningstar's unhedged Global Value Class ETF; First Asset Morningstar's International unhedged Value Index ETF; and First Asset Morningstar's unhedged U.S. Value Index ETF.
Fundamental ETFs have also grown cheaper. By business valuations, they have become 1.29 per cent cheaper per year over the past 10 years. Fundamental ETFs that trade on the TSX include iShares Canadian Fundamental Index ETF and iShares unhedged U.S. Fundamental Index ETF.
If you must buy a smart beta ETF, think like Mr. Buffett. Ignore past performance. Instead, think about business valuations. That's what market masters do.
Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can read more in the series at tgam.ca/strategy-lab.
Andrew Hallam