Warren Buffett once said, "If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy." That's true for investors, too. But Pattsyville isn't a place reserved for the dumb. Most of us live there. We gain citizenship, it seems, just by being human.
Among us, however, is a group of smart investors. They don't need high IQs. They don't need to follow the market's twists and turns. They just need to be a little less, um, human. To understand how smart investors think, we need to watch the flock.
Most investors jump on bandwagons. They buy what's hot. Perhaps they're drawn to a fund manager with a great three- to five-year track record. Or, they could fall for a growth index that's tearing up the track like an F1 car. These choices, unfortunately, could be headed for the ditch.
UCLA Anderson School of Management researcher Jason Hsu (who also works for Research Affiliates), Texas Tech University's assistant professor of finance Brett Myers and Utah State University's Ryan Whitby found that strong mutual fund performances lure investors like a dramatic sunset on a cliffside road. In their article, Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies, they found that what's hot, over one time period, can dump us over the edge.
According to eVestment's data, most fund managers who deliver above-average results during one five-year period underperform during the next five years. Managers who underperform during one five-year period usually outperform during the next five years. No, the smart and average fund managers don't trade brains. What's in vogue simply changes.
Sometimes, value stocks win. Other times, it's growth stocks. Most investors, unfortunately, jump on these wagons at exactly the wrong times.
But by betting against the crowd, investors can profit when the lagging style leaps back into favour.
Instead of buying what's hot, Dr. Hsu says, "buy the style that is out of favour and whose stocks are trading meaningfully below historical norm. Sell the popular style and its expensive stocks."
That sounds simple enough. But how do we know what's cheap? Dr. Hsu references the CAPE ratio. It's a cyclically adjusted price-to-earnings ratio, defined as a price divided by the 10-year average of business earnings, adjusted for inflation. It sounds complicated. But we don't need a PhD in finance to smell what stinks. We can check out past performance.
If we look at Canadian index fund investment styles over the past three years, we can see that value stocks have languished. In contrast, growth and low-volatility stocks have soared. This coincides with Dr. Hsu's recent findings, which he published in his paper, If Factor Returns Are Predictable, Why Is There An Investor Return Gap? Dr. Hsu says low-volatility stocks are currently the rage – so they're expensive, based on comparative historical measures. He says that value stocks, by comparison, are cheap.
Acting on such information might sound complicated – and speculative. But it doesn't have to be. Investors who start with the current ugly duckling can take advantage of the flock.
For example, assume an investor has $10,000 to invest in Canadian stocks.
They could split this money unevenly between growth stocks, value stocks and low-volatility stocks. The past three years have been hard on value stocks.
The iShares Canadian Value index ETF (XCV) has averaged just 6.25 per cent. More popular indexes, such as the iShares MSCI Canada Minimum Volatilty index ETF (XMV) and the iShares Canadian Growth index ETF (XCG), have stomped the returns of the value ETF. They averaged 9.28 per cent and 9.1 per cent respectively over the past three years.
By tilting toward the laggard, an investor with $10,000 to invest in Canadian stocks could put $7,000 of it in the value index. The remaining $3,000 could be split evenly between the minimum volatility and the growth index. When value reigns supreme again (and it will) such investors will reap large rewards.
Popularity swings, however, take time. Investors might need to wait three to five years. That's when they need to ask, which index was the ugliest over the past few years?
If it's one of the others, the portfolio could be tilted to favour the new ugly duckling.
Such a process takes patience, an iron gut, and an ability to be a little less … human.
But it beats being Mr. Buffett's poker table patsy.