There are two ways to spend money: on experiences or stuff.
Tim Maurer, Director of Personal Finance, The BAM Alliance
My favorite discovery in the field of behavioral economics confirms what we already knew deep down, even if it contradicts “common sense”--that experiences are more valuable than stuff. I recently put this finding to the test:
Concert of a Lifetime
“You’re crazy.”
Those were my wife’s words when I called her from the road, rushing to discuss what I termed “the concert of a lifetime.”
I’d just learned that living legends U2 were touring in support of the 30th anniversary of their most celebrated album, “The Joshua Tree.”
The greatest live band of a generation playing the soundtrack of my youth from start to finish.
Andrea was on board with going to the show--she’s a big fan, too. But what invited her claim of insanity was my insistence that we take the whole family to Seattle to see the show. We live in Charleston. South Carolina.
But the Seattle show promised to be superior to almost all others along the route. In the Emerald City, the Emerald Isle’s most melodic export would be supported by Mumford and Sons as the opening act, playing only the first three West Coast stops.
The two best live bands performing in one of the world’s greatest cities in a single concert.
(In case you’re wondering, music is not subjective, but objective. These are all facts.)
I insisted that we had a moral obligation to go as a family--assuring my wife that it would result in a lifelong memory soon to be deemed priceless.
Reality Check
Now, we’re a family of four (and a half) with two boys--13 and 11--in youth sports (and an adorable puppy). One could argue that every piece of furniture in our home is a candidate for replacement.
If you are in--or remember--or tried to forget--this phase of life, you know that, regardless of your income, every dollar seems to be pledged even before it is earned. Even when you’re occasionally surprised by a surplus inflow, it feels like the money has already been spent (if it hasn’t) on the necessity du jour.
Experiences > Stuff
But a mathematical fact remains: There are only two ways to dispose of our money--on experiences or stuff. Even if we save, invest or give, we’re just deferring when and where the money will be spent on experiences or stuff.
Our eyes tell us that stuff is worth more because we can see it.
But our hearts know what has now been proven in numerous studies--that we derive more joy from [insert experience] than by purchasing a [product of comparable price].
For our family, going to see Mumford and U2 in Seattle was simply more valuable than something like … replacing the battered couch, maybe the bedroom furniture.
WHY?
But why? It’s not necessarily because it’s obvious from the start. Initially, the experience worth $X gives about the same amount of joy as the stuff worth $X. But as we adapt to the stuff, as it literally depreciates in value, our joy in its utilization also decreases. Or as Cornell psychologist Dr. Thomas Gilovich puts it, “One of the enemies of happiness is adaptation.”
But while stuff devalues, the recently elapsed experience can actually increase in value. “Even if it was negative in the moment,” writes James Hamblin in the The Atlantic, “it becomes positive after the fact. That's a lot harder to do with material purchases because they're right there in front of you.”
Furthermore, those material purchases aren’t only in front of you. They’re in front of lots of people who have the same thing--or better. My black four-door Jeep was awesome until my buddy pulled up--right behind me--in his black four-door Moab-edition Jeep (with the top down and the doors off).
The intangible nature of experience means that no one has the exact same one. Meanwhile, having shared experiences compounds their value further, as diverse recollections tend to open our eyes to elements we didn’t catch the first time around.
Sadly, despite the conviction in our collective gut and the studies that prove it’s right, “ People do not accurately forecast the economic benefits of experiential purchases.
Where the Streets Have No Name
By now, you know what happened, right? Yes, my loving wife succumbed to my outlandish pledge that “this will be the best memory we’ve ever had as a family!” We scraped together all the respective rewards points and discretionary dollars we could muster, ordered the tickets, booked the flights and reserved the room.
We fought through jet lag to enjoy hiking in a blizzard on Mt. Ranier, having coffee at the first-ever Starbucks, enjoying breakfast overlooking a bustling Pike Place Market, going up the Space Needle and down the Great Wheel, taking in a comedy show at a vintage theater near University of Washington, running to catch the ferry to Bainbridge Island for lunch and--the best part--watching my boys’ eyes light up as the prelude to “Where the Streets Have No Name” rumbled through our bellies.
On the plane ride home--gloriously exhausted--my wife turned to me and said, “You were right. It was worth it. But you’re still crazy.”
She’s right. About all of it.
This commentary originally appeared May 20 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Does popularity impact size of premiums? Usually but not always, if the factor meets Larry Swedroe’s criteria.
Larry Swedroe, Director of Research, The BAM Alliance
Financial research has uncovered many relationships between investment factors and security returns. Given that popularity is a curse in investing, the growing popularity of factor investing has led to worries that factors have become overvalued, posing risks to investors in these strategies.
For investors, an important question is whether the past relationship between factors and returns will continue after the research has been published and factor investing becomes popular. Said another way, if everyone knows about it, should we expect the premium to continue outside of the sample period?
In the introduction of our new book, “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” my coauthor Andrew Berkin and I provide five criteria that a factor should be required to meet before the premium can be expected to continue: The factor should be persistent, pervasive, robust, investable and have logical, risk-based and/or behavioral-based explanations.
Does Popularity Destroy Persistence?
Chapters 1 through 7 of the book provide evidence and explanations for why we believe the premiums for each factor addressed (beta, size, value, momentum, profitability/quality, term and carry) should be expected to continue.
However, this conclusion says nothing about the size of the premiums, provoking the question: Does the publication of research impact the future size of premiums? The question is important on two fronts.
First, if anomalies are the result of behavioral errors—or even investor preferences—and publication draws the attention of sophisticated investors, it is possible that post-publication arbitrage would cause the premiums to disappear. Investors seeking to capture the identified premiums could quickly move prices in a manner that reduces the return spread between assets with high and low factor exposure.
However, as we explain in the book, limits to arbitrage (such as aversion to shorting and its high cost) can prevent arbitrageurs from correcting pricing mistakes. And the research shows this tends to be the case when mispricing exists in less liquid stocks, where trading costs are high.
Second, even if the premium is fully explained by economic risks, as more cash flows into funds acting to capture the premium, the size of the premium will be affected. At first, publication will trigger inflows of capital, which drives prices higher and thus generates higher returns. However, these higher returns are temporary because subsequent future returns will be lower.
With these questions in mind, we’ll turn to the academic literature. Paul Calluzzo, Fabio Moneta and Selim Topaloglu contribute to our understanding of how markets work and become more efficient over time (the adaptive markets hypothesis) with their 2017 study “When Anomalies Are Publicized Broadly, Do Institutions Trade Accordingly?”
They hypothesized: “Institutions can act as arbitrageurs and correct anomaly mispricing, but they need to know about the anomaly and have the incentives to act on the information to fulfill this role.”
How Institutions Affect Anomalies
To test their hypothesis, Calluzzo and colleagues studied the trading behavior of institutional investors in 14 well-documented anomalies: net stock issues, composite equity issues, accruals, net operating assets, asset growth, investment-to-assets, distress, momentum, gross profitability, return on assets, book-to-market, Ohlson O-score, post-earnings announcement drift and capital investment.
To determine if investors exploit these anomalies and help bring stock prices closer to efficient levels, Calluzzo and colleagues built portfolios that consisted of long stocks with positive expected returns, and short stocks with negative expected returns. Their study covered the period January 1982 through June 2014.
Following is a summary of their findings:
Calluzzo and colleagues concluded: “Institutional trading and anomaly publication are integral to the arbitrage process which helps bring prices to a more efficient level.” Their findings demonstrate the important role that both academic research and hedge funds (through their role as arbitrageurs) play in making markets more efficient.
Further Evidence
These findings are consistent with those of R. David McLean and Jeffrey Pontiff, authors of the study “Does Academic Research Destroy Stock Return Predictability?” McLean and Pontiff re-examined 97 factors published in tier-one academic journals and were able to replicate the reported results for 85 of them. That the remaining 12 factors were no longer significant may be due to a variety of reasons, such as incomplete details in the original paper or changes in databases.
They also found that, following publication, the average factor’s return decays by about 32% (note the agreement of that figure with the one in the Calluzzo, Moneta and Topaloglu paper), and returns do not decay to zero but remain positive.
In addition, McLean and Pontiff found that factor-based portfolios containing stocks that are more costly to arbitrage decline less post-publication. This is consistent with the idea that costs limit arbitrage and protect mispricing.
We can draw two conclusions from the research. First, anomalies can persist even when they become well-known. As McLean and Pontiff remark: “We can reject the hypothesis that return predictability disappears entirely, and we can also reject the hypothesis that post-publication return predictability does not change.”
Second, research appears to lead to increased cash flows from investors seeking to gain exposure to the premiums, which in turn lead to lower future realized returns. However, where logical, risk-based explanations exist, premiums should never disappear.
For example, no one expects the market-beta premium to disappear even though it has been well-known for decades. However, investors should not automatically assume that future premiums will be as large as the historical record.
International Evidence
Heiko Jacobs and Sebastian Muller provide us with evidence from international markets with their 2016 paper, “Anomalies Across the Globe: Once Public, No Longer Existent?” Their study covered the pre- and post-publication return predictability of 138 anomalies in 39 stock markets that account, on average, for almost 60% of global equity market capitalization and more than 70% of global gross domestic product. The data covered the period January 1981 to December 2013.
While their findings for the United States were similar to those of McLean and Pontiff, showing declining premiums, none of the 38 international markets yielded a significant post-publication decline in anomaly returns.
In fact, Jacobs and Muller found that returns to anomalies in international markets actually increased. Equally weighted (value-weighted) monthly returns increased from 34 (28) basis points between 1981 and 1990 to 56 (40) basis points between 2001 and 2013.
Following is a summary of their findings:
Jacobs and Muller concluded that, while their findings point to a strong negative time trend and increased post-publication arbitrage trading in the United States, they did not find reliable evidence for an arbitrage-driven decrease in anomaly profitability in international markets. In addition, the authors found that differences in standard arbitrage costs “seem to explain at best a fraction of the large differences in post-publication.”
They did add that they explored “several possible mechanisms behind the surprisingly large differences between the return dynamics in the U.S. and international markets” but were “unable to fully explain the results” and their findings were “consistent with the idea that sophisticated investors learn about mispricing from academic studies, but then focus mainly on the U.S. market.” They conclude with the following: “Our results may thus be interpreted as a puzzle that calls for further theoretical and empirical investigation.”
Are Factors Expensive?
Clifford Asness, Swati Chandra, Antti Ilmanen and Ronen Israel contribute to the literature on factor investing with their March 2017 study “Contrarian Factor Timing is Deceptively Difficult.”
The paper will appear in a forthcoming edition of the Journal of Portfolio Management. It addresses two issues: Just how rich, if at all, have style premia factors (often referred to as smart beta) become? And should investors hold off on investing in rich factors until they cheapen?
Following is a summary of their findings:
Value Timing Of Factors
Asness, Chandra, Ilmanen and Israel noted that value timing of factors, because it is buying what is relatively cheap, is correlated to the standard value factor as it adds further value exposure to a portfolio.
They explain: “If a multi-style portfolio already includes value at optimally diversified levels, value timing the styles may increase value exposure to levels that undermine diversification, leading to weaker performance, particularly in a risk-adjusted sense. For many investors, the original intention of a multi-style allocation is to balance risk across multiple sources of return and capitalize on the power of diversification. Value timing a multi-style allocation may work against that very purpose by effectively increasing the allocation to value.”
They add: “Portfolio math tells us that returns add linearly while risk adds quadratically. Hence, at larger tilts, the increase in risk from timing may be proportionately larger than any increase in return, resulting in lower risk-adjusted returns.”
The authors also examined whether timing would add value if it were done only at extreme levels—when spreads passed a certain threshold. They found: “The timed strategy Sharpe ratio improves as we increase the threshold, but it is a very modest improvement. The timed strategy Sharpe ratio barely exceeds the Sharpe ratio of the non-timed. In fact, increasing the threshold further leads to a slight drop in the Sharpe ratio.”
These findings add further support to investors building portfolios that are strategically (as opposed to tactically) diversified across each of the factors that show persistence of their premiums; low correlation to other factors; are pervasive around the globe and across asset classes; have intuitive reasons to believe the premiums should persist (whether behavioral- or risk-based); and are implementable (survive transactions costs).
The Importance Of Factor Diversification
Chapter 9, Implementing a Diversified Factor Portfolio, in “Your Complete Guide to Factor-Based Investing,” demonstrates that a portfolio that is diversified across factors has been more efficient than any of the individual factors, producing dramatically higher Sharpe ratios. This table from the book covers the period 1927 to 2015.
For each factor, it shows the mean premium, volatility and the Sharpe ratio. It also provides the same information for three portfolios. Portfolio 1 (P1) is allocated 25% to each of four factors: market beta, size, value and momentum. Portfolio 2 (P2) is allocated 20% to each of the same four factors and 20% to the profitability factor. Portfolio 3 (P3) is allocated the same way as P2, substituting the quality factor for the profitability factor.
You can also see the benefits of diversifying across factors in this table from the book, which shows the odds of underperformance over various time horizons. It too covers the period 1927 to 2015.
As you can see, no matter the time horizon, the odds of underperformance are lower for each of the three portfolios than for any of the individual factors.
Summary
The research makes clear that, while publication and ensuing popularity has, on average, reduced the size of premiums by about one-third, the premiums can disappear entirely for factors that are pure anomalies (behavioral mispricings or perhaps the result of data mining activities).
However, for the factors that have passed the tests of persistence, pervasiveness, robustness, intuitiveness and implementability, the premiums don’t disappear, and in some cases, may not have even shrunk.
Given that there aren’t any crystal balls that can tell which factors will deliver premiums in the future, the prudent strategy is to strategically diversify across factors that meet your criteria for investment and then stay the course, rebalancing but avoiding tactical adjustments based on value spreads.
This commentary originally appeared May 8 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Larry Swedroe reviews how hedge funds have performed through the first quarter of 2017.
Larry Swedroe, Director of Research, The BAM Alliance
Hedge funds entered 2017 coming off their eighth-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins. And for the 10-year period ending 2016—one that included the worst bear market in the post-Depression era—the HFRX Global Hedge Fund Index managed to produce a negative return, -0.6%, underperforming every single major equity and bond asset class.
These results explain why more hedge funds closed in 2016 than in any year since the 2008 financial crisis, as investors moved money to larger firms and withdrew assets (Bloomberg, March 2017). Liquidations totaled 1,057 last year and outflows were $70.2 billion.
Unfortunately for hedge fund investors, so far 2017 has not been much better. For the first quarter, the HFRX Global Hedge Fund Index returned just 1.66%. This table below shows the first quarter 2017 returns for various equity and fixed-income indices.
The Results
As you can see, the hedge fund index underperformed eight of the 10 major equity asset classes, but managed to outperform each of the three bond indices. We can, however, take our analysis a step further and determine how hedge funds performed against a globally diversified portfolio.
An all-equity portfolio allocated 50% internationally and 50% domestically—equally weighted in the indices within those broad categories—would have returned 5.4%, outperforming the hedge fund index by 3.7 percentage points.
Another comparison we can make is to a typical balanced portfolio of 60% equities and 40% bonds. Using the same weighting methodology as above for the equity allocation, the portfolio would have returned 3.3% using one-year Treasuries, 3.6% using five-year Treasuries and 3.8% using long-term Treasuries. Each of the three would have outperformed the hedge fund index.
With the freedom to move across asset classes that hedge funds often tout as their big advantage, one would think that would have occurred. The problem is that the efficiency of the market, as well as the costs of the effort, turns that supposed advantage into a handicap. Given the evidence, it’s a puzzle why hedge funds were still managing about $3 trillion in assets at the end of 2016.
This commentary originally appeared May 5 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE