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Smart thinking – Smart beta may make it easier to buy and sell but that is not how value works

21/04/2015

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Great timing has been integral to the sporting success of the likes of David Beckham, Roger Federer and Michael Jordan. Ultimately, it has also helped to place that trio among the richest dozen or so athletes of all time – and yet it might reasonably be argued that even their combined wealth would be eclipsed by someone who could consistently match their timing in an investment context.

There are plenty of studies that illustrate the key role timing plays in investment although, for ease of reference, we will point you towards an article of our own from a few years back, A fighting chance. Among other things, this noted the negative effects of missing out on just the best 30 days of the market over a 15-year period, when compared with staying invested that whole time.

The trouble is, investors who are great at timing are even thinner on the ground than sporting legends. Industry folklore has it that Peter Lynch, one of the most successful mutual fund managers ever, would complain that many investors missed out on the full benefit of his Magellan fund’s outperformance because they would buy in and sell out at the wrong time.

More recently (and verifiably), the tendency among investors to buy high and sell low – and the percentage-point impact this has on their returns – was addressed in the 2014 edition of Credit Suisse’s highly regarded Global Investment Returns Yearbook, to which we added some thoughts of our own in Weighting game.

Our current reflections on this subject were prompted by a fascinating piece of research from our friends at Empirical Research Partners. In passing, this notes an academic paper that has now found investors to be so bad at timing that, when it comes to taking decisions on whether to buy or sell, it would actually profit them more if they stopped thinking and simply tossed a coin.

In other words, the decisions of the average investor are worse than random chance and the reason for this, of course, is that humans are emotional creatures – greed makes them buy when they should be selling while fear makes them run away when they should stand their ground. As Empirical puts it, however: “There’s value in patience and sometimes doing nothing is doing everything.”

In this regard, of course, a disciplined and structured investment process, such as the one we follow here at The Value Perspective, can be of great benefit. Indeed, even simply adhering to our preferred time horizon of three to five years will help to prevent rushed decision, ward off the inclination to follow the crowd and generally smooth out the emotional rollercoaster that is the stockmarket.

That was the broadcast on behalf of the Value Party you were no doubt expecting so let’s move on to the less well-trodden aspect of the Empirical research that caught our eye. This concerns poor investor timing in the context of so-called ‘smart beta’ strategies, which try to build on simple index-tracking products by focusing in on a specific factor, such as growth, momentum or value.

A value-oriented smart beta strategy might therefore be set up to buy, say, the cheapest 100 stocks of the FTSE All-Share index as determined by their price-to-book ratio or price/earnings ratio or however else the product’s operator chooses to define it – and the fact these are essentially quantitative screens allows investors to gain access to their preferred factor in a cheap and liquid way.

And therein lies an issue with smart beta products. To quote Empirical again: “There’s nothing wrong with them per se, but they do make it very easy to jump in and out of strategies, like value and momentum, that really only pay off if one has the mettle to ride out the short-term rapids. Just because we can trade something, doesn’t mean we should.”

Turning value into a pure factor rather than a portfolio of underlying companies leaves investors more opportunity to focus on timing – to buy in and sell out when they judge the moment to be right – and, as we have already discussed, that is not their strongest suit. What we ‘traditional’ value investors have that our smart beta counterparts do not is our link to the underlying companies.

That means if, say, Tesco’s share price were to fall 30%, then we have something tangible that enables us to form a view as to the business’s value. That in turn should give us the confidence – indeed, the discipline – to buy into the company when so many others will be looking to sell up. Those who owned the cheaper, more liquid way of investing will arguably have found it easiest to head for the door.

Smart beta is all very well in theory but, as Empirical observes, “we humans have a poor track record of executing on good ideas”. After all, eating lots of vegetables, getting plenty of exercise and enough sleep, saving steadily for retirement, driving under the speed limit and “avoiding that third glass of wine” are undeniably all good things to do but few of us are able to tick all those boxes.

“Needless to say,” the note concludes, “collectively we do a pretty mediocre job on all of these or, to put it bluntly, anything that requires a modicum of discipline and the willpower to forego near-term pleasure for the long-term gain. Will smart beta be any different?”

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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