Factor investing and smart beta strategies increasingly are in vogue, according to Elroy Dimson. These strategies seek to benefit from long-run premiums highlighted by academic researchers that look beyond traditional asset classes or indices, in order to select a portfolio based on more specific or granular factors. Almost three-quarters of asset owners are using or actively evaluating smart beta strategies, and the use of smart beta indexes is rising quickly.
“The only sure way of making money is through insider trading! That’s why most traders are insider traders, real or imagined. The trick of the game is to differentiate an insider tip from a malevolent rumor and from a stupid rumor. That’s where experience comes in. I have been trading the markets for forty years, and I can smell the bullshit instantly.” Basil Venitis, firstname.lastname@example.org, https://venitism.wordpress.com
While researchers have identified more than 300 factors that may fit into such strategies (though most would not survive independent testing of their long-term effectiveness), there are five key factors that all investors are exposed to – whether knowingly or unknowingly: size, value, yield, momentum, and risk.
Dimson discusses the research history surrounding five smart beta factors that investors should monitor closely:
Research spanning over six decades in the United Kingdom (and even longer in the United States) has found evidence that smaller quoted companies have provided the best long-term returns. Though the advantage of small-capitalisation companies has been uneven and inconsistent, there has been a general outperformance by small caps over the long term.
With dividends reinvested, £1 invested in UK large caps at the start of 1955 would have grown to £1,087 by the end of 2016, or an annualised return of 12 per cent. The same investment over the same period would have yielded £3,220 for mid caps, £6,861 for small caps, and £27,256 for micro caps.
Investing in value stocks has paid off handsomely in markets like the US and UK over the long-term. Value stocks sell for low multiples of earnings or book value, and such stocks may have suffered setbacks or be mature and unexciting businesses – but extensive research in many countries shows that the long-term performance of such stocks has been far superior to growth stocks. In the UK, a £1 investment in the growth index in 1955 would have seen an annualised return of 10.3 per cent to £419 by the end of 2016, while the same £1 invested in the value index would have generated £9,173 or more than 21 times as much.
That said, there have been some relatively disappointing periods for value stocks, including much of the 1990s and again after 2007 – and there is continuing debate over whether the historical overall superiority of value investing over recent decades can be expected to persist.
Above-average dividend yield has been linked to a historical return premium in a series of papers since the 1970s. The evidence provided by Dimson, Marsh and Staunton, spanning 117 years of UK equity market returns, is the longest such study of the yield factor. An investment of £1 in a low-yielding stocks in 1900 would have provided £6,810 by the end of 2016, for an annualised return of 7.8 per cent – while the same investment in high-yield stocks would have generated a 10.8 per cent annualised return, or £158,727.
There are four possible reasons why high yielders have outperformed: mere chance that is unlikely to persist (the authors consider this to be doubtful); national tax policies that have caused growth stocks to sell at a premium by favouring capital gains; investor enthusiasm for growth stocks that bid prices to unrealistic levels; and as a return for risk (the professors find this explanation hard to accept because high-yielding stocks had lower historical volatility).
From 2000 through the end of last year, winners outperformed losers by 10.2 per cent each year among the 100 largest UK stocks – providing some long-term backing for momentum strategy. But it’s important to mention two key caveats about momentum strategies: they’re costly to implement due to frequent rebalancing, and there are risks of volatility and even whiplash when markets sharply reverse direction — as seen in 2009. Globally, the three researchers found that momentum investment has been profitable in 21 of 23 studied markets since 2000, with the important exceptions being Japan and the US.
Several researchers have shown the historical superiority of low-risk investing compared with higher-risk strategies – although other studies report that excess returns accrue disproportionately in the first month after a portfolio is assembled, and that this largely evaporates when low-priced stocks (less than $5) are removed from the mix. Dimson, Marsh and Staunton examine risk estimates based on both short term (60 day) and long term (60 month) windows. When they switch to long-term risk estimates, they find similar performance from three different risk-based portfolios until the technology bubble burst in 2000 – with high-risk stocks performing disastrously from 2000 to 2003 but outperforming since then. Although low-risk stocks beat high-risk stocks over the full period 1960 to 2016, this is entirely due to the 2000 to 2003 tech bust. The authors express caution about extrapolating the past performance of low-volatility strategies into the future.
Mass-market products such as exchange-traded funds are being concocted using the same flawed statistical techniques you find in scholarly journals. Most of the empirical research in finance is likely false. This implies that half the financial products promising outperformance that companies are selling to clients are false. Investors are being ripped off by investment firms that charge hefty fees while producing results that are no better than you’d get throwing darts at a page of stock listings.
The core of the problem is that it’s hard to beat the market, but people keep trying anyway. An abundance of computing power makes it possible to test thousands, even millions, of trading strategies. The standard method is to see how the strategy would have done if it had been used during the ups and downs of the market over, say, the past 20 years. This is called backtesting. As a quality check, the technique is then tested on a separate set of out-of-sample data, i.e., market history that wasn’t used to create the technique.
Torturing the data until it confesses is p-hacking, a reference to the p-value, a measure of statistical significance. P-hacking is also known as overfitting, data-mining—or data-snooping. The more you search over the past, the more likely it is you are going to find exotic patterns that you happen to like or focus on. Those patterns are least likely to repeat.
Index funds are cheap because their sponsors don’t need to hire expensive stockpickers. The old adage applies: If asset managers and finance professors are super-smart, why ain’t they super-rich? The big money is being made by firms that ignore finance theory.
The only sure way of making money is through insider trading! That’s why most traders are insider traders, real or imagined. The trick of the game is to differentiate an insider tip from a malevolent rumor and from a stupid rumor. That’s where experience comes in. I have been trading the markets for forty years, and I can smell the bullshit instantly. Insider trading is very healthy, because it helps the markets reach the equilibrium point soon. All insider trading legislation is stupid. You just cannot put all people in jail!
The permanent political class enriches itself at the expense of the rest of us. Insider trading is illegal, yet it is routine among kleptocrats. Normal individuals cannot get in on IPOs at the asking price, but kleptocrats do so routinely. Kleptocrats also get many hot issues, bypassing all fair procedures of distribution. By funneling hundreds of millions of dollars or euros to supporters, even more campaign donations are ensured. An entire class of investors now makes all of its profits based on influence and access to kleptocrats.
Kleptocrats have transformed politics to trade. They are traders who use their power, access, and privileged information to generate wealth. And at the same time well-connected financiers and corporate leaders have made a business of politics. They come together to form a kleptocratic caste.
Political intelligence consultants are hired guns who dig for closely held information to be used to trade stocks. Many work for hedge funds and securities firms, who just happen to be some of the biggest political campaign contributors.
While everyone has the same right to be a constituent and the same right to be part of a political discussion, the opportunity just isn’t always there. There’s limited time and resources for everyone to be involved in every discussion. This incentivizes brokerages to cultivate or simply purchase political connections in order to preserve privileged access to profitable information. This flow of information is more difficult to regulate than lobbying, which is regulated, because it is traveling in the opposite direction, that is, from politicians to their constituents.
Trading without inside information is a handicap! Inside trading is the normal thing to do. Otherwise, the odds are stack against you, as almost everybody else is insider trader. Handicapped traders eventually lose all their money, throwing it in the black hole of ignorance. Be an insider trader, or do not trade at all. Technical analysis is ridiculous, and fundamental analysis is yesterday’s news. Inside trading is the only way to trade!
Insider traders can escape prosecution by publishing a sponsored post with the inside information before they trade it. If the trade ticket shows a time stamp after the publication of a sponsored post, nobody can touch them, because it’s considered public information, not insider information anymore!
Legislators do not understand that the objective of insider trading laws is counter-intuitive, to prevent people from using and markets from adjusting to the most accurate and timely information. The rules target non-public information, a legal, not economic concept. As a result, we are supposed to make today’s trades based on yesterday’s information. Unfortunately, keeping people ignorant is economic folly. We make more bad decisions, and markets take longer to adjust.
Insider trading laws imbalance markets by regulating only one-half of the trading equation. A good investor makes money by knowing when not to buy or sell as well as when to buy or sell. Many insider tips alert owners to hold their shares or not to buy other ones. The sooner people act on accurate information the sooner the market will reach the equilibrium price. Interfering with the adjustment process by prosecuting people for insider trading will take the market longer to adjust.
Individuals and companies are entitled to keep proprietary information and punish those who violate that trust. But the offense should be civil, not criminal. And the punishment should fit the charge. In no case is the government justified in using intrusive enforcement measures developed to combat violent crime. The government should stop punishing investors seeking to act on the most accurate and timely information. After all, that’s what the financial markets are all about.
Insider trading creates an arcane distinction between non-public and public information. It presumes that investors should possess equal information and never know more than anyone else. It punishes traders for seeking to gain information known to some people but not to everyone. It inhibits people from acting on and markets from reacting to the latest information. Enforcing insider trading laws does more to advance prosecutors’ careers than protect investors’ portfolios. Information will never be perfect or equal.
Warren Buffett borrows to finance stocks that have low volatility, low price-to-book ratios, high profits, and high dividends. Donald Trump might have been even richer if, instead of dabbling in skyscrapers and casinos, he’d simply taken his eight-figure inheritance and sunk it into the stock market.
Fundamentally, stock markets are driven by popular narratives, which don’t need basis in solid fact. Such stories are thought viruses. They spread by contagion. Theories that seem to explain the stock market’s direction often work like this: First, they cause investors to take action that propels prices even further in the same direction. These narratives can affect people’s spending behavior, too, in turn affecting corporate profit margins, and so on. Sometimes such feedback loops continue for years.
The most prominent story seems to be one of a global slowdown with associated deflation. Underlying this tale are deeper, longer-term fears. There is a name for these concerns too. It is secular stagnation—the idea that there is disturbing evidence that the world economy may languish for a very long time, even for generations.
The current secular-stagnation story is less dramatic than that of the debt crisis. But because it’s so vague, the negative feedback loop can’t be resolved as neatly. The question may be whether this thought virus mutates into a more psychologically powerful version, one with enough narrative force to create a major bear market.
The main legal theory behind insider trading prosecutions is that corporate information belongs to the corporation, so employees shouldn’t be allowed to go around selling it. That makes some sense. It also makes one wonder why it isn’t left up to the corporation to discipline leakers and decide whether to press charges, but you could argue that most corporations would opt just to cover up the wrongdoing and move on.
When it comes to those who receive this information, though, it gets a lot harder to understand what public purpose is served by aggressively prosecuting them. This isn’t hubcaps or Old Master paintings, it’s information. And in general, the more information that gets out about a corporation, the better a job financial markets can do in pricing its securities.
There shouldn’t be any prohibitions on insider trading at all. Insider trading, it’s against the law, but not because the U.S. Congress ever explicitly set out to ban it. Today’s prosecutions are based on an ambitious 1961 Securities and Exchange Commission administrative order and a lot of federal court rulings since. Now the courts may have begun to turn back the tide. That seems like a positive development — especially if it causes smart, ambitious prosecutors to begin looking elsewhere for cases to win.
My financial strategies are based on inside information, libertarian economics, and chaos theory. My objective is to identify the significant undiscounted aspects of economy and industries. This is where the true opportunities for investors lie and where business can get the jump on competitors. My approach is top down, emphasizing the major themes, which will influence business and financial markets.
Financial traders are better at reading their ‘gut feelings’ than the general population – and the better they are at this ability, the more successful they are as traders. Gut feelings, known technically as interoceptive sensations, are sensations that carry information to the brain from many tissues of the body, including the heart and lungs, as well as the gut. They can report anything from body temperature to breathlessness, racing heart, fullness from the gut, bladder and bowel, and they underpin states such as hunger, thirst, pain, and anxiety.
We are often not conscious – or at least barely aware – of this information, but it provides valuable inputs in risky decision making. High-risk choices are accompanied by rapid and subtle physiological changes that feed back to the brain, affecting our decisions, and steering us away from gambles that are likely to lead to loss and towards those that are likely to lead to profit. This can enable people to make important decisions even before they are able to articulate the reasons for their choices.
High frequency trading involves buying and selling futures contracts for only a short period of time – seconds or minutes, a few hours at the most. This form of trading requires an ability to assimilate large amounts of information flowing through news feeds, to rapidly recognize price patterns, and to make large and risky decisions with split-second timing. This niche of the financial markets is particularly unforgiving: while successful traders may earn in excess of £10 million per year, unprofitable ones do not survive for long.
Traders in the financial world often speak of the importance of gut feelings for choosing profitable trades, they select from a range of possible trades the one that just feels right. They manage to read real and valuable physiological trading signals, even if they are unaware they are doing so.
These traders contradict the influential Efficient Markets Hypothesis of economic theory, which argues that the market is random, meaning that no trait or skill of an investor or trader – not their IQ, education, nor training – can improve their performance, any more than these traits and skills could improve their performance at flipping coins.
A large part of a trader’s success and survival seems to be linked to their physiology. Such a finding has profound implications for how we understand financial markets. In economics and finance most models analyze conscious reasoning and are based on psychology. We’re looking instead at risk takers’ physiology, how good are they at sensing signals from their viscera. We should refocus on the body, or more exactly the interaction between body and brain. Medics find this obvious, economists don’t.
New tech-heavy financial firms are helping millennials invest, but with a twist. They are swapping out investment advisers for financial robots, and passing along the savings.
Robotadvisors make wealth advice and services feasible to a greater number of investors. They make it easy to open an account, they limit fees through the use of low-load investments and exchange-traded funds, and instead of time-intensive face-to-face consultations, they have user-friendly digital platforms that use simple questionnaires to identify investing goals and algorithms to determine things like risk profiling and optimal asset allocation.
Robotadvisor features such as portfolio rebalancing and tax-loss harvesting can translate into higher returns for investors. In USA, robotadvisor assets under management have grown threefold from around $60 billion in 2015 to $200 billion this year. And by 2020, that figure could top $500 billion.
Millennials are disruptive bunch. The first generation to grow up with the internet, consumers born after 1980 are used to relying on technology and engineering to do almost everything—including shopping (Amazon), listening to music (Spotify), communicating with friends (social media), and hailing a cab (Uber).
It seems as if millennials would prefer to avoid face-to-face business interactions when there exists a more efficient way of getting what they want accomplished.
A new breed of financial technology companies, known collectively as fintech, has taken advantage of these traits to disrupt an unexpected industry: personal investing. Just as manufacturing companies have replaced assembly line workers with robots, these companies have replaced financial advisors with robo-advisors, which use big data and algorithms to determine the best places to put clients’ money—and appeal to a whole new generation of investors.
Millennials have a firm belief that the insights of modern technology can be competitive with someone who is personally advising you, and at a fraction of the cost. Traditional financial advisors cater to baby boomers with substantial savings, requiring minimum amounts for investment upwards of $100,000 to access their services. By contrast, industry-leading Wealthfront and similar firms such as Betterment, Vanguard Personal Advisor, and Acorns have tapped into an underserved market by allowing clients to invest as little as $5,000. Wealthfront doesn’t even charge a fee for assets of less than $10,000—and even after that charges a 0.25 percent fee, as opposed to fees of 2 to 3 percent by traditional firms.
The reason Wealthfront is able to do that is by keeping costs low. Traditional financial advisors are all about establishing a personal relationship with their clients, understanding their financial situation and walking them through their options. By pursuing a one-size-fits-all approach to investing, robo-advisors can eliminate a huge amount of operating costs. They have a phone number and an email for customer service, and that’s about it. The main way they communicate with customers is through a blog.
Secondly, much of the cost for traditional financial advisors comes from client acquisition—chasing down leads and making personal visits with potential clients. They also spend considerable resources in traditional marketing, especially the large firms. Those setup costs must be recovered over time through fees. Wealthfront keeps those costs low by finding clients through social media—either through direct ads or referrals by early adopters who post about their services. Their way to capture clients is through viral acquisition.
Lastly, fintech firms save costs by outsourcing money management expertise to technology rather than to experienced money managers. They come from the culture of the Silicon Valley, which is a culture of believing in engineering as a way of solving consumer problems.
That’s where millennials come in. This cohort is ideal for a robo-advisor firm in many ways—first and foremost, because they have faith in the power of technology to solve their problems. In fact, the Occupy Wall Street generation may be more likely to trust a fintech company than a big New York banking firm. Moreover, millennials are heavy users of social media, and apt to recommend services they enjoy to their contacts.
Studies also show millennials are financially responsible, with two-thirds of them putting more than 5 percent of their paychecks into savings, the highest rate of savings of any current generation. Having gone through the Great Recession, they tend to be more conservative with their money. That means that they have been accumulating savings, even if they are not yet large enough to be served by traditional brokers. They are going to be the asset accumulators of the future.
Lastly, millennials show a set it and forget it attitude towards money management, desiring to delegate the responsibility elsewhere so they have more time for their passions, whether that’s their careers, hobbies, or travel.
Despite the big differences in operations, the investment strategy Wealthfront pursues is not dissimilar from a mainstream financial investor. Its portfolio emphasizes a diversification of assets, managed through a portfolio of exchange-traded funds (ETF’s) that track market indexes. It’s a great way to invest cheaply in a diversified basket of stocks, bonds, and other securities.
If anything, Wealthfront’s offering is more diversified than typical balanced mutual funds, with 11 categories of investments, including global stocks, corporate and municipal bonds, real estate, natural resources, and treasury bonds. The fund also automatically rebalances itself over time just as mainstream financial advisors and brokers do for their clients—if for example, stocks do very well over a period of time relative to other asset classes and become too large a percentage of the portfolio, the robo-advisor automatically reinvests in the other asset classes to control investment risk, frequently through the reinvestment of stock dividends or the investment of new contributions.
Most of the strategy Wealthfront pursues is identical for each client; however, it does provide some amount of individual customization through a process known as tax-loss harvesting and asset allocations tailored to the tax status of the client. For example, tax-loss harvesting aims at realizing capital losses that help offset realized capital gains to reduce the amount of capital gains tax paid. Capital gains are computed based on when each individual made contributions to her account and in this sense efficient tax loss harvesting requires customization.
The strategy Wealthfront has pursued has resulted in growth of assets under management from $100 million to over $3.7 billion by September 2016, placing it in the top 100 independent registered investment advisors in the United States. Their diversified portfolios have outperformed the S&P 500 by 40 percent on a risk-adjusted basis. There have been challenges, too. CEO Adam Nash stepped down in October of 2016, replaced by founder Andy Rachleff returning as CEO. Nash retained his seat on the board of directors.
But regardless of their growth, the biggest indication of the success of these firms is the fact that mainstream investment firms have decreased their fees and added their own robo-funds with lower minimum asset amounts in an effort to compete directly with Wealthfront and its ilk.
They have been clearly disruptive. Most of the big brokers, such as Vanguard and Schwab, have seen that there is a way to address this segment of the market, and developed similar offerings. That’s brought this to the attention of not just millennials who have thousands of dollars to invest, but also Gen-Xers who have tens of thousands.
The bigger issue is whether, as millennials get older and develop more sophisticated investing, tax and estate planning needs, firms like Wealthfront will continue to keep them as customers, or lose them to more traditional firms. They are hoping that as millennials grow, the technology will grow with them to continue to offer sophisticated portfolio advice with technological solutions. Whether that will happen or not is an open question. If it does, then expect more disruption in the financial advising industry in the next generation.
We visited Bernie Madoff in prison. Madoff, a renowned stockbroker turned fraudster, lives in FCI Butner, a medium-security federal correctional institution in North Carolina. Madoff is serving a 150-year prison sentence for orchestrating the biggest Ponzi scheme in history.
Madoff told us: In hindsight, when I look back, it wasn’t as if I couldn’t have said no. It wasn’t like I was being blackmailed into doing something, or that I was afraid of getting caught doing it. I, sort of, you know, I sort of rationalized that what I was doing was OK, that it wasn’t going to hurt anybody.
Madoff exhibits several all-too-familiar cognitive biases, psychological tendencies that can lead to irrational behavior. We hear Madoff describe a multitude of common biases. They’re amplified—biases on steroids, in Madoff’s case. But they’re biases that we all have, that we all experience.
Ambition: Madoff describes his ambition, which is something that every person aspiring to be successful in business—can relate to.
Overconfidence: “I built my confidence up to a level where I…felt that…there was nothing that…I couldn’t attain,” Madoff told us. The “slippery slope” that enables a small transgression to grow into a bigger one: “I started to go off the tracks, and I was able to convince myself that this was, you know, a temporary situation,” Madoff said.
Lack of self-control: “I…probably…just didn’t give it enough thought or wasn’t frightened enough…to say to myself, I can’t, you know, I can’t do this, I can’t take the risk,” Madoff told us.
Rationalization of iffy decisions: The piece that’s most humbling in the recording is the realization of rationalization. Madoff recognizes now that it was all rationalization.
Once our readers recognize that this is a smart guy, and he didn’t need to do what he did, but he still did it anyway, there is a degree of humility in the venitism blog. Madoff is an extreme case in many ways, but in other ways, he is just someone who fell prey to biases and the tendency to rationalize.
It’s especially important for budding entrepreneurs to appreciate the link between Madoff’s ambition and his slippery slope to infamy. While Madoff possesses an extraordinary lack of empathy for his victims, he didn’t explicitly set out to commit the crime of the century.
Madoff is respected in prison because it looks like he was the mastermind of this extraordinary plan. But to say that he sat down and planned a two-decade, multibillion-dollar Ponzi scheme, that’s giving him too much credit as an individual financier, or even as a sinister deviant. He couldn’t have planned such a long-running and extraordinarily devastating fraud in advance even if he tried.
Madoff was once best known for pioneering the controversial but legal practice of payment for order flow, in which he would pay brokerage firms a couple of cents per share to send orders through his firm. This made him popular among investors, who previously had to pay brokers for the service of buying shares; now Madoff had turned the practice upside down and was paying them to trade.
That innovation diverted trading away from the New York Stock Exchange floor, and by the early 1990s, Madoff’s firm was handling upwards of 10 percent of all NYSE-listed stock trading. Outside his brokerage business though, in his growing investment management practice, Madoff started to feel greater strain in generating profits.
He began naked shorting to clients. Another controversial but legal practice, this involved short-selling a stock without first borrowing the security, and then acquiring the security after the sale. But then he started conducting short sales without putting them on the books, which is illegal. Eventually he stopped trading altogether, once he realized he couldn’t generate the profits he continued to promise his investors. A few steps down the slippery slope later, he was running a Ponzi scheme.
“It’s like a comedy of errors,” Madoff told us. “I allowed myself—and I really have to say ‘allowed,’ since no one put a gun to my head—to keep taking in more money. I kept on waiting for the environment to change and of course it never did. It turned into a total fiasco.”
It’s a mundane series of errors, one leading to another, which grew into something of remarkable proportions. Even as famous white-collar criminals go, Madoff is an outlier, both in the size of his crime and in its longevity. But it’s important to appreciate the slippery slope of small crimes often becoming bigger ones, especially in today’s entrepreneurial culture, which tends to accept and even glorify bending the law a little.
Within entrepreneurial cultures, there’s often a feeling that it’s OK to ignore or bend some regulation. Sometimes regulations are legitimately outdated or potentially too restrictive to let innovation flourish. But the challenge for entrepreneurs is that the line between appropriate and illicit is often quite murky.
Case in point, the ride-hailing company Uber, which is thriving in spite of pushing legal boundaries—and fighting its case in court—in cities all over the world. In some places Uber is hailed as a brilliant company, and in other places its executives are convicted criminals. Many well-respected entrepreneurs, from Michael Dell to Steve Jobs, have faced their own allegations of wrongdoing, but still managed to build remarkable enterprises. At the same time, many white-collar criminals also break rules in the process of believing they are on the cusp of doing something great. Navigating the fine line of which regulations might be legitimately broken and which cannot is sometimes difficult. But understanding this distinction is critical for entrepreneurs who want to operate on the most innovative frontiers of business. Entrepreneurs who are trying hard to make their mark often need to be aggressive. This sometimes leads to successful businesses like Uber or Airbnb, and other times it leads to terrible failures like Enron.