'Get On The Bus'
Nov 24, 2010
In old-school financial theory, ‘the market’ was often assumed to be the S&P 500. Many people in the financial industry grew up on defining things (like Beta –> and therefore Alpha) relative to the S&P 500. This wasn’t the correct interpretation from Modern Portfolio Theory --- but as the 1990’s bull market raged, the question was not about U.S. equities vs bonds vs international investing or anything else --- it was more a discussion of simply ‘which US equities?’ – and the popularization of ‘style boxes’ that carved up the U.S. market according to size (small , mid or large cap) and style (value vs core vs growth).
In 1998, the S&P 500 rallied 25%+ while small cap U.S. stocks were essentially flat. The dispersions between picking segments of the U.S. were very important then. Much discussion was also whether you were overweight technology – or underweight sector XYZ – all along assuming that of course your universe was U.S. equities. The economy was robust and it was not unusual for companies to grow 5-10%+ every 90 days (sequential quarterly growth).
Those days of course are long gone. The companies growing 5-10%+ every 90 days now are more likely located in Brazil or India etc… Still, the dispersions between market segments can be very large. The conversation doesn’t end at --- overweight bonds --- but which bonds? Long-duration corporates or intermediate high-yield -- or preferred stocks for that matter? Overweight international stocks? Which international stocks – what regions, which countries?
One very interesting aspect of ETFs is that they allow allocations to be adjusted not just easily – but with such precision and at essentially no cost. Expense ratios are in the 0.40% zone and are already accounted for in market prices. With free trading now available --- it just gets better.
But ETF investing doesn’t have to end at allocation decisions. ETF rotation involves rotating beta exposures over time. Its not just about picking a low-cost allocation and sticking to it. Surely you have some view on some market segment in some region of the world?
Importantly, expressing this view can be done as a satellite rotation strategy against a core portfolio of conservative investments, or on its own. Its up to you and your risk tolerance and any other constraints you impose.
The point is that there is tremendous value to be added that has nothing to do with stock-picking. ETF's allow us to operate at a level that is above stock-picking – and picking market segments has and always will be more important than stock-picking.
Even with all the ‘insider networks’ of professional money managers --- hedge fund indexes have shown very mediocre net performance, with any benefits of outperforming funds accruing primarily to the hedge fund manager -- and not to the investor. Moreover, the data to fully risk-adjust these performances just isn’t available without a daily NAV – something hedge funds do not report.
So here we have transparent, ultra low expense ratio, free trading vehicles that operate at a level far more important than adding (or subtracting) 2.00% in stock-picking.
To quote a recent line I heard from a high-profile CEO: “Get on the bus.”
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