Notes From the Morningstar ETF Conference
Thursday, October 1, 2015

I attended Morningstar’s annual ETF conference this week. Though the event is mostly attended by financial advisers, there were several topics of interest to individual investors.

One of them was factor investing, which is financial services industry terminology for taking advantage of stock characteristics associated with higher returns. Jason Hsu of Research Affiliates described factors as being counter-cyclical, meaning that when a factor becomes popular, it underperforms. This is because when too much money tries to exploit the same return anomaly, the anomaly vanishes until enough investors move on to a different anomaly. Hsu pointed to low volatility as being a current example, with low-beta stocks trading at historically high valuations.

In a different session on factor investing, one of the panelists said value is particularly unique in its persistence of outperformance. Though value does underperform at times—particularly during speculative bubbles—its periods of underperformance tend to be comparatively short. As far as pairing value with other factors, the same panelist said to pair it with quality, while another said he likes to pair it with price momentum. (I suggest combining the three factors.) The panelists agreed that patience is required when following a factor-based strategy, since periods of underperformance will occur.

Which brings me back to Hsu. He explained a fund’s alpha (outperformance due to skill) as being created by someone else having negative alpha. In other words, if a certain group is going to beat the market, another group has to lag. Hsu believes fund shareholders provide negative alpha (0.9% in negative return) through bad timing. He further said that a mutual fund’s ability to outperform is influenced by the inflows from and outflows to investors. The timing and amount of these flows can force a fund’s manager into making decisions he would otherwise not make.

Fund performance was also the subject of AQR’s Andrea Frazzini's presentation. Frazzini disputed the need for high levels of active share in order for a fund to outperform. (Active share is the extent to which a fund’s weighting of stocks differs from that of its benchmark index.) Rather, he believes that alpha is created by what the benchmark index emphasizes (e.g., large-cap stocks). Furthermore, when the alpha of the benchmark is considered, there is no statistical difference between closet indexers (fund managers whose portfolios mimic the index) and fund managers who have high levels of active share.

Charles (“Charley”) Ellis has been a long-term critic of the fees charged by many actively managed funds. His talk was not about fees, however, but rather about the retirement system. Ellis explained how a desire to prevent older railroad workers from causing train accidents was one of the reasons age 65 emerged as the targeted age for retirement in the 19th century. He then went onto explain how the responsibility for funding retirement changed from employers (meaning pension plans) to employees (meaning 401(k) plans). He described this shift as resulting in a system where people with no investment experience are put in charge of ensuring their financial security in retirement.

Ellis did have some solutions. He suggests that postponing retirement from age 62 to age 70 can increase the median retirement savings account from $110,000 to $260,000 for a person earning $60,000 per year, assuming a 6% rate of return and contributions to retirement savings equal to 12% of salary each year. In addition, Social Security benefits would increase by 8% per year over this period. He further advises constantly learning new skills, thinking young and understanding all of the choices available before making a financial and retirement decision.

A focus of the session I attended today was robo-advisers. These online platforms offer financial advice at fees well below what most traditional advisers charge. A panel of three industry experts did not view them as a threat, however, but rather as agent of change. Jim Crowley of Pershing said the growing popularity of robo-advisers greatly reduces the value of simply providing a portfolio allocation and doing an annual review of performance. As such, traditional advisers need to put more effort into proving their value to clients. He and the other two panelists said this can be accomplished by helping clients to understand their goals, by incorporating the entire family into the planning process and by providing financial education.

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The Week Ahead

I will speak to our Charlotte, NC Chapter on Thursday, October 8, and to our Research Triangle chapter on Saturday, October 10. Computerized Investing Editor Jaclyn McClellan will speak to our Chicago, IL Chapter on Saturday October, 10. To find a meeting near you, visit our Local Chapters page.

Third-quarter earnings season will “officially” start when Alcoa (AA) releases its results on Thursday. Joining it will be fellow S&P 500 members PepsiCo (PEP) and Yum! Brands (YUM) on Tuesday and Constellation Brands (STZ) and Monsanto Company (MON) on Wednesday.

The first economic report of note will be the ISM’s non-manufacturing index, released on Monday. Tuesday will feature August international trade data. The minutes from last month’s Federal Open Market Committee meeting will be released on Thursday. Friday will feature September import and export prices.

San Francisco Federal Reserve Bank president John Williams will speak on Tuesday and Thursday. Also making public appearances will be Minneapolis president Narayana Kocherlakota on Thursday and Chicago president Charles Evans on Friday.

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AAII Sentiment Survey

Pessimism among individual investors surged to a two-month high in the latest AAII Sentiment Survey. Neutral sentiment plunged and optimism fell, setting a new record in the process.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.0 percentage points to 28.1%. This is a six-week low. It is also the 30th consecutive week that optimism is below its current historical average of 39.0%, the longest such streak in our survey’s history.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, plunged 7.2 percentage points to 32.0%. Even with the drop, neutral sentiment is above its historical average of 31.0% for the 37th week this year.

Bearish sentiment, expectations that stock prices will fall over the next six months, spiked 11.2 percentage points to 39.9%. The rise puts pessimism above its historical average of 30.0% for the eighth time in 10 weeks.

Bearish sentiment is at its highest level since July 30, 2015 (40.7%). Notably, last week’s bearish sentiment reading of 28.7% was its lowest level since July 23, 2015. This week’s sharp rebound occurred as the major stock indexes either tested or closed below their late-August lows. At its current level, pessimism is near the upper end of the typical range recorded in our survey. Optimism is just slightly above what we could consider to be an unusually low level.

This week’s special question asked AAII members what factors are currently having the greatest impact on their six-month outlook for stocks. More than one out of every three respondents (35%) listed global and international events, particularly China and global economic weakness. U.S. monetary policy—both the possible timing of the first rate hike and the decision not to raise rates at last month’s Fed meeting—was a close second, listed by 31% of all respondents. About 19% pointed to technical factors, seasonal trends, the recent correction or the chance of further price declines occurring. More than 17% of all respondents cited U.S. politics, including the upcoming election, the budget and the national debt. Nearly 15% pointed to the pace of U.S. economic growth. Many respondents listed more than one factor as influencing their outlook.

This week’s Sentiment Survey results:

Bullish: 28.1%, down 4.0 points
Neutral: 32%, down 7.2 points
Bearish: 39.9%, up 11.2 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

AAII Asset Allocation Survey

Individual investors raised their cash levels to the highest level and reduced their stock allocations to the lowest level in two years, according to the September AAII Asset Allocation Survey. Fixed-income allocations rose slightly.

Stock and stock fund allocations declined 1.4 percentage points to 63.6%. This is the smallest exposure to equities since August 2013 (62.3%). Even with the decrease, stock and stock fund allocations remained above their historical average of 60% for the 30th consecutive month.

Bond and bond fund allocations rose 0.2 percentage points to 16.5%. The modest increase puts fixed-income allocations at a six-month high. The historical average is 16.0%.

Cash allocations rose 1.3 percentage points to 20.0%. Cash levels were last higher in August 2013 (20.5%). Even with the continued increase, last month was the 46th consecutive month with a cash allocation reading below its historical average of 24%.

Cash allocations had been trending higher prior to the increased volatility incurred by stocks. September was the fifth increase to cash allocations in the past six months.

Last month’s special question asked AAII members what portfolio changes they made in reaction to the late-summer drop in stock prices. Nearly one out of three (31%) respondents said that they bought stocks, with an additional 6% saying that they bought equity funds. Conversely, about 13% said that they sold stocks and 12% reported higher cash allocations. (Some of those who sold stocks said that they increased their cash allocations.) Slightly less than a quarter of all respondents (23%) said that they didn’t make any changes.

Here is a sampling of the responses:

  • “I added to the positions of what I felt were well-run companies.”
  • “I managed to add a couple of stocks that I felt were now ‘on sale.’”
  • “I made no changes to my portfolio. I’ll let this fear cycle run its course.”
  • “Raised cash. Some stocks were stopped out.”
  • “Reduced stocks and increased cash.”
September AAII Asset Allocation Survey results:

  • Stocks/Stock Funds: 63.6%, down 1.4 percentage points
  • Bonds/Bond Funds: 16.5%, up 0.2 percentage points    
  • Cash: 20.0%, up 1.3 percentage points

September AAII Asset Allocation Details:

  • Stocks: 30.8%, down 1.3 percentage points
  • Stock Funds: 32.8%, down 0.2 percentage points
  • Bonds: 3.9%, up 0.7 percentage points
  • Bond Funds: 12.6%, down 0.6 percentage points

Take the Asset Allocation Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!