Taking Irrationality Out Of Investing

January 06, 2016

How do you use ETFs in your practice?
We use ETFs in a couple of ways. To manage a global allocation the traditional way, using individual stocks and bonds, would take literally hundreds of securities. That’s not very friendly to the investors trying to figure out what’s going on in their retirement accounts, or to the advisors trying to manage all these moving parts. So ETFs allow us to manage a global allocation effectively with far fewer securities.

Secondly, ETFs allow us to mitigate a lot of individual security risk. Is it Coke or Pepsi? What if you pick the wrong company? ETFs mitigate much of that. Being able to avoid individual stocks allows us to spend the majority of our time managing the most impactful part of the process: asset allocation.

How many ETFs do you use?
We own 15-20 ETFs, depending on the portfolio.

You use ETFs for your alternatives allocation. Which ones do you like?
That’s a space that’s been a good investment for us, especially in this environment where equity valuations are challenging. It’s nice to have another avenue to pursue.

One example that’s really worked out well for us is the PowerShares S&P 500 BuyWrite ETF (PBP | A-73), which is a covered-call writing strategy. Given the volatility in today’s equity market, we can now take some of that volatility and turn it into a return stream by covering calls.

Also, the First Trust Preferred Securities and Income ETF (FPE | D) has worked out very well for us. FPE is actively managed, so it shifts between variable and fixed preferreds. We really like that, especially in this environment. You can generate a little additional return and not take on the interest-rate sensitivity that you would have, if you’d had a passively managed preferred strategy. So even with the more recent volatility in interest rates for the 10-year [Treasury note], FPE has held up very well for us.

Have you encountered any major challenges in using ETFs over the years?
I wouldn’t call them challenges, exactly. But we’ve seen a lot of change in the ETF space and a lot of fad products. The ETF industry is no different than any other fast-growing industry. Take the late '90s, when, if you didn’t have an Internet fund, you were missing out. And now there are thousands of ETFs to sift through. So it’s just a matter of recognizing what the next big fad is and not chasing that.

What industry fads are you seeing right now?
Currently there’s a lot going around about currency-hedging strategies. I think they’re timely, but I don’t know how long-lived they’ll end up being. Also, a lot of new products coming out in fixed income are particularly frightening. Chasing yield is a very dangerous thing. I don’t think it will last. People will get burned on it.

But there are ideas coming up that are real, like factor-based investing. They call it “smart beta” now, but there’s nothing new about fundamental analysis, of course. The Fama-French model goes back a long way. So there’s nothing new about these factors, except that now there’s an efficient way to package them in a portfolio.

Looking ahead to 2016, what are your expectations for the coming year? Have they impacted your asset allocation?
Yes, they have. For the past 18 months or so, we’ve been starting to pare back some of our equity risk, because we think we’re in the later stages of the business cycle. We do think there will still be opportunities for investors to make money in equities, but risk management will be more and more important moving forward. So we’ve been reducing some of our beta exposures and eliminating some of our most volatile or aggressive positions. We’ve replaced them with lower-volatility securities.

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