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Factoring in Behavior
Mike Fardy, National Sales Manager, CIMA, FlexShares
“Not For Use with Retail Investors”
For Use with Financial Intermediaries Only
Global Equities Performance
Source: Northern Trust Investment Strategy, Index data for the various return calculations above are as follows: U.S. is the MSCI U.S. Equities IMI; Emerging Markets is the MSCI Emerging Market Equities Index; Dev. ex-U.S. is the MSCI World ex-U.S. IMI; Global Equities is the MSCI ACWI (All Country World Index) and is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. Indexes are gross of fees and indexes cannot be invested in directly. Past returns are no guarantee of future results. Charts are as of December 31, 2017.
-60
0
60
120
180
240
300
Dec-08 Dec-11 Dec-14 Dec-17
Re
turn
(%
)
U.S. Dev. ex-U.S. Emerging markets Global equities
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Global Equities Had Historically low Volatility in 2017
Source: Northern Trust Investment Strategy, Bloomberg. MSCI ACWI (All Country World Index). Indexes are gross of fees. Past returns are no guarantee of future results. Data through 2/15/2018
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“The study of Psychology as it relates to the economic decision-making processes of individuals and institutions” *
What is Behavioral Finance?
2002 Daniel Kahneman wins
Nobel Prize in Behavioral Economics
2017 Richard Thaler wins Nobel
Prize in Behavioral Economics
Image Source: https:www.rolandberger.com/en/Blog/Buying-into-simplicity.html Image Source: http://content.time.com/time/magazine/article/0,9171,2099712,00.html
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The Market Cycle of Emotions
Source:https://www.elphoscapital.com/single-post/2016/11/09/Understanding-Market-Cycles-The-Key-to-Successful-Investing
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Why Should You Care?
Source: Harvard Business Review, “The Value of Keeping the Right Customers,” October 29, 2014
a 5% increase in customer retention
produces more than a 25% increase in
profit
Acquiring a new customer is anywhere
from 5 to 25 times more expensive
than retaining an existing one.
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Common Pitfalls Your Clients Face
Anchoring
Status Quo
Cognitive Overconfidence
Overchoice
Herd Mentality (aka “FOMO”)
Endowment Theory
Regret Aversion
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Common Pitfalls Clients Face
Framing
Sunk Cost
Confirmation
Disposition Effect
Risk Aversion
Selective perception
“Recency” Effect
Guessing at Patterns
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The Problem
Are you and your clients buying and selling at the wrong times due to behavioral biases?
Information Ratios during Manager Life Cycles
1.08
-0.11
0.97
Before Manager Hired After Manager Hired After Manager Fired
For Illustrative Purposes Only: Source Norther Trust data dervied from Goyal, A. and Wahal, S., “The Selection and Termination of Investment Managers by Plan Sponsors,” Journal of Finance 63(4) 1805‒1847, 2008 Data based on 3400 plan sponsors between 1994 and 2003
Before Manager Hired-
Previous 3 Years After Manager Hired- Next 3
Years
After Manager Fired-
After Manager Fired- Next 3
Years
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The Solutions
SMAs / Multi Asset Class
Solutions Factors
ETFs
Defining Factor Investing
Quality Value Low
Volatility
Dividend
Yield
Size Momentum
Factor investing seeks to identify and target these drivers of return through systematic strategies
that can be implemented in risk-controlled portfolios.
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ACTUAL INVESTOR PORTFOLIO EXAMPLE
Strategies Growth Value Momentum Size Volatility
Small-Cap Value – + – + –Small-Cap Growth + – + + –Small-Cap Growth + – + + –Mid-Cap Value – + – – –Mid-Cap Growth + – + + +Large-Cap Value – + – – –Large-Cap Value – + – – +Large-Cap Growth + – + – +Aggregate Portfolio
Exposure 0 0 0 0 0
Consequences of Cancellation
Note: “+” denotes an addition to factor exposure, while the “–” denotes a detraction from factor exposure.
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Factors Have Driven Mutual Fund Excess Returns For 50 Years
Northern Trust. Decomposition of mutual fund excess (monthly) for top performing mutual funds over time derived from
Source: For Illustrative Purposes Only. Carhart, Mark M. “On persistence in mutual fund performance.” The Journal of Finance 52.1 (1997): 57–82.
6.6%
-1.6%
5%
Skill
“Stock Picking”
Annual
Excess Return
Common
Style Factor
Exposure
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For Use with Financial Intermediaries Only
ETFs
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Factor-based
Outcomes-Focused
Traditional
Index
Management
Traditional
Active
Management
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Deploy factors to stave off effects of behavioral concerns
3 Actionable Items
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Be cognizant of your client’s risk tolerance AND how they behave
Become dispassionate…. about your positions
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Research has been clear for some time…
1960’s
Expected Return = Risk-free Rate + (Market Beta * Market Premium)
1992
Expected Return = Risk-free Rate + (Market Beta * Market Premium)
+ (Size Beta * Small Minus Big)
+ (Value Beta * High Minus Low)
Source: Eugene Fama & Kenneth French, “The Cross-Section of Expected Stock Returns”, The Journal of Finance, June 1992.
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For Use with Financial Intermediaries Only
…But behavior makes it difficult
Source: Northern Trust Quantitative Research, cycle lengths as determined using spectral analysis, Dec 2016
0
20
40
60
80
100
120
Low Volatility Dividend Yield Momentum Value Size
Average Factor Cycle Length
# of Months
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For Use with Financial Intermediaries Only
Should I Even Bother with Factors?
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We are all factor investors
FactSet. Data as of 2/28/2018 from the Barra USE3L risk model – factor exposure subject to change.
USEarnings
YieldUS Value
USVolatility
USLeverage
USEarningsVariation
USDividend
Yield
USMomentu
m
USGrowth
US Size
Factor 0.07 -0.05 -0.10 -0.13 -0.07 0.03 0.02 -0.06 0.36
-0.20
-0.10
--
0.10
0.20
0.30
0.40B
arr
a F
acto
r E
xp
osu
re
S&P 500 Factor Exposure as of 2/28/2018
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For Use with Financial Intermediaries Only
Return assumptions declining
7.20%
7.40%
7.60%
7.80%
8.00%
8.20%
8.40%
State & Local Pension Plan Return Assumptions
Return Assumption
Source: Public Plans Data. 2001-2015. Center for Retirement Research at Boston College, Center for State and
Local Government Excellence, and National Association of State Retirement Administrators. National data
averages, weighted by plan size.
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For Use with Financial Intermediaries Only
Why international?
Source: FactSet P/E Ratios, Monthly data through 2/28/2018. Indices are the MSCI USA Index, MSCI World Excluding United States Index and the World Excluding United States
Index begins 1/31/1997, MSCI Emerging Markets Index 10/31/1999. Normal range is +/- 1 standard deviation from median
8
10
12
14
16
18
20
8
10
12
14
16
18
20
United States Developed ex US Emerging Markets
Global Equity Market Valuations
Normal Range
Median
Current
Past performance is no guarantee of future results. Periods greater than one year are annualized except where indicated. Returns reflect the reinvestment of dividends and other earnings and are shown before the deduction of investment management fees, unless indicated otherwise. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved
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For Use with Financial Intermediaries Only
The temptation of factor timing
Source: Bloomberg, as of 7/3/17, FlexShares Market Signal dated July 2017
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
-10.00
-5.00
0.00
5.00
10.00
15.00
Retu
rns,
%
Flo
ws, $ B
illio
ns
U.S. Listed Small Cap ETF Flows and Returns
Monthly Net Flows Russell 2000 Performance - Russell 1000 Performance
Past performance is no guarantee of future results. Periods greater than one year are annualized except where indicated. Returns reflect the reinvestment of dividends and other earnings and are shown before the deduction of investment management fees, unless indicated otherwise. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved
Russell 2000 Index Return- Russell 1000 Performance
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For Use with Financial Intermediaries Only
Are more factors better than fewer?
Momentum Quality Dividend Yield
Volatility Value Size
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The Importance of Implementation
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Evolution of factor investing
Smart Beta 1.0 Fundamental/
Alternatively Weighted
Smart Beta 2.0 Single Factor
Strategies
Smart Beta 3.0 Multi-Factor
Strategies
FlexShares.com 2018 | 28
For Use with Financial Intermediaries Only
Refined factor models
How efficiently is the factor captured?
Unintended factor exposures
Sector, country, industry biases
Broad universe vs. sector neutral
Factor maximization or incremental exposure
How are factors combined?
Target each independently, then combine (sub-index approach)
Apply each in succession (step-through approach)
Apply all factors in concert (optimization approach)
Smart Beta 4.0?
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For Use with Financial Intermediaries Only
Using the factor cycle to drive design
Source: Northern Trust Quantitative Research, cycle lengths as determined using
spectral analysis, Dec 2016
0
20
40
60
80
100
120
Low Volatility Dividend Yield Momentum Value Size
Average Factor Cycle Length
# of Months
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For Use with Financial Intermediaries Only
Holding period matters
Source: Ken French Data Library, monthly observations, Dec 2017
U.S. Growth Index is Fama/French U.S. Growth Index (ex utilities), provided by Fama/French. U.S. Value Index is Fama/French U.S. Value
Index (ex utilities), provided by Fama/French. Indices are not available for direct investment. Their performance does not reflect the expenses
associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Values change frequently and past
performance may not be repeated. There is always the risk that an investor may lose money. Even a long-term investment approach cannot
guarantee a profit. Economic, political and issuer-specific events will cause the value of securities, and the portfolios that own them, to rise or fall.
Because the value of your investment in a portfolio will fluctuate, there is a risk that you will lose money. Indexes are referred to for comparative
purposes only and do not represent similar asset classes in terms of components or risk exposure; thus, their returns may vary significantly. U.S.
Growth Index measures the performance of U.S. stocks with higher price-to-book ratios. U.S. Value Index measures the performance of U.S.
stocks with lower price-to-book ratios.
1-year 3-year 5-year 10-year 15-year 20-year 30-year 40-year
Value Wins 62% 75% 83% 96% 100% 100% 100% 100%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Perc
en
tag
e
Value Win % Over Growth US Equity, 1926 - 2017
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Complimentary factors ARE Key
Multifactor data provided by http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. SmB and HmL research factors.
Past performance is not a guarantee of future results. Values change frequently and past performance may not be repeated. There is always the risk that an invest may lost money. Securities of small firms are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Even a long-term investment approach cannot guarantee a profit. Economic, political, and issuer-specific events will cause the value of securities, and the funds that own them, to rise or fall. Because the value of investments will fluctuate, there is a risk that investors will lose money.
1930 1940 1950 1960 1970 1980 1990 2000 2010-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
1930 1940 1950 1960 1970 1980 1990 2000 2010-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
Five Year Moving Average of U.S. Value Factor: 1926 to 2017
Five Year Moving Average of U.S. Size Factor: 1926 to 2017
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Factor tilt: different than factor weighted
“Tilting” is a nuanced approach to factor investing that seeks to generate the targeted, systematic exposure through weighting adjustments to its holdings.
• Total market ownership: exposure to entire investable universe – even large cap growth
stocks
• Targets a specific exposure to size and value in an effort to enhance returns while
maintaining a consistent level of risk to those factors across entire product suite
• By targeting specific levels of factor exposure and rebalancing to those exposures at
reconstitution, there should be less drift compared to other methodologies
• Lower turnover compared to other factor-based strategies
• Lower tracking error to the market
Design of a tilted approach
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Built by investors, for investors
Twitter@FlexSharesETFs
LinkedIn.com/FlexShares
FlexShares.com
1.855.flexetf (1.855.353.9383)
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FlexShares.com Your Advisor Portal
A redesigned advisor site gives you unique access to performance information,
in-depth commentary and fund analysis
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The FlexShares mission is to provide exchange traded funds that serve as the building blocks for outcome-oriented portfolios. This focus on “investing with purpose” is at the heart of our unique brand of ETFs.
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Important Information
Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest.
Foreside Fund Services, LLC, distributor.
An investment in FlexShares is subject to investment risk, including the possible loss of principal amount invested. Funds’ returns may not match the returns of their respective Indexes. The Funds may invest in emerging and foreign markets, derivatives and concentrated sectors. In addition, the Funds may be subject to asset class risk, small cap stock risk, value investing risk, non-diversification risk, fluctuation of yield, income risk, interest rate/maturity risk, currency risk, passive investment risk, inflation protected security risk, market risk and manager risk. For a complete description of risks associated with each Fund please refer to the prospectus.
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