Financial planning,  Investing,  Markets

Yet another example of how market timing is really hard

Trying to time markets is really, really hard, in fact, to do it consistently well is all but impossible. Yet almost every investor is guilty of it at some point. One way you might be doing it without even realising is by investing in ‘factors’, and if you get on the wrong side of them you can seriously underperform the market without even knowing why.

Factors are basically underlying themes that can drive the market at any one time, either by themselves or in combinations, such as value, quality, yield, or momentum, and ‘factor investing’ is one of the latest fads in portfolio management, particularly in the US. And as usual, whenever there’s a fad in the financial markets, there’s a host of money makers only too happy to oblige with new financial products.

The classic factor battle is between so-called ‘value’ vs ‘growth’, that is, buying stocks that are cheap compared to the market (for instance, a lower PE ratio, or lower price to book value) which is the classic Warren Buffett strategy, as opposed to buying companies that boast higher earnings growth than the market.

Chart 1 shows growth stocks have way outperformed value stocks since the end of the GFC. While the chart is for the US, it was a similar story for the Australian market where value stocks underperformed growth by more than 40% between 2009-15.

Chart 1: value stocks have underperformed growth in the US since the GFC

Charts like the one above have led to a plethora of growth ETFs, also referred to as ‘quality’, all trying to take advantage of that outperformance. And of course, all those ETF’s are issued with back-testing that looks amazing – now with more than 10 years of strong returns.

The thing is, if you’d have issued a value ETF in 2000 after the dotcom crash, you’d have killed it for seven years. In other words, these things go in cycles and it’s really tough knowing when or why a cycle will turn.

The almost alarmingly colourful chart 2 also shows how much factor returns jump around on a year to year basis. Each colour represents a different factor (value, quality, momentum, etc) and they are ranked by returns over the past 13 years. The striking thing is just how much the colours jump around: what is top of the pops one year can be rock bottom the next, and there’s no rhyme or reason. In other words, trying to predict which factor will be the best performing on a year to year basis is next to impossible.

Chart 2: trying to pick which factor will be top of the pops

from year to year is next to impossible

There’s now a bunch of ETFs available in Australia that target a particular factor, things like the iShares Australia Minimum Volatility, or the iShares Australia Multifactor, or the SPDR Australia Select High Dividend Yield Fund, or the one in chart 3, which is a photo of the full page ad in last Thursday’s AFR which prompted me to write this post, the VanEck Vectors MSCI World ex-Australia Quality ETF.

Chart 3: factor ETF’s can feature in full page ads

The thing is, if you buy a factor ETF you’re betting that portion of the market will do better than the others, and you’ve got to ask yourself how you can be sure of that. If you’re persuaded by the last three years of returns who knows if reversion to mean isn’t about to kick in? And if you hedge your bets by buying two or three factor ETF’s, you may as well just buy an index fund at half the cost. And then you don’t even have to think about timing.

 

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product.

 

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