Top 4 Takeaways From the Morningstar ETF Conference

The article was published in the September 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.

We held our seventh annual Morningstar ETF Conference from Sept. 7–9 in Chicago. The three-day event brought together over 700 advisors, strategists, due-diligence analysts, exchange-traded-fund providers, and a host of other industry participants. As is the case with all Morningstar conferences, this is not a pay-to-play affair chock- a-block with product pitches. Our analysts craft each year’s agenda. We set out to put together a solid lineup of industry luminaries to spur good conversation about important issues facing investors, as well as to give them practical ideas about how to put ETFs to work in practice. I think this year’s conference was our best yet, and I’d like to share with you my top four takeaways from the event.

Not Quite Euphoric Charles Schwab's chief investment strategist Liz Ann Sonders presented this year's opening keynote address. She discussed the current state of the U.S. economy and gave her thoughts on its future direction, as well as the implications for global markets. Sonders began by sharing one of my favorite quotes on the nature of market cycles, from Sir John Templeton: "Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria."

Where are we in the current cycle? Sonders believes the U.S. market is somewhere in the optimism stage, oscillating between fits of panic and spells of relief, but she insisted that it’s still far from euphoric. Her team had a “neutral” rating on U.S. equities as of early September, meaning that it was maintaining current allocations with an eye toward adding to them in the event of any fear-induced selling.

As for the outlook for the U.S. market, Sonders stated, “Better or worse for the stock market matters more than good or bad.” Based on her read of leading economic indicators in the United States, things continue to improve, albeit very gradually. Notably, she shared that the Conference Board Leading Economic Index had yet to reach its pre-financial-crisis highs. This index has retested and exceeded prior highs in advance of prior recessions. The implication here is that the U.S. economy might have more gas in the tank.

Sonders lamented the current “wisdom” that bad news for the economy is good news for the markets. Many investors have been assuming that bad economic news implies the Federal Reserve will keep refilling the punch bowl. She urged investors not to forget that bad news is still bad and good news is still good. On the whole, she said that the current economic recovery has been trending weaker relative to prior recoveries. This is attributable in large part to the fact that we spent much of the past few decades binging on debt. Per Sonders, more debt means less growth.

In Sonders’ eyes, valuations for U.S. stocks are neither too hot nor too cold. Accounting for prevailing interest rates and the recent crash in oil prices, which has weighed on energy-sector earnings, they look to be occupying a space somewhere between fairly valued and slightly stretched. Sonders believes the U.S. market could very well “grind higher” from here, but not without some “drama” along the way.

My Take-Away: I agree that the current market sentiment is hardly euphoric. But I'm hard-pressed to think of what might push the current bull run—the second-longest in history—into its final stage. It's been said that bull markets don't die of old age. If that's the case, will the current bull market simply get put out to pasture?

Fact, Fiction, Value, and Momentum Investing Ronen Israel, a principal with AQR, shared the findings of a pair of papers [1],[2] that he coauthored in a presentation titled "Fact, Fiction, Value, and Momentum Investing." Israel claimed that investors can be roughly divided into two camps: those who follow the crowd (momentum investors) and those who are contrarian (value investors). He argued that both camps have long claimed superiority over one another. In doing so, they have littered the literature with some persistent fictions that might mislead investors. Here are the some of the more interesting facts and fictions as Israel presented them to our audience, along with my thoughts on each.

Fact: "Value can be measured in many ways, and is best measured by a composite of many variables." As I shared in "Playing Favorites With Multifactor ETFs," measuring value using just one metric introduces an element of risk. The chief risk in this case is that a particular measure of value can become so widely popular so as to be rendered useless. The second risk is more technical in nature. Accounting standards change over time, as does the manner in which public companies engineer their finances (think of debt-financed share repurchases). Diversifying across a number of value metrics protects against these risks. Look for funds tied to indexes that use multiple value measures in isolating relatively cheap stocks.

Fiction: "Value is a passive strategy because it is rules-based and has low turnover." All value indexes are rules-based, and most have low turnover. I agree with Israel and others that this does not make value a passive strategy. As I discussed in "Everything You Need to Know About Strategic-Beta ETFs," strategic beta (a family to which we would argue ETFs tracking value-oriented indexes belong) is a new form of active management. This brand of active portfolio construction differs from conventional active management in that it is active by way of design (active bets are baked into these funds' indexes) and passive in its ongoing implementation (once the rules have been written, there is no ongoing discretion). As such, it is important to know the nature of the active bet you are making with these funds and how the bet has been drawn up—index construction matters!

Fact: "Value and momentum work best in combination with each other." I've previously described value and momentum as the peanut butter and jelly of factors. While the two camps' history would seem to indicate that their differences are irreconcilable, these differences make the two approaches such a good pairing. Value tends to zig when momentum zags, and vice versa. As I discussed in "The Case for Multifactor ETFs," putting factors with low correlations to each other together in a portfolio setting can mitigate cyclicality relative to owning them on a stand-alone basis and thus have the potential to reduce the risk of bad behavior.

Alpha Is a Sideshow Jason Hsu, chairman and CEO of Rayliant Global Advisors and co-founder of Research Affiliates, is widely recognized as one of the pioneers of "smart beta." Hsu began his conference presentation by retracing the benefits of this marriage between the positive attributes of active (an opportunity for, but no guarantee of, outperformance) and passive (transparency, low costs) approaches to portfolio management. In its essence, Hsu argues that strategic beta is just "low-cost factor investing."

While the democratization of low-cost factor investing has been a generally positive development for investors of all stripes, early indications are that this phenomenon brings some old baggage. Specifically, Hsu showed that “timing woe,” as he calls it, is everywhere. Hsu and his Research Affiliates colleagues documented this “woe” in a research paper that was first published last year. [3]

What they call woe Morningstar regulars will know as the "behavior gap" that my colleague and Morningstar FundInvestor editor Russ Kinnel has documented for years in his annual "Mind the Gap" study. Both studies lay bare a sometimes vast differential between the returns that funds experience (time-weighted returns) and those that investors, on average, experience (cash-flow-weighted returns). This gap is tantamount to a self-imposed behavioral cost, and it is every bit as present and persistent in low-cost factor funds as it is in high-priced active strategies.

With investors suffering these self-inflicted wounds, “alpha is a sideshow,” said Hsu. In other words, it hardly matters whether funds beat the market if investors keep beating themselves up.

My Take-Away: Yes, yes, 1,000 times yes. We cannot pound on the behavior drum enough. But it seems as though no matter how loudly the drum beats, investors keep marching in the same direction, following one another over the cliff. Is there any hope for us? Can we rewire our lizard brains? I'd argue no, though we can try to trick ourselves.

Here are a few tips I’d offer:

1) Don’t look at your portfolio too often. You’ll be tempted to tinker, and tinkering is hazardous to your wealth.

2) Keep a journal documenting your investment decisions. This will help you to learn from past mistakes and hopefully give you better odds of replicating past successes.

3) Implement a self-enforced cooling-off period. Put 24 hours between the time that you make an investment decision and the time you spend executing that decision. This should help to keep emotion out of the process.

Never Quit I had the honor and privilege of introducing this year's luncheon keynote speaker, Rob O'Neill. He was a SEAL Team Six leader and is one of the most highly decorated combat veterans of our time--a true American hero. O'Neill's mantra is "never quit." For an hour and 15 minutes, O'Neill held our attention (not a fork dropped, not an email checked) with his stories from SEAL training and special operations.

The key lessons O’Neill shared during his talk were the importance of preparation, of controlling your emotions, and of never giving up. According to O’Neill, the best plan ceases to be the best plan as soon as it leaves the planning room. Faced with uncertainty, chaos, and extreme emotional stress, it is critical to keep one’s emotions in check. O’Neill said that our first instincts are typically our worst. Only countless hours of training and emotional discipline can help us overcome these instincts. Per O’Neill, panic breeds panic and calm breeds calm. The former is unproductive, and the latter will keep you on track. Above all else, O’Neill urged his audience to never quit.

My Take-Away: O'Neill learned these lessons in the highest-stakes scenarios imaginable. However, they're every bit as relevant in the much lower-stakes setting of investing to reach your financial goals. Particularly relevant is the importance of controlling your emotions and remembering that your first instinct is typically your worst.

[1] Asness, C.S., Frazzini, A., Israel, R., & Moskowitz, T.J., 2015. "Fact, Fiction and Value Investing." J. Portfolio Management, Vol. 42, No. 1, P. 34.

[2] Asness, C.S., Frazzini, A., Israel, R., & Moskowitz, T.J., 2014. "Fact, Fiction and Momentum Investing." J. Portfolio Management, Vol. 40, No. 5, P. 75.

[3] Hsu, J., & Viswanathan, V., 2015. “Woe Betide the Value Investor.” https://www.researchaffiliates.com/Production%20content%20library/ Woe%20Betide%20the%20Value%20Investor.pdf

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