ETF Edge - Timing isn’t everything: Top ETF Strategy Pitfalls

Episode Date: March 8, 2021

CNBC's Bob Pisani spoke with Kim Arthur, CEO of Main Management, Wes Crill, Head of Investment Strategists and Vice President at Dimensional Fund Advisors and Dave Nadig, Director of Research at ETF Trends. They discussed sector rotation in full swing this year and the big debate over market timing; does it work and what are some of the biggest pitfalls and perils? In the 'markets 102' portion of the podcast, Bob continues the conversation about marking timing with Wes Crill from Dimentional Fund Advisors. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge Podcast is sponsored by InvescoQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange-traded funds, you're in the right place. Every week, we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani. The sector rotation in full swing this year, today we're taking a look at the big debate over market timing. Does it work? What are some of the bigger pitfalls and perils of trying to figure out when it's right to go in and out of the markets?

Here's my conversation with Kim Arthur, the CEO of Maine Management. West Crills, the head of investment strategist, and vice president at dimensional fund advisors, and Dave Nottings, the director of research at ETF trends. Kim, there's a lot more interest in market timing and rotation this year. I don't know if it's just in the air. Is that because we've seen so much rotation in different sectors this year with, you know, the reflation trade coming to floor and tech kind of taking the back seat? Yeah, Bob, good to hear your voice. Yeah, there's definitely been a lot more in the air, as you say. If you really can pinpoint it, it started at September 1 of last year.

And just to give you a real kind of like realized data point there, from September 1 of last year, you. from September 1 of last year, value through Friday, values up 19%, 1-9, growth is up two. And how about the MAG-5, Microsoft, Amazon, Apple, Google, and Facebook, they're down one. They're down one during that time. Why is that rotation happen? I think we think that after people realized there was not going to be a double-dip recession, rates bottomed in August, and as they saw them starting to move up, that's when you get the rotation that goes into the value in cyclical plays and the small cap.

And it's been historically, it's happened with that as people start to see real rates. We went from negative 45 basis points in the 30 year to where we're now positive 11. So all the tailwinds were all lined up for it to happen, and we're seeing the results, and we think it probably continues for a while. Now, you've got this sector rotation ETF, SECT. You move in and out of sectors, ETF sectors, not stocks, and it's been outperforming the S&P year to date

because you've had, it seems like, increased bets on banks, energy, and small-cap ETFs. How do you decide when to rotate the portfolio? I don't mean, like, describe what's happened. I mean, when do you actually rotate more into energy and rotate out of technology? What criteria do you use? Just briefly describe that.

I don't want to know how the market is doing it. How does, when do you do you, decide to get in now? Yeah, great question. So there's two parts to it, Bob, in our process. The first is valuation. We're big fundamental value people here. So we've got all kinds of data on looking at sector, size, and style for its historical valuation. It's price to book, price to price to earnings and dividend yield. So we look at that and it gives us a menu to choose from. But the menu alone is not enough. You need to have a catalyst. You've got to have a catalyst. So what we looked at with the financials, for instance, is a steepening yield curve typically

has been very, very bullish for that. And then you throw on top of it where they were prohibited from buying back stock. They were green lighted in the middle of December. So that's another tailwind for them or on the energy side you had two big things going on you had seven percent of the global supply taken out of the global area during the pandemic and we know with the with the vaccine rollout that's going on here demand is going to pick back up so demand was going to exceed supply but even more importantly here in the u.s we have an administration that is curtailing supply on federal lands where there's 20% of the supply that comes out of that. So again, it's the process for price valuation and then a catalyst.

You know, Wes, it's interesting to hear him talk about this. This kind of makes sense in terms of why rotate into banks, why rotate into energy. But Dimensional Fund Advisors has been studying market timing efforts for decades now. Could you summarize what you... have found out. Summarize the research and the academic literature on market timing for us. Yeah, thanks Bob. Thanks for having us on today. I think that just the greater kind of body of work that's been conducted on researching market timing strategies really goes back for about a half a century now, both from academics as well as practitioners. And whether they're looking

at it through the lens of stock picking, whether it's looking at the performance of active mutual funds, or whether it's looking at asset class timing strategies like managed future. types of approaches. By and large, the evidence points in the same direction, which is that these strategies tend to underperform passive benchmarks. And I think that, you know, to Kim's earlier points, you know, it's important for investors to be cognizant of the potential opportunity cost of trying to time markets, because for something like the value premium, we see that historically it has often showed up in large bunches very quickly. If you look back at the calendar year average for value versus growth, values outperform growth by about 4 percent per year.

years when that premium was positive, the level of outperformance was over three times that amount. And, you know, we see it even when we're just looking at the broad market. You know, if I look at the growth of wealth for the U.S. stock market, starting in 1970, going through the next 50 years, your total growth of wealth, if you missed out on the best day for the U.S. market, just one single day, your growth of wealth dropped by about 10%. And so, again, it's important for investors to understand what the potential implications might be if they do try and outguess markets. And this is consistent with a very competitive marketplace. It's incorporating millions of trades every day, accounting for hundreds of billions

of dollars. And that's a very comprehensive price setting exercise. And that's what you're up against when you do try and outguess markets. Yeah, I want to keep that. I wonder if we could put that up, that hypothetical growth of $1,000 of vests in the S&P, because in my mind, this is the easiest way to explain to people why market timing doesn't work very well. And the way you do it is just look at if you're not in the market on the best days. Now, Wes, you provided this information to us and I thank you for it. So this is the $1,000 invested in the S&P 500. Pick it on the first day of 1970. The total return you had today will be $138,000, believe it or not, in 1970. That's $1,000 invested in 1970. Just buy and hold the whole thing here. Wes, does this include

dividends the total return there that's a total return right so it includes dividends correct correct it is total return so this is a good reflection of okay so let me just finish the point i'll jump back in west so if you take out one day the single best day in the last 51 years you only have 124 000 instead of 138 if you take out the five best days in the last 51 years you only have 90 000 instead of 130 if you take out the 15 you have 52 instead of 138 and if you take out the 15 you have 52 instead of 138. And if you take out the best 25 days, you have 32,000 instead of 135,000. This is to me the easiest.

The problem, of course, as you have written before, Dave, my old friend, you've written about the folly of market timing. The problem is nobody knows what are those best 25 days that are out there, Dave. And so, therefore, this goes, logic tells you that it's very difficult to figure out market timing under any circumstances, Dave. Yeah, and I think this is also behind the rise of low volatility investing, because, of course, the math works the same way on the downside, too. If you miss the 10 or 25 worst performing days, you obviously massively outperform on the upside. And that really gave birth to a whole raft of strategies that sought to exclude all of the outliers and,

you know, quote-unquote smooth out your ride. And those strategies really haven't quite delivered the way people wanted them to in the sort of recent spikes. of, you know, VIX over 20. So I think it's reasonable for people to look at the market, see these outliers, and figure that there must be a better way. You know, history would suggest there really very rarely is a better way. But, you know, it's the Lake Wobagon problem. Nobody wants to be average, even though they know on average they're going to be. And certainly if you're a professional investor who's being paid to advise clients, it's very difficult to build that business on the back of trying to be as average as possible. Right. Now,

Well, Wes, long-term, the stock market tends to outperform. It's up year over year. The S&P 500 since 1928 has been up 72% of the time. That's a pretty good average, Wes. But as you know, there are years, and in some cases, many years, when it underperforms. Owning the broad market, and there's your statistic. People ask me, you know, is the stock market a good investment? I say, three out of four years, it tends to move up, but it doesn't mean it goes up every year.

So owning the broad market, Wes, seems to be the right play, but if market timing doesn't work, and I think we can agree that it'd be difficult to make it work, is there anything that does outperform? What is your studies shown? Obviously, you guys have emphasized value in small caps. Is there any evidence long term that that would be a better strategy in just owning the broader market? What outperformance can you possibly get out of the market? Yeah, certainly one way you could outperform markets is if you could predict when those negative. years are going to occur. Of course, this half century of historical evidence suggests that people can't consistently do that. But then the key point for investors to remember is you don't have to outguess markets to outperform them. And this is a function of not all stocks having the same expect to return, just like when different investors go to get a loan from the bank, they're not all going to receive the same interest rate. It's similarly for different stocks, they don't all have the same rate of return that's demanded by investors.

And we can see just through the principles of valuation that by combining variables related to the price of a stock and what we expect to receive in the future in terms of cash flows, we can identify these differences systematically, these differences in expected returns across different stocks. And by emphasizing these stocks with higher expected returns, so stocks that are smaller in market capitalization are lower in valuations, for example, price to book, and higher in profitability, we can identify a subset of the market with higher expected returns. and outperform just by using market prices and without trying to outguess or figure out where the market got things wrong. Yeah. The other thing I think that's very important to point out to people, and if they ask me all the time about this, what's the evidence? I say long-term stocks outperform bonds. You want to own generally, unless you're towards the very end of your life, you want to have a heavier weighting in stocks than bonds. And I'm going to put up that full screen, a dollar return since 1926. Again, West's in dimensional has provided this to us. It's rather remarkable. If you put a dollar in 19, going back to 1926, inflation would make that dollar, you know, essentially is pumped that up to $14. But long-term government

bonds, remarkably only $175. I find that amazing. But a dollar in a large cap portfolio would net you a little over $9,000, as small caps $25,000. Amazing, two things here, Wes, number one, $175 in long-term government bonds, that's sort of incredible, but small cap over very long periods of time still outperforms a big cap even though the last 10 years that has not been the case overall. Yeah, it certainly hints that just the awesome power of markets and the ability for equities to help investors to get to their goals in many ways if those goals involve how much their current savings can be used to afford consumption in the future. There's certainly an element of growing your invested savings.

And the stock market has been a very great avenue. Just in the US, when back in time, we're looking at about an average return of 10% per year for US stocks. And that is a very important contributor to many investors' long-term goals. And again, it gets back to this premise of trying to guess when the markets are going to be negative.

Well, if you end up missing the days when they're positive, those numbers you just showed on the screen might look substantially less impressive for an investor who is on the wrong side of the market timing. Yeah. So, Kim, let me just, I mean, I think West's point is very well taken. It's very hard to beat the S&P 500. Your sector rotation fund is beating the S&P this year. You've been around a little more than three years. It's done well. It's not outperform the S&P in three years. I see it up 50% versus 56% for the S&P 500. But it's not bad overall. You have a slight overweight. It looks like. and financials in health care this year and an overweight and an overweight and energy, too. I guess the issue is we still have demand for this kind of rotational vehicle at this point. And it seems to me like this is having a little bit of a moment.

Does this happen because we suddenly have seen these sort of very quick moves in sectors as a result, we have people talking about it more? Or is this just a part of a Reddit meme thing where people are suddenly just more interested in playing around with the market and active management in general? So, Bob, first of all, what I would say is I totally agree with the whole narrative here that we tell our clients,

it's time in the market, not timing the market. But under the cover there, again, we think that valuation does matter. So you can rotate from, expensive factors into cheaper factors, expensive sectors into cheaper. Let's not forget back in the 2000 bear market of the NASDAQ from March of OO to March of O2 before the recession took everybody out. The NASDAQ was down 61 percent, but the value line composite index, it's multiple from 10 times to 18 times. As one of your other colleagues on CBC, Jim Kramer,

says, there's always a bull market somewhere. So what's happened with our SECT, which like you said It's only been out for three years now, but it has a separately managed account that's been around since 2002. So we have a lot longer sweep of time. From 2002, it's beaten the S&P because we think over time we have been able to rotate into it. But remember since 2016, that large-cap NASDAQ concentrated Fab 5, that dominated everybody's returns. If you didn't know that, you were not going to outperform. That over concentration, we don't think, is healthy over the long term, and we think that's what you're seeing happening now as NASDAQ is now starting to underperform, and some of these other cheaper factors, these cheaper sectors, are outperforming. So we think that, as you said, they're energy, financials, value, cyclicals right now, they have more tailwind to go.

As I mentioned, I may have mentioned earlier here, the growth value. again, if you just take that factor, in a 10-year suite from 1995 to 2005, value went from growth went from being really cheap, and then in 2000 to really expensive, and then they cut it in half again. So these big cycles do happen in the past, and they will happen again because of the economy and price. And, Bob, I think there's opportunity here for active management, and I think that gets missed in some of the noise here, right?

I think Kim's exactly right. The large cap growth space in particular has been effectively impossible for active managers to do much about. And if you look at things like the Standard & Poor Spiva reports, they would suggest that over the last five years, effectively no managers have really been able to carve out a hole there that they can dominate. But if you look at things like mid-cap growth and small-cap growth, active management is actually having a great run on a one, three, five-year basis. the average active manager has actually beaten their benchmark if they're focused on that mid and small cap space. So I think we paint the market with this very broad brush. And to Kim's point, I think that belies a lot of what's going on under the hood. And there's always opportunity.

Yeah. And Wes, maybe you can put a bullet point on that. You guys, Hugh, very closely to index style investing, but you are active managers. You do have a value tilt, small cap, tilt. as well. I guess the question is, how do you get people away from the Get Rich Quick Reddit thing where you can see despite all the rhetoric about we've been oppressed and we've been disadvantaged? It does evolve into a get rich quick scheme, a lot of this Reddit stuff. How do you fight against that dopamine rush in the brain and encourage people to get rich slow? Do you feel you're making

progress? I've been doing this for 30 years. And someday, I feel like it, I think people sort of get it. And other days I feel like, oh, well, we're back to get rich quick pretty quickly. Yeah, certainly you start by appealing to the financial science. And the financial science, to your point, suggest that we can manage investment solutions in an active way. And what I mean by that is you can take the best benefits of an index type of approach, the broad diversification, relatively low turnover, low expenses.

And then you can add on an active component to it that helps manage risk and also increases expected returns by emphasizing segments of the market with higher expected returns. And the good thing about this is the premise behind pursuing these different premiums or emphasizing stocks that are lower in price and higher in profitability, you know, that's a higher expected return proposition 365 days a year. I wake up every day believing that if I pay a lower price for a higher expected future cash flow stream, then that's associated with higher expected returns. And the evergreen nature of that logic is a really important.

important component of the financial science. And then it just comes down to implementation, making sure that you're doing this in a low opportunity cost way, where you're managing really the day-to-day changes and the costs associated with pursuing these premiums. Yeah, very well said. And I want to pursue that a little bit more in the podcast. We've got to go, guys. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Markets 1002. portion of the podcast. Today will be continuing the conversation about marketing timing with Wes Krill from Dimensional Fund Advisors. Wes, thanks very much for joining us again. And I want to

just pick up on our conversation earlier about market timing. I think everyone agrees that it generally doesn't work. And yet what's amazing to me is just how prevalent it is. It doesn't ever seem to go away. I'm wondering if you could expound on why that is. I mean, It seems to me there's a behavioral economics answer to all of this. Market timing scratches that itch to get a little thrill out of some new outperformance, that dopamine rush from getting a bet on a horse, on a stock, on a sector, right somehow. Is there a behavioral economics explanation? Because we know the academic evidence is market timing doesn't work.

And yet there's a whole legion of people that still want to convince the world they can do it. Yeah, absolutely. I mean, market timing comes in different forms. For some, it might mean picking stocks, for others, it might be trying to time segments of the market, figure out when they can get in and out of the markets, preferably to avoid losses, I think in some cases. When you look at the evidence, broadly speaking, it suggests that active management or trying to time markets by and large doesn't add value over passive benchmarks.

That's not to say that you don't end up seeing eye-popping results when you look at individual mutual funds. You know, that's one thing we see with enough people flipping coins in a ballroom, sooner or later you're going to have someone that gets 10 heads in a row just by chance alone, even if there's no actual skill. And so I think that part of the allure for trying to tie markets is sourced in seeing some of these investment strategies that at least historically have had really strong returns compared to the market. But again, if we just look at how competitive the marketplace is, the amount of trade volume within equity markets, you know, I think I've mentioned before, that on an average day in 2020, equity markets saw about $650 billion worth of trade volume.

And that's really what you're going up against when you try and outguess markets. So a daunting proposition, to be sure. Yeah, I'm an efficient market hypothesis guy, too, but we both agree there are micro inefficiencies in the market that enable people to do better on one day over the other. The problem is just, you know, it's sort of like the inability to get people to sit still in a room. They can't. The humans have this need to just keep moving around, trying new things. We're innovative species, and that includes buying and selling stocks. You know, Bogle's old line don't just do something, stand there. It is a really hard thing to do, you know, just in terms

of what human beings are like. You know, Wes, one of the things that's interesting to me is one of the reasons that I have found the active management community really despises the academic community is that the academic community has called out the active management community over their failure to outperform over the year. So understandably, their livelihood is threatened by the academic community. But another thing I have noticed is one of the reasons the academic community has a fairly low opinion of the financial press, which would be me, by the way, is that we often give way too much publicity and credence to active advisors. And it's true. I mean, every financial reporter has reported on the latest hedge fund manager outperforming and suddenly made him a superstar

going back into the 1970s on this. So, you know, I keep coming back to this behavioral level where people want to see who's winning and losing, the horse race, as we like to call it. And yet, it's very hard to get people to be disciplined about how they believe in things, how they should believe in things in the long run. How do you feel about the 10% rule? A lot of people say, look, if you're really got the itch to try to do market timing or to day trade or actively manage, you know, on a really, almost daily level, take 10% of your money and play around with it. But for heaven's sake, keep the rest in a relatively safe area. Does that advice make any sense?

I'm trying to figure out a way to let people scratch the itch and not be idiots. So when I think about just the active landscape and implementation versus academic, even if we take sentiment out of it, there is an adding up constraint, right? This is known as the arithmetic of active management, a term that was coined by Bill Sharp many, many moons ago, where if you look at the overall marketplace and you take out passive, you're basically taking out a pro rata slice of the market. So then what is left over is the market. The return on that portfolio of active managers is the rate of return on the market

before fees and expenses. Now we know after fees and expenses, in aggregate, they have to be getting less than the overall market. The constraint really does apply at all times. That's not a model. That's just simple arithmetic. So then the question for investors is whether they can identify, certainly in that population of active managers,

you can have both winners and losers? And the question is, can you identify the ones ex ante, not ex post when you've seen their returns, but can you identify the mid-advance, which ones are going to outperform and how you disentangle skill versus luck? There's been a lot of academic attention devoted to this, and they find that generally you can't extricate

those two components of skill versus luck. So then it comes down to investors and maybe how sensitive they are to the potential opportunity costs. We do know that missing out on the best days in the market can greatly harm an investor's long-term growth of their savings. And so it's where you land in that trade-off versus the potential opportunity costs and the potential gains if you actually can identify a skilled manager. Yeah.

I want you to go back to Sharp's comment earlier because Sharp's famous paper is is really one of the groundworking pieces of research that's ever been done. Now, go back and say this a little slower so people can absorb this lesson. It's critical to understand this. Your point is that take out the passive part of the market. What you've got left is the active research part of the market or the active investment part. And Sharps, summarize Sharpe's insight about that. Just explain that to people.

It's very important they understand that. Yeah, a simple analogy is, a bucket of paint, let's say it's blue paint, and I take out a scoop of the paint. I'm going to call that the index portion, index funds at this point are much larger than a scoop of the market. But if I take out a scoop of the blue paint, what color is a paint that's still in the bucket? Well, it's blue. And that's the way to think about the slice of the market that's left over for active investors once you take passive approaches out, which means that in aggregate, the rate of return is the market. So for one manager to have a higher rate of return

than the markets, it has to come in the expense of another active managers, not coming at the expense of passive managers. This is what we talk about with that adding up constraint. So if the total return prior to fees and expenses on that portion of the market is the market's return, that means what's left over is the market minus average fees and expenses. So that adding up constraint means that you've got to be able to find one that is going to outperform at the expense of the others, and it's not clear investors can do that on a going forward basis. Right. So the important point is that passive management has been increasing, which means the pie that's left for the active managers is smaller, meaning it's getting more difficult. Is that

a correct way to look at it? Well, certainly we've seen growth in index funds. I think at this point they're about the size of the active management landscape within equities. But, you know, again, it really comes down to, it doesn't really have an implication for whether you would choose necessarily one versus the other. I think the increase in index fund asks. that doesn't mean that active funds are going to be any better or worse going forward, because, again, no matter how big the passive segment of the market gets, you still have the adding up constraint for the active managers.

And so they can only win at the expense of each other. By the way, how would you characterize dimensional funds? People ask me about dimensional, I say, well, it's like Index Plus. You're an active manager, but you're closely hewed to indexes. In your own words, how would you describe Dimensionals' investment philosophy? Certainly we start off with what we think of are the most appealing attributes of index investing, having broad diversification, low turnover, low expenses, and then we combine that with an implementation that is active.

And what I mean by that is we have a daily process to assess expected returns and risks of securities in the portfolio. And then you're using that daily process to keep an emphasis on stocks with higher expected returns in the market. So you can keep many of the appealing attributes of passive investing, but target higher expected returns than the market. And again, that's just using market prices. This is an approach to outperform markets that does not involve trying outguess them. Okay. I want to let everyone know that if you want more information on dimensional funds, I've been following them for many, many years. They've got a lot of very, very solid research behind them. I've got some Nobel Prize winners, including Eugene Fama, that's on their board with

them. The site is Dimensional.com. Is that right, Wes? Got that right? Dimensional.com is the site. I believe so. I've been to the public site in a while, but I believe, I'm pretty sure if you Google dimensional fund advisors, you will be taken to our homepage. Yeah, dimensional fund advisors are where you want to go. There's very good stuff that's on the public part of the website for people who want some basic information on investing, and I mean long-term investing. And I mean long-term investing. And I think very highly of the research that Dimensional has put in over many, many decades. A lot of work has gone into understanding the markets by these guys. Wes Krill, thanks very much for joining us.

Wes is the Vice President of Research and Dimensional Fund Advisors. Everybody, again, healthy, happy, and safe, trading week. InvescoQQQQQ believes new innovations create new opportunities. Here's the greater possibilities together. Learn more at Invesco.com slash QQQ. Invesco Distributors, Inc.