The Fable of the Deserted Beach

Imagine you're on an adventure in the Caribbean and you discover a beautiful deserted beach. While the mass tourists crowd the crowded beaches of the all-inclusives, you spend your vacation lounging in your own little piece of paradise. Back home, you tell your story to a few friends. When you return to your "deserted beach" the next year, you find that not only are your friends there, but they have invited other friends. The third year, a tour operator opens a weekly flight to the beach and it's only a matter of time before hotels are built there. Goodbye deserted beach!

What does this have to do with investments?

In the early 90's, financial academics discovered the equivalent of deserted beaches in investing! By analyzing databases (new at the time), they demonstrated that by selecting stocks with certain characteristics (the stocks that had risen the most in the last year, those with the lowest price/earnings ratio or those that were the least volatile, for example), it was possible to build portfolios that generated higher returns than the stock market indices. The first firms to exploit these "factors" - AQR in the U.S. and Bolton Tremblay in Canada - did indeed generate very attractive returns.

Charter flight to poor performance

Unfortunately, like the proverbial deserted beach, these factors have not remained secret for long. Today, no investment professional is unaware of these factors and many financial institutions have launched products to exploit them - the equivalent of a charter flight to the deserted beach! The result: these factors no longer work. Over the past five years, 12 of the 17 factors identified by S&P Dow Jones have underperformed the S&P 500 Index before fees and expenses. Considering that most of the strategies exploiting these factors require frequent trading (up to 3 times the portfolio in the case of momentum), the returns after fees are mediocre at best.

An example? I was recently reading a column by a financial advisor employed by a large financial institution. In it, she explained that the "smart beta" (not my term!) funds that the financial institution she works for has launched to exploit factors are an important part of her investment strategy. So I took the liberty of checking out the returns posted by these funds since their launch in early 2017. The "Canadian Multi-Factor" fund, for example, which seeks to beat the performance of the Canadian stock market, has a cumulative return as of July 31, 2019 of 4.5%, while the XIC Canadian Equity ETF's return was 13%. The investor who invested $10,000 in the multi-factor fund is now $850 poorer than if he or she had simply purchased XIC (which has an annual fee of 0.06%).

The moral of the story

Anyone who tells you that you can outperform the indices by exploiting quantitative "smart beta" strategies is probably selling you a charter flight to a deserted beach. You don't need to "beat the stock market" to achieve your financial goals. All you need to do is find a financial advisor who provides "smart advice".

Have a good back to school!