While I think these types of ETFs have a place in certain portfolios, I believe investors need to have a better understanding of what they are investing in and why. One must understand that when you buy a momentum factor ETF and growth stocks go out of favor, the ETF will likely underperform the market. It may make someone feel cozy to know they own an ETF that exhibits low volatility, but will they continue to own the ETF when low volatility stocks underperform?
This leads me to my main point: good investors should focus on diversification and having an open mind when it comes to investing. My former boss, Ensign Cowell, once told me that when he founded his firm over 30 years ago their investing mantra was “investing for all seasons”. Meaning, they did not constrict themselves to being just “growth” or “value” investors. Instead, they wanted to invest in companies that would do well in different market environments. They sometimes purchased “out of consensus” stocks that had been hated by growth investors or they would buy stocks that had very expensive valuations that were not liked by value investors. I have read many mutual fund strategies and many of them sound exactly the same because they espouse to buy high-quality companies at reasonable valuations. I have never heard of anyone who wants to buy low-quality companies at high valuations. It is difficult to outperform the market when everyone is looking for the same thing.
So often, money managers get caught up in “fighting the last war,” meaning that they can’t get past previous market events. They stick to their guns and may not realize that the world is changing and so are trends in the market. The stock market is a chaotic place that has very little regularity. Having a portfolio of stocks that have a mix of the factors listed above allows investors to participate in market cycles while not having to worry about having to make major shifts in investment strategies. As we know, human beings are biased and overconfident in their abilities (read previous blog: We've All Been Misbehaving). Just because you were successful during one market cycle doesn’t mean you will be in the next one.
Being humble, having an open mind and admitting your own mistakes in investing (and life) allows you to question your own investment process and find ways to improve upon it. One of the best examples of this is how Warren Buffett previously shied away from investing in technology companies because he didn’t understand them. Take a guess at the largest stock holding at Berkshire Hathaway? You guessed it - its Apple. Buffett recently negotiated a deal to invest in Uber but could not come to an agreement on price. Last year, Buffett was asked why he hadn’t purchased shares of Amazon and his response was “stupidity”. Has Buffett lost his mind? No, he is flexible in his thinking and admits when he makes mistakes. I don’t want to speak for the fans of Berkshire Hathaway, but if you asked them why they didn’t invest in Amazon, I would guess the majority of the responses would be “valuation,” not “stupidity”.
In the end, the best investors focus on diversification, aren’t overconfident and don’t allow past events to cloud their judgment. While this is all very easy to write, it is difficult to do in practice and is something I constantly remind myself of when working on client portfolios. Thinking you are the smartest person in the room and making big bets is fun and enthralling, while being diversified can be viewed as "boring". I liken this to what Warren Buffett once told Jeff Bezos “…no one wants to get rich slowly.”