(Not so) Smart Beta

[TPI]

Seriously, what you are doing is very admirable. I'd do the same thing. To search and learn from others, see different point of view and take what is useful... what can be better than that? And RY is one of the guys you'd want to talk to.... could save you an entire university degree in finance and investment.

Thanks luutzu, yeah I think I would skip the university degree and just get the practically applicable knowledge any day!

 

[TPI]

This old article on Buffett, referencing a Yale paper, is interesting:

http://www.telegraph.co.uk/finance/...n-Buffetts-success-unveiled-by-academics.html

http://www.econ.yale.edu/~af227/pdf/Buffett's Alpha - Frazzini, Kabiller and Pedersen.pdf

"Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks."

So the article suggests to me the use of leverage along with tilts to value ("cheap"), low-volatility ("safe") and quality factors.

The main difference for individual investors though is that the cost of leverage is likely to be much higher than for Buffett, but at the present time still at historically low levels (eg. home loan variable rates <5% and negotiated margin loan variable rates <5.5%).

 

[DeepState]

This old article on Buffett, referencing a Yale paper, is interesting:

http://www.telegraph.co.uk/finance/...n-Buffetts-success-unveiled-by-academics.html

http://www.econ.yale.edu/~af227/pdf/Buffett's Alpha - Frazzini, Kabiller and Pedersen.pdf

"Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks."

So the article suggests to me the use of leverage along with tilts to value ("cheap"), low-volatility ("safe") and quality factors.

The main difference for individual investors though is that the cost of leverage is likely to be much higher than for Buffett, but at the present time still at historically low levels (eg. home loan variable rates <5% and negotiated margin loan variable rates <5.5%).

Yes....Buffett is a Smart Beta investor. His genius was realizing which betas to hunt within from very early on. Well before the idea was even expressed as anything like it. He then overlayed these with his own specific analysis....just like you (well, kinda sorta). I'm so very glad you found this paper. I hope it adds conviction to your path.

 

[luutzu]

This old article on Buffett, referencing a Yale paper, is interesting:

http://www.telegraph.co.uk/finance/...n-Buffetts-success-unveiled-by-academics.html

http://www.econ.yale.edu/~af227/pdf/Buffett's Alpha - Frazzini, Kabiller and Pedersen.pdf

"Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks."

So the article suggests to me the use of leverage along with tilts to value ("cheap"), low-volatility ("safe") and quality factors.

The main difference for individual investors though is that the cost of leverage is likely to be much higher than for Buffett, but at the present time still at historically low levels (eg. home loan variable rates <5% and negotiated margin loan variable rates <5.5%).

Buffett's leverage is not debt. As in, he doesn't go and borrow money to invest.

The leverage the article refers to is the "float" from his insurance companies or banks/finance companies like Amex. While these floats are technically liabilities and can be seen as debt/leverage, they're more like free money loaned to his companies as insurance premium (ones that may never need to be repaid if no claims are made) or floats from travellers cheques that earn interests while it's not yet drawn or lost cheques etc.

So while technically the article might be right that Buffett uses leverage/debt, I think a proper way to see these liabilities is it being him buying good businesses that, in the medium/long term, actually earn most of their floats/"liabilities"... or at least get to use it before it is actually theirs.

That I think is very different from the traditional definition of debt and leverage where the company simply borrow money.

---

What modern finance tend to do, and all academics and "scientific" approaches tries to do, is to quantify observations and create models and formulae... So they look at Buffett and either see his achievements as outliers and so not statistically significant; that or like these guys and look at the leverage his businesses provide and see it as simply debt so then conclude that leverage and debt plays an important part in his success and not the business.. then like here, say he focuses on value, take more risks... then define value as something like P/B ratio or P/E ratio; define risk as fluctuations against an index's price movements... then if that fails, try a smarter version.

It's basic in finance and accounting that whether a number or ratio is good or bad "depends"... it depends on the context, the various other factors and their impact on the business... and if we were to make proper sense of the factors that influence the performance of a particular business/investment, we might as well look at the individual business and its various influences.

I mean, it's good to buy valuable businesses at reasonable prices... but it's much better to buy them at bargain prices. How do we know when a business is a real bargain if we do not know it thoroughly? How do we get the courage to really commit on the rare few occasions when the market is really really wrong if we don't know enough?

If a company we kinda sorta is familiar with were to drop by 50%... and we don't really know the business, chances are we'd either abandon or hold on and pray. It's just common sense to follow the herd when you don't know what's going on.

---

General investment principles, general market trends, general influences from macro/political policies... all these most of us could kinda guess as to its influence - generally. But if we want to be generally right, might as well buy an index fund and go fishing. I don't know of any great fortunes or great businesses that were build from general understanding.


Take a general rule of thumb about Enemy at the Gates.

If you're the commanding general in a castle with 100 troops and an army of 200 000 is at your gates... what would you do?

Rule of thumb is you either surrender and may save some civilian lives; that or lock the gates and fight to the death. But the wisest thing to do may be to open the gate and act as if nothing is happening. It all depends on the situation.

If the enemy is Genghis Khan or Santa Anna at the Alamo, opening the gates will just end you very quickly and very painfully. But if your enemy is Sima Yi and you're Zhuge Liang, opening the gate wide and play a nice tune atop the walls will save your entire city.

 

[The Falcon]

This is a great thread and one that I will come back to. Really trying to get a handle on whether any of the strategy ETFs actually cut the mustard in a taxable environment. Earlier in the thread pointed out that RVL (Russell Australia Value) has an unacceptable turnover, essentially killing its "on paper" advantage over a dumb index, now I have also looked at Market Vectors QUAL product, fees of 75bps and turnover of 25% p.a. suggest that it will struggle to beat the dumb indexes too. Really seems that value or quality tilts are hard to make work in ETF form, in a taxable environment. Appreciate feedback from RY and others on this.

 

[DeepState]

This is a great thread and one that I will come back to. Really trying to get a handle on whether any of the strategy ETFs actually cut the mustard in a taxable environment. Earlier in the thread pointed out that RVL (Russell Australia Value) has an unacceptable turnover, essentially killing its "on paper" advantage over a dumb index, now I have also looked at Market Vectors QUAL product, fees of 75bps and turnover of 25% p.a. suggest that it will struggle to beat the dumb indexes too. Really seems that value or quality tilts are hard to make work in ETF form, in a taxable environment. Appreciate feedback from RY and others on this.

Welcome back. Hope you had a great break.

What is the tax environment that you house your investments within?

 

[The Falcon]

Cheers RY, I've attached a quick iphone Pano shot of White Beach, Boracay, right in front of EPIC/D'Mall....for you , also a bit of time in Manila for work but not so photogenic as you can imagine.

Two environments ;

- SMSF
- Family Trust, lowest tax beneficiary approx. 30% at the moment, probably max in a couple of years though due to distributions from private company shareholding.

 

[TPI]

Buffett's leverage is not debt. As in, he doesn't go and borrow money to invest.

The leverage the article refers to is the "float" from his insurance companies or banks/finance companies like Amex. While these floats are technically liabilities and can be seen as debt/leverage, they're more like free money loaned to his companies as insurance premium (ones that may never need to be repaid if no claims are made) or floats from travellers cheques that earn interests while it's not yet drawn or lost cheques etc.

So while technically the article might be right that Buffett uses leverage/debt, I think a proper way to see these liabilities is it being him buying good businesses that, in the medium/long term, actually earn most of their floats/"liabilities"... or at least get to use it before it is actually theirs.

That I think is very different from the traditional definition of debt and leverage where the company simply borrow money.

Sure I appreciate that, but the basic premise of using some form of leverage still makes a lot of sense to me. For Buffett it maybe free or low cost, but for the rest of us who don't own insurance businesses then we just have to accept that it will come at some cost, that is just reality. If you use leverage that is not subject to margin calls that is of course even better, and will make you more likely to withstand large drawdowns without fire sales just as Buffett has.

 

[TPI]

Yes....Buffett is a Smart Beta investor. His genius was realizing which betas to hunt within from very early on. Well before the idea was even expressed as anything like it. He then overlayed these with his own specific analysis....just like you (well, kinda sorta). I'm so very glad you found this paper. I hope it adds conviction to your path.

Thanks RY, yeah this is also what the authors suggest about Buffett in the paper.

 

[DeepState]

1. I've attached a quick iphone Pano shot of White Beach, Boracay, right in front of EPIC/D'Mall....for you , also a bit of time in Manila for work but not so photogenic as you can imagine.

2. Two environments ;

- SMSF
- Family Trust, lowest tax beneficiary approx. 30% at the moment, probably max in a couple of years though due to distributions from private company shareholding.

1.




2.

In comparison to Vanguard VAS which charges 0.15% fees and has about 4% underlying turnover based on annual reports...just as an indication...I know this is domestic and you are looking at international, but I can get the annual reports for this one...

These Alternative Betas are expected to generate something like 1-2% per annum over the standard indices over time. Global developed market indices have lower yield than domestic equivalents. When you work it out, it falls into the grey zone for 30% tax. I would call it a wash if the comparative funds are massive and everything else you are saying is taken as given. It is more likely to be sensible for a SMSF environment and looks likely to be a positive, if incremental, move to make.

However, in the particular instance of MarketVectors, the ETF you are looking at is tiny. Market maker movements into and out of the unit will create very large turnover beyond index related movement. In an expectations sense, that pushes it out of the grey zone for me and into the avoid-like-the-plague zone. Perhaps you can get cheaper and larger versions listed elsewhere. These may be listed in the US or UK for example.

Basically, you have the tools to work it out. The bulk betas are worth about 1-2% per annum before tax and fees. A switch from index will make more sense if the fees are at or lower than ~50bps per annum for SMSF environments. If those conditions are met, there is a reasonable chance that smart beta will add value in the aggregate if the underlying ETF is well behaved in terms of unit creation/destruction with underlying turnover in the range that you have specified.

 

[DeepState]

Sure I appreciate that, but the basic premise of using some form of leverage still makes a lot of sense to me. For Buffett it maybe free or low cost....

Good of you to raise the float costs.

This float is a form of working capital for insurance companies. Every insurance company has them. The valuation of premiums takes into account the fact that some investment income is earned on them. Hence, if you expect that you will need to pay out $100 in a year, the premium you will require is less than that (expenses etc aside). So, the absence of an explicit interest charge emanating from the float against the company in an explicit sense doesn't make it non-existent.

The float actually isn't free by any means. You can infer the cost of it from looking at other more traditional insurance companies if you like. That is actually the charge against Buffett's investment earnings for using these assets. For greater clarity, Buffett's investment earnings should really be broken down into a "covering the float opportunity cost" component and a "surplus performance" component.

Whilst the cost of float would be lower than what the average person on the street could get on a loan, the margin between their leverage costs and Buffett's is not as large as often assumed once it is realized that the float cost is most certainly not zero.

 

[TPI]

What modern finance tend to do, and all academics and "scientific" approaches tries to do, is to quantify observations and create models and formulae... So they look at Buffett and either see his achievements as outliers and so not statistically significant; that or like these guys and look at the leverage his businesses provide and see it as simply debt so then conclude that leverage and debt plays an important part in his success and not the business.. then like here, say he focuses on value, take more risks... then define value as something like P/B ratio or P/E ratio; define risk as fluctuations against an index's price movements... then if that fails, try a smarter version.

It's basic in finance and accounting that whether a number or ratio is good or bad "depends"... it depends on the context, the various other factors and their impact on the business... and if we were to make proper sense of the factors that influence the performance of a particular business/investment, we might as well look at the individual business and its various influences.

I mean, it's good to buy valuable businesses at reasonable prices... but it's much better to buy them at bargain prices. How do we know when a business is a real bargain if we do not know it thoroughly? How do we get the courage to really commit on the rare few occasions when the market is really really wrong if we don't know enough?

If a company we kinda sorta is familiar with were to drop by 50%... and we don't really know the business, chances are we'd either abandon or hold on and pray. It's just common sense to follow the herd when you don't know what's going on.

---

General investment principles, general market trends, general influences from macro/political policies... all these most of us could kinda guess as to its influence - generally. But if we want to be generally right, might as well buy an index fund and go fishing. I don't know of any great fortunes or great businesses that were build from general understanding

luutzu, you are right that specific and deep understanding and insight into a business is important, and in an ideal world we would all aim to achieve this for all the stocks we choose to own.

But we all have different constraints on our time that limit our capacity to do this to the fullest extent possible and to the level of mastery that you are perhaps suggesting.

You seem to be advocating an all or nothing approach, but I'm not sure how realistic that is, particularly for part-time stockmarket investors?

Even the know nothing approach of using index funds/ETFs may not achieve the right outcome in terms of tax efficiency and also income requirements if that is important to you.

In any case at the end of the day, investing is not rocket science either, so I think there is some merit in thinking broadly and strategically and in not over-complicating things as well.

And I believe that you can gain a broad and deep insight into the important and material drivers of a business without necessarily going into enormous minutiae in your research and analysis.

In doing this of course you have to accept a level of risk and that you may lose your capital in doing so, but you just have to choose the right position size, diversify, watch your investment closely and take corrective action early if you need to (ie. not buy, hold and pray)... all pretty basic stuff really.

If you're not comfortable with this risk, then fine, there is always residential property, commercial property, hybrids, bonds etc...

 

[luutzu]

luutzu, you are right that specific and deep understanding and insight into a business is important, and in an ideal world we would all aim to achieve this for all the stocks we choose to own.

But we all have different constraints on our time that limit our capacity to do this to the fullest extent possible and to the level of mastery that you are perhaps suggesting.

You seem to be advocating an all or nothing approach, but I'm not sure how realistic that is, particularly for part-time stockmarket investors?

Even the know nothing approach of using index funds/ETFs may not achieve the right outcome in terms of tax efficiency and also income requirements if that is important to you.

In any case at the end of the day, investing is not rocket science either, so I think there is some merit in thinking broadly and strategically and in not over-complicating things as well.

And I believe that you can gain a broad and deep insight into the important and material drivers of a business without necessarily going into enormous minutiae in your research and analysis.

In doing this of course you have to accept a level of risk and that you may lose your capital in doing so, but you just have to choose the right position size, diversify, watch your investment closely and take corrective action early if you need to (ie. not buy, hold and pray)... all pretty basic stuff really.

If you're not comfortable with this risk, then fine, there is always residential property, commercial property, hybrids, bonds etc...

Yea, there is the cost-benefit tradeoffs. Phillip Fisher raised this very same issue you're saying in his book. That an ideal level of understanding would require an investor/analyst to look over the accounts year by year; study the trade journals, analyse the impact of costs and competition etc. etc. Who have time for that? I agree.

I can't remember what his suggested solution was exactly but it seem sensible to not go into too much detail yet not then just speculate either. That if you want to guess the guy's weight, you got to at least look at him a bit and not just ask what his age and ethnicity is and blindly assume it ought to be around the average of that group.

So you're right that there ought to be a balance. But I think that if the balance is between knowing the business "enough" and leaning towards general macro or other generic fundamental measures like beta or smart beta... to me I would lean more towards understanding the business itself.

I mean, you could spend enormous amount of time balancing and rebalancing your portfolio so it doesn't fluctuate too wildly against the market; or too far off from some index or variables... I'd rather devote more time to knowing the business and its industry because I found that once I know enough about the particular business, I could make decisive judgment about its value in the future without too much fuss - once you've studied a big business in detail, it tend not to change that much and so when the price is right, you'd just know it.

I think Fisher was saying that of the 100 companies he look at, he might be interested in two. Of the two he's interested in, he might only like one after a visit to management. We might be luckier and like 20 out of 100, but the prices are often either too high or not interesting enough... and so we wait until it get interesting.

Anyway, I just do what I can with the tools and resources I have, so yea.

 

[TPI]

Yea, there is the cost-benefit tradeoffs. Phillip Fisher raised this very same issue you're saying in his book. That an ideal level of understanding would require an investor/analyst to look over the accounts year by year; study the trade journals, analyse the impact of costs and competition etc. etc. Who have time for that? I agree.

Exactly, who has the time for this?!

And speaking of Phillip Fisher, I have a Phillip Fisher book on my list of books to read, but haven't bought or read it yet as I'm still not finished reading a book by Peter Lynch I bought 6 months ago! Back in my university days I would have knocked these over in a few days. I first started reading about stocks when I was 19, then stopped soon after and started only reading about property and only investing in property for the next decade+. I only got back into reading and investing in shares in the last few years. If I hadn't have been so single-minded in my choice of investment vehicle I might have read a few more books on shares by now, but it's still not too late and hopefully I will get around to reading these classics over the next few years!

So you're right that there ought to be a balance. But I think that if the balance is between knowing the business "enough" and leaning towards general macro or other generic fundamental measures like beta or smart beta... to me I would lean more towards understanding the business itself.

Me too, I think we are on the same page here. With the smart beta stuff, once you know what it's about that's it, it may influence your broad portfolio construction/portfolio strategy if you agree with it but that's about it, so shouldn't really consume any ongoing time.

I'd rather devote more time to knowing the business and its industry because I found that once I know enough about the particular business, I could make decisive judgment about its value in the future without too much fuss - once you've studied a big business in detail, it tend not to change that much and so when the price is right, you'd just know it..

Agreed, that sounds sensible.

 

[luutzu]

I do my reading while on the throne So there's a book I've been reading for a year now and it's only half way.

Try audio books from torrent or download them from YouTube. I listen while working so sometimes I missed half or miss completely... but it tend to make up after a few repeats.

 

[TPI]

Whilst the cost of float would be lower than what the average person on the street could get on a loan, the margin between their leverage costs and Buffett's is not as large as often assumed once it is realized that the float cost is most certainly not zero.

Good point and if you look at margin loan interest rates on US stocks in USD, they are now as low as 1.12% pa for loans between 100k and 1M with Interactive Brokers, which to me is pretty close to zero anyway.

 

[TPI]

I do my reading while on the throne So there's a book I've been reading for a year now and it's only half way.

Try audio books from torrent or download them from YouTube. I listen while working so sometimes I missed half or miss completely... but it tend to make up after a few repeats.

Haha, thanks yeah I might look into a few audio books for the drive to work and back.

 

[DeepState]

Good point and if you look at margin loan interest rates on US stocks in USD, they are now as low as 1.12% pa for loans between 100k and 1M with Interactive Brokers, which to me is pretty close to zero anyway.

Unbelievable. What am I missing? From IB you can finance a portfolio of stock more cheaply than you can borrow money for a residence in Australia??? The IB loan rate for Aus is 3% for $1-20m. The RBA survey rate for discounted variable mortgages out of the banks is 5.1%. The mortgage is not tax deductible either.

https://www.interactivebrokers.com/en/index.php?f=interest&p=schedule2

 

[TPI]

Unbelievable. What am I missing? From IB you can finance a portfolio of stock more cheaply than you can borrow money for a residence in Australia??? The IB loan rate for Aus is 3% for $1-20m. The RBA survey rate for discounted variable mortgages out of the banks is 5.1%. The mortgage is not tax deductible either.

https://www.interactivebrokers.com/en/index.php?f=interest&p=schedule2

View attachment 60776

Yeah, our rates are pretty expensive by comparison! The main difference is that in the US your shares are not held in your own name, they are held in the name of the broker in trust for you or something like this. So there is some risk if the broker goes bust, which is not the case here in Aus with our CHESS system. But they have an insurance policy through the "SIPC" that covers them for this to some extent. Some investment banks in Aus use a similar structure to give margin loan rates around 4% or so, but still not as cheap as Interative Brokers. There's a few other differences, like no margin calls, ie. they can just sell the shares when you breach the max LVR without telling you and the max LVR is about 50%, so much lower than you can get here. They recently just stopped offering margin to Aus investors due to some licensing issue in Aus, but only for accounts in your own name, trust accounts were still ok the last time I checked. I would consider using them for only a portion of my lending, but for peace of mind have stuck with regular Aus margin lenders to date.

 

[The Falcon]

1.

View attachment 60768


2.

In comparison to Vanguard VAS which charges 0.15% fees and has about 4% underlying turnover based on annual reports...just as an indication...I know this is domestic and you are looking at international, but I can get the annual reports for this one...

These Alternative Betas are expected to generate something like 1-2% per annum over the standard indices over time. Global developed market indices have lower yield than domestic equivalents. When you work it out, it falls into the grey zone for 30% tax. I would call it a wash if the comparative funds are massive and everything else you are saying is taken as given. It is more likely to be sensible for a SMSF environment and looks likely to be a positive, if incremental, move to make.

However, in the particular instance of MarketVectors, the ETF you are looking at is tiny. Market maker movements into and out of the unit will create very large turnover beyond index related movement. In an expectations sense, that pushes it out of the grey zone for me and into the avoid-like-the-plague zone. Perhaps you can get cheaper and larger versions listed elsewhere. These may be listed in the US or UK for example.

Basically, you have the tools to work it out. The bulk betas are worth about 1-2% per annum before tax and fees. A switch from index will make more sense if the fees are at or lower than ~50bps per annum for SMSF environments. If those conditions are met, there is a reasonable chance that smart beta will add value in the aggregate if the underlying ETF is well behaved in terms of unit creation/destruction with underlying turnover in the range that you have specified.

1. Ha.

2. Cheers RY. Great info and appreciate your confirmation of what I was thinking. I've come to; if you are going to index..then index. So, a portfolio with ETFs at its core might look like; VAS and VTS (I am leary on Europe long term), then pick up the "smart Beta" from larger tilts to US Small Caps and Emerging markets, via cheap, dumb index ETFs.