Pages Menu

Posted by on Mar 2, 2016 in ETF Strategist, Investment Perspective

Hindsight Bias & Incorrect Expectations

Hindsight Bias & Incorrect Expectations

By Roger Nusbaum, AdvisorShares ETF Strategist

The Barron’s cover story read like a paid advertisement for a mutual fund company. Paid advertisement or not, the company in question was featured for how well its liquid alternative funds have been performing since the broad equity market started to roll over last summer.

Of more interest than the article was a reader comment that both isolates yet misses a key point of active portfolio management (as a note, even if you use passive ETFs, there’s a good chance your strategy is at least a little active even if you don’t realize it).

The comment:

“…I just scrolled down to the table showing the YTD and 5 year returns. Not very impressive. BTW, just about anyone who is underweight stocks has beaten the market YTD.”

The table in question is a table of funds whose names include terms like market neutral, long/short and arbitrage. The reader misses the key point that the objective of these funds is to not look like the equity market which means they won’t go up anywhere near as much as the equity market during bull markets and will not look like the equities during bear markets (hopefully).

Generically speaking if a fund’s objective is to go up CPI plus 300 basis points then of course its returns will be “unimpressive” in a year when the stock market goes up 20%. That same fund would be considered a huge winner if it went up CPI plus 300 basis points in a year when the stock market goes down 20%.

Considering long term growth, nothing beats equities, again over the long term. We’ve all seen that Ibbotson’s chart back to the 1920’s, growth comes from equities. Of course equities carry the most volatility over the long term (I acknowledge and am intrigued by the theory that equities become less volatile the longer you hold them but that is a topic for a different post).

An investor using liquid alternatives should have the right understanding of their role in a portfolio and the proper expectations of what they can do. The role they play is to help smooth out the ride. In years past I’ve mentioned work by John Serrapere who wrote about a what he called the 75/50 portfolio which sought to capture 75% of the upside with only 50% of the downside. The math works for anyone who can achieve those numbers.

While achieving exactly 75/50 is difficult the concept is easy to understand, it is along the lines of the David Tepper quote about knowing when it is time to make money versus time to not lose money and has been a cornerstone to this blog since its inception; smoothing out the ride (repeated for emphasis) and avoiding the full brunt of large declines.

If this resonates with you then you probably use liquid alternatives (or diversifiers as I have referred to them before) and if it doesn’t resonate with you then you don’t use them.

The other point from the reader comment to address is that “just about anyone who is underweight stocks has beaten the market YTD.” If you are familiar with top down portfolio management then you’ve probably seen one of the many studies that conclude being in or out of the market is the most important decision that can be made, it accounts for 70% of what the portfolio’s return will ultimately be.

The comment reads like there’s a fair bit of hindsight bias, making the assumption that the decision to underweight equities is easy when we see and read investment professionals with plenty of experience get this wrong all the time.

Right here right now there are plenty of smart people who’ve made plenty of correct calls in the past who believe a bear market has started and plenty of smart people who’ve made plenty of correct calls in the past who believe we still in a bull market. One of those groups will be wrong.

If you participate in markets for an extended period then you will be wrong many times in that extended period, there is no avoiding getting some calls wrong. The idea is to mitigate the consequences of the times you are wrong which can be a topic for another post.