Want to succeed at investing in the 21st century? Remember this: Don’t eat too many coconuts.
History is full of strange characters and a man named August Engelhardt might be the strangest. In the early 1900s, he made a small coral island in Papua New Guinea his home. The land consisted of a small plantation.
He gave up clothing and subsisted on a diet only of coconuts. His steadfast belief in ‘cocoivorism’ and ample outdoor living was his attempt at immortality. He encouraged others to join the ‘Order of the sun.’ However, man cannot live on coconuts alone. He died at 43.
The lesson: variety matters.
Investors take note: Limiting your appetite for innovation can be detrimental to your financial health. Today, investors have access to more financial products than ever. This variety empowers people to diversify their holdings and capitalise on new trends.
In this article, we will explore the potential of three innovative solutions for investors. They are:
1. Smart Beta
3. Auto Investing
Evolved Investing: Smart Beta
The ‘Smart Beta’ strategy argues that everything we believe about indexing is wrong. Index investing consists of buying a broad group of stocks to capture the entire market. Exchange traded funds (ETFs) have become an easy way to do this. Each ETF share represents a basket of stocks. Instead of buying shares of each company in the S&P 500 you can buy one ETF.
If you looked at this ETF under a microscope, you wouldn’t see 500 equal-sized pieces. Some companies are big. Other companies are small. Therefore, larger companies represent a more significant portion of the ETF. Size is measured by market capitalization (outstanding shares x individual share price). Smart Beta argues this method is flawed. Why? Just because a company is big (large market cap) doesn’t mean it’s good. Enron was big at one time.
Therefore, Smart Beta ETFs don’t use market capitalization to determine proportions. Instead, proportions are based on different criteria. What criteria do Smart Beta ETF designers use? They focus on characteristics (‘factors’) like momentum, value, dividend, quality and volatility. For example, stocks with the highest dividend payout are the biggest piece of a dividend Smart Beta ETF.
Let’s look at what the other characteristics mean:
The idea is simple; winning stocks will continue to win. Losing stocks will keep losing. In a momentum, Smart Beta ETF stocks with the strongest recent performance lead the team.
Stocks that appear inexpensive relative to their long-term earning potential have ‘value.’ A value Smart Beta fund goes for the high-value players.
Definitions differ on this opaque name. Most consider quality to consist of profitability and stability. These companies hold potential for long-term performance.
These stocks have fewer peaks and valleys in their performance.
This style focuses on smaller stocks. The theory is that smaller companies outperform big ones.
Smart Beta argues that size doesn’t matter. Rather, stocks in the ETF should be weighted based on one of the above factors. This approach is called rules-based investing. The selection process adheres to specific, pre-determined criteria, or ‘tilting.’
Does this new method work? A study from the Wharton School sheds some light. Between 2003 and 2014 ‘60% of SB fund categories have beaten their raw passive benchmarks.’ The researchers were sceptical however of long-term prospects.
More recently academics have published more in-depth results in the Global Investments Return Yearbook from Credit Suisse. They tested each factor with varied results. During 2016, factors like size, income (divided) and value all posted strong results. Volatility and momentum were poor. The data underscores the importance of a long-term strategy. Last year’s winner may be this year’s loser.
The import takeaway is this: Smart Beta puts more choices on the table. This new product has a long way to go before there’s enough history to call winners. In the meantime, investors should consider how these ETFs might fit into their portfolio and how traditional market cap methods come up short.
With Smart Beta, we have the choice to focus on more than just the big companies. Interest is growing among investors. By the end of January 2017 assets invested in global Smart Beta ETFs reached $534 billion.
Innovations like Smart Beta encourage investors to think more strategically. The common tactic of holding 60% stocks and 40% bonds is becoming outdated. Today, investors want creativity and choice. They’re expanding beyond traditional asset classes. There is no clearer example of this evolution than peer-to-peer lending (P2P). Let’s look closer.
Phoenix From the Ashes: Peer-to-Peer Investing
Lending ceased amid the global financial crisis of 2008. At the epicentre of the disaster were banks. Fearing defaults and losses, they became risk averse. As a result, they slowed or even stopped lending. Only the safest applicants received loans. This tightening of credit gave rise to P2P lenders.
The once uncharted territory of P2P lending has become familiar terrain for many. Now, more than a decade since its emergence, the revolution is here to stay. As recently as 2016, Transparency Market Research estimated a market valuation of $897 billion for the industry by 2020.
This democratisation of lending offers broad appeal. Borrowers have access to fast, affordable capital. Lenders can earn a competitive return over the long-term with managed risk. The speed, transparency and low cost of the P2P system all work particularly well in under-banked regions of the world. The same body of research found that ‘In 2014, out of the 400 million borrowers in India only one in every seven borrowers acquired a formal loan.’ The world moves fast, and P2P is keeping pace.
To measure the impact of this growth we have the Orchard Index. Orchard aggregates the returns of more than 980,000 loans totalling over $10 billion in principal balance outstanding. The index shows P2P investing can deliver annual returns ranging from 3.95% to 8.71%. These returns have proven P2P as a legitimate part of an investment portfolio.
This legitimacy is further evidenced by emerging regulatory changes. In 2017 U.S. regulators agreed to grant special licenses to fintech firms. The Office of the Comptroller of the Currency will allow federal charters for P2P businesses. The office’s decisiveness signals confidence in the industry’s growth. With this firm foundation in place, people are asking how they can get in the game. Here’s a plan:
1. Research Lenders
Whether you’re an investor or borrower, you’ll need to do some homework. Find out the interest rates, costs, penalties and default rates. Make sure you’re comfortable with the integrity of the P2P business you’re considering. If rising default rates and falling originations are trends, look elsewhere.
2. Learn the Risks
The risks to borrowers are clear. There will be penalties in the form of fees or even damaged credit if payments slow or stop. Investor risk is harder to measure. The industry is new, and therefore metrics are limited. However, you can familiarise yourself with the experience of others. Look at the hard data to estimate your earnings.
3. Think Holistically
Engaging in P2P should be part of a larger plan. Diversification is important whether you’re an investor or a borrower. P2P solutions alone will not suffice as a financing strategy or investment. Returns can drop or, in some cases the provider may cease operations.
4. Form an Exit Strategy
All investment plans should include an end game. As a lender, ask how long you can leave the money invested. Try to think long-term. A longer timeline will often yield better returns. If you’re borrowing, consider the lifetime interest you’ll pay. Any good P2P business will have tools to help you calculate these numbers.
P2P represents fintech at its finest. Why? It makes an otherwise impossibly complex task simple. Without its technological underpinnings, matching millions of lenders with borrowers would be insurmountable. Digitally, however, it can happen in seconds. P2P is not the only system to leverage this speed. Automated investing is enabling ordinary investors to do more. Let’s find out how.
The Pyjamas Investor: Automated Investing
Remember travel agents? They were the people who booked your flight, arranged hotel reservations and planned your vacation. You probably haven’t seen one in a decade or two. Why? Technology has made their services obsolete.
Investment managers are going the same route. Investors are learning to do more with their laptop. As ‘Q’ remarked to James Bond, “I can do more damage on my laptop sitting in my pyjamas before my first cup of Earl Grey than you can do in a year in the field.”
Sophisticated, but user-friendly, programs are guiding investors to wealth. These algorithmic solutions are generally not motivated by monthly performance benchmarks or sales. As a result, there is trust. Until recently advisors weren’t even required by law to act in the best financial interest of their client. The late-in-coming ‘Fiduciary Rule’ was designed to correct this problem. It’s no wonder “millennials tend to not fully trust their adviser,” according to research from Deloitte. However, there are some automated investment tools that are promoting their own performance figures as well.
With just a few quick questions about age, goals and risk tolerance automated investing can provide answers. Let’s take a closer look at which aspects are automated.
1. Setting A Plan
Why is an investment plan important? The answer: behavioural finance.
Behavioural finance is a relatively new field. It seeks to understand how our psychological flaws misdirect decisions about money. The sunk cost fallacy, herd behaviour, and the telescoping effect are all examples. When you set a plan, you remove these traps. For investors, a train on rails is better than off-roading. The addition of a financial advisor does little to mitigate the problem. ‘Professional traders and money managers are subject to the same behavioural biases that are more commonly discussed in the context of individual (typically assumed uninformed) investors,’ remarks The Research Foundation of CFA Institute Literature Review. Automated investing creates a fixed route uninterrupted by impulse.
2. Risk Assessment
Gauging your risk should be done in private because it’s a personal question. When sitting face-to-face with an advisor one may feel compelled to be bold. Automated investing tools avoid this problem. Moreover, an optimistic advisor may underplay the inherent risks of an asset. Automation bypasses theses issues with a scale enabling users to rank their tolerance honestly. The result is a customised plan.
3. Portfolio Allocation
Automated investing is helping investors venture safely into non-traditional asset classes. These areas include real estate, commodities and more. Technology has made assets that were once the providence of the Wall Street elite more accessible. While some regard these alternative investments with scepticism, the numbers illustrate the value of a portfolio beyond stocks and bonds. Research from BlackRock shows that over the 15-year period ranging from 2001 to 2015 “alternatives had returns similar to stocks.” In fact, some alternative classes like long/short fixed income and real estate outperformed stocks.
Even more encouraging is the volatility picture. Many consider the performance of alternatives to come at elevated risks. This notion is untrue. Additional research shows that a portfolio of 60% stocks and 40% fixed income between 2000 and 2016 generated an average annual total return of 5.55% with a standard deviation of 8.6%. Meanwhile, over the same period a portfolio of 50% stocks, 35% fixed income and 15% alternatives delivered 5.90% returns with lower volatility of 7.0% standard deviation. More returns at lower risk. What’s not to like?
4. Portfolio Management
Even the best plans require follow-up. Automated options provide real-time insights and rebalancing as you move toward your goals. For example, over time the growth of one asset class (e.g. bonds) may create an imbalance that has drifted from the original intentions of the plan. Automated investing corrects this with algorithms set to execute trades to reestablish the preferred weightings. This feature is invaluable for many of us who are distracted by the daily responsibilities of life.
Technology is enabling a new generation of more strategic and more sophisticated investors. Fintech allows anyone to participate in markets that are more diversified than ever.
Poor Engelhardt. If only he added only a few more foods to his diet, he would have survived much longer and enjoyed his island living. Don’t eat too many coconuts.