What are the Biggest Myths About Investing

What's Behind the Biggest Investment Myths?

"The investment management industry relies on foundations that greatly influence beliefs and decision-making. While some are well-defined, others are either flawed or not well-defined, which creates misunderstandings. This is especially important at a time when the industry is flooded with buzzwords and unreliable terminology such as smart beta, factor investing and passive investment.

Misunderstandings are often triggered by a lack of clear definitions and can directly lead to significant consequences in the portfolio allocation. Below are some of these myths and their consequences.

Myth 1) If you can't predict, go passively

It is well known that passive management - the replication of market capitalization-weighted indices - is “neutral” and that this provides “neutral” and well diversified access to the risk premium. Unfortunately, this is not the case. Investing in a capitalization-weighted benchmark means buying a portfolio that is very focused and speculative. A greater index weighting of stocks or factors is made when they have risen in value and less when they have become cheaper. These benchmarks predict that past successes will be future successes.

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This leads us to a second misunderstanding, namely that passive as opposed to active investing is much “cheaper”. Investing in market capitalization-weighted benchmarks ultimately destroys wealth for investors and emphasizes the speculative aspect of market pricing. While "cheap" may apply in terms of fees, passive investing is quite "expensive" in terms of portfolio efficiency. Passive is a cheap way to buy expensive stocks ...

Myth 2) Low tracking error = low risk

A second myth is that tracking error is an accurate measure of risk. Accordingly, a low tracking error equals a low risk, a high tracking error signals a higher risk. This is wrong. A tracking error does not measure anything in absolute terms; it is only a relative measure. Its interpretation necessarily depends on the basis of comparison. A tracking error cannot be interpreted as a rough measurement of the risk; it does not even coincide with the absolute risk. The table below shows the All Countries-World-Funds (ACWI) universe, consisting of the MSCI ACWI, TOBAM's anti-benchmark ACWI equity strategy and the special funds that invest in the same universe created by Evestment, Das Diagram shows the tracking error compared to the benchmark index and the risk of the funds (measured by the standard deviation). The graph shows that there is no correlation between the two measurements.

The tracking error is not a rough measure of risk, there is not even a correlation to a measure of risk. It does not measure: the capital risk, the risk of loss or specific risks (concentrations). He doesn't even give an indication of the risk.

Myth 3) Look at your asset inventory

Another myth suggests that the degree to which a portfolio is exposed to a risk driver can be judged simply by the weighting of a stock or a sector. “Take a look at your system inventory” is not the solution. In order to reduce the stock-specific risk, many investors decide to compose portfolios as far as possible using the largest possible selection of stocks and / or simply to keep portfolio weights similar to the market capitalization benchmark. However, either practice can lead to an overemphasis on stock-specific risk factors.

Let's look at a Japanese equity portfolio and try to answer two simple questions about that portfolio:

Question 1: How exposed is the portfolio to oil price fluctuations? In order to answer this question, an investor should not walk to his desk and count the oil barrels in the portfolio, the scientific answer to this question is to calculate the correlation of the portfolio with the fluctuations in the oil price.

Question 2: How exposed is the Toyota portfolio? Don't answer: "The portfolio holds 2.5% of Toyota shares"! Indeed, if the remaining 97.5% of stocks are unrelated to Toyota, then your portfolio dependency on Toyota is lower than if you held just 1% of Toyota stocks, but the remaining 99% is highly correlated to Toyota. Never forget to wear your "correlation glasses"!

What matters is not the weight of a stock or a sector in the portfolio, but the correlation of the portfolio with a risk driver, be it oil price, Toyota or another factor.

Myth 4) Risk Factor Investing is part of Smart Beta

In 2005 and 2006, a handful of pioneers launched a new initiative that was later defined as the Smart Beta Initiative. Over time, an increasing number of strategies have been launched under the "Smart Beta" designation that vary in their ability to deliver pure beta. One of the most notable changes has been the proliferation of “factor-based” investment strategies.

A beta portfolio is not about having special knowledge. The good news that Smart Beta brings is that even if you can't predict price developments, even if you don't have any knowledge, you can still put together a portfolio that makes a lot of sense, more sense than the market cap-weighted beta, which really " stupid beta ”. In contrast, we can still put together a smart beta portfolio. From this point of view, a beta portfolio needs to be built without any special knowledge, as agnostically as possible.

Factor investing involves focusing on a specific factor (such as intrinsic value, low volatility, or growth stocks). The point is to use the diversity of the risk / opportunity profiles. It relies on the ability to determine mispricing, which would be an ability to evaluate what is cheap and will become expensive. We therefore doubt its affiliation with the “Smart Beta” strategy. In fact, it's not about beta at all. It's about making predictions. So it's about alpha. It is a very good complement to Smart Beta, but cannot be integrated into Smart Beta.

Myth 5) The role of active management is to beat the benchmark

There is a common but deeply erroneous perception that the average active manager is not getting value for money because they cannot beat a market cap benchmark.

By definition, the average active manager cannot outperform the benchmark as the benchmark is determined by the sum of the activities performed by the active and passive managers. And because passive managers have no influence on the benchmark - they just follow it - the sum of all bets made by active managers actually determines the benchmark.

Obviously, it is impossible for the average active manager to outperform (or even outperform) the average active manager. After all, the benchmark is the result of all activities carried out by active managers.

The role of active managers as a group is not to outperform the index, but to drive that index and, with it, the economy.

Conclusion

Myths and misconceptions exist in the asset management industry, and more training and education needs to be done to help investors understand the real meanings of various investment terms. Otherwise, this could lead to unwanted negative consequences for your investments. "

Yves Choueifaty, President and CEO, TOBAM

Guest comments are written by recognized experts whose opinions do not have to match those of the e-fundresearch.com editorial team.

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