Morningstar Advisor - August/September 2011 - (Page 44)

Spotlight Beware, the Accidental Portfolio Manager By Samuel Lee A hidden migration is under way among money managers, a countless legion entering the rarified ranks of hedge funds, pension funds, and mutual funds. Many of these newly minted portfolio managers have little formal training and don’t have the monomaniacal devotion to analyzing the markets that the best portfolio managers have. Who are these brave souls? Why, none other than do-it-yourselfers who actively attempt to time, trade, and pray their way to superior risk-adjusted returns, often with the help of exchange-traded funds. ETFs can be used effectively to achieve a good long-term result, but investors who trade too often and venture into asset classes they know little about, or obtained insufficient research on, are setting themselves up for disappointment. The frequent traders are not capitalizing on the low costs or tax-efficient traits of ETFs. In fact, they are likely getting a worse result than most actively managed mutual funds could provide, and they are almost certainly going to underperform a more passive strategy over time. The criticism of ETFs that we hear most frequently from mutual fund boosters is that ETF investing leads to bad behavior. But just because ETFs trade intraday does not mean that investors should make it a daily or even weekly habit. ETFs should be used in nearly the same way a mutual fund is used. ETFs have not revolutionized investing concepts; they are merely changing the way in which investors can gain access to asset classes. Investors who actively time their ETF trades to exploit valuation or technical views don’t realize how tough it is to consistently generate excess returns. Investors who have thought about the skill hurdle involved may reason that because the top third of mutual funds beat their benchmarks over five years, all they have to do is be in the top third skillwise relative to mutual fund managers to generate excess returns (no mean feat!). However, much like poker, with just a few trials it’s hard to tell whether an investor is good or just plain lucky. In fact, the markets are even more luck-driven than poker, so even fairly long performance records don’t give investors a foolproof litmus test of skill. Despite the high skill hurdle investors must surpass to be confident of generating alpha, many ETF investors still choose to run a high-turnover, often-expensive investment strategy. The problem is behavioral. People tend to overestimate their positive qualities, thinking they’re smarter, better-looking, and more skilled than they really are, a phenomenon called illusory superiority. This cognitive bias traps most investors in an epistemological pit, where their self-assessments don’t reflect reality. One way to avoid falling prey to illusory superiority is to anchor skill assessments to an objective measure, such as outperformance against the benchmark. But because the market is extremely noisy, it’s impractical for most investors to obtain a statistically significant measure of their own skill. Even if the measured period is long enough, choosing the right benchmark— a science unto itself—compounds the difficulties of the typical investor. The statistically high skill hurdle for active management to pay off and the cognitive biases that trap most investors suggest that investors should take a margin-of-safety approach to active management. This means keeping costs down as much as possible and being extremely picky about exotic investments that venture beyond low-cost, well-diversified funds with fundamental cash flows. Investors should treat the market with respect—it’s something not easily conquerable— and acknowledge the sheer amount of luck that determines investment results. To do otherwise is foolhardy. Samuel Lee is an ETF analyst with Morningstar. 12-month P/E ratio is more in line with the overall market’s. The ETF’s expense ratio is 0.37%. German Appeal ETFs that invest outside the United States have been a popular category of new launches this year, and one we find appealing is Market Vectors Germany Small-Cap ETF GERJ. Germany tends to be underrepresented in most portfolios given its lower marketcap-to-GDP ratio, relative to other large, developed economies. And when compared with the broad market iShares MSCI Germany Index EWG, small-cap German stocks are less correlated to the S&P 500 (91% for EWG versus 85% for MSCI Germany Small Cap Index). EWG is dominated by large-cap firms that compete directly with many of the large-cap multinational U.S. firms that populate the S&P 500. GERJ’s largest sector weightings are industrial and technology (35% and 16% of assets, respectively). These firms in these sectors tend to be highly specialized with defendable competitive advantages. GERJ’s expense ratio is 0.55%. K Patricia Oey is an ETF analyst with Morningstar. 44 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011