From Behavioral Finance to Factor

Journal of Financial Planning: March 2017


Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz/Foldes Financial in Coral Gables, Florida, and Lubbock, Texas. He frequently speaks on investment and financial planning issues, and is author of Wealth Management and co-editor of The Investment Think Tank.

Xianwu (Sean) Zhang is a Ph.D. candidate in personal financial planning at Texas Tech University.

You’re in for a treat this month as I’m revisiting guest contributors to my regular roundup of the financial planning research that practitioners should not miss—a successful experiment from a few years back. I carefully considered who to select as my first guest contributor, and I’m pleased to introduce Xianwu Zhang. Xianwu (or as I know him, Sean) is a Ph.D. candidate in the Texas Tech personal financial planning program and my teaching assistant in the graduate wealth management class. He holds master’s degrees in mathematics/statistics and finance. Here is Sean’s excellent contribution:

“Understanding Behavioral Aspects of Financial Planning and Investing” by H. Kent Baker and Victor Ricciardi (Journal of Financial Planning, March 2015). It is never too late to emphasize that your clients may have behavior biases. A few important points from this paper are:

The market participant rationality assumption from traditional finance theory (for example, the efficient market hypothesis and capital asset pricing model) is unrealistic. Now-adays, behavioral finance theory can arguably explain financial anomalies and market inefficiency. Few people think the market is always efficient and people are always rational.

A list of widespread investor biases is defined and explored, incuding heuristics; disposition effect; mental accounting; overconfidence versus status quo bias; trust and control; self-control bias and framing; familiarity bias, risk, and return; worry; and risk-taking behavior and the anchoring effect.

The authors suggest it is important to gain a good understanding of the client’s biases, follow a well-determined long-term asset allocation strategy, and rebalance on an annual basis.

“Frontier Market Investing: Active Versus Passive,” by Larry Speidell (The Journal of Investing, Winter 2016). The literature comparing active and passive investing is always intriguing as the debate about active versus passive endures. I believe this paper offers useful insights. The author finds evidence that in frontier markets, which are not efficient or weak efficient, active investing has proven rewarding. But the author also argues that an index fund is still needed for liquidity purposes because investing in chosen stocks is a generational opportunity.

Key takeaways include:

The most efficiently priced markets will favor index funds as active managers rely on inefficient pricing. Thus, large-cap U.S. stocks have been a large component of index funds, while small-cap, international, and emerging markets are only a small share.

Out of 60 frontier stock markets around the world, some are extremely small or restricted, so only about 30 markets are sufficiently developed and available to frontier investors. This author further believes that frontier markets, excluding Gulf Cooperation Council (GCC) countries, are truly frontier markets.

The stocks in truly frontier markets are believed to be inefficiently priced, because empirical work shows that the frontier stocks are small-cap stocks that have low liquidity, higher bid-ask spreads, and minimal analyst coverage.

Active investing in frontier markets is capacity constrained. A firm with AUM of $750 million in frontier markets may be at full capacity because it has lost trading flexibility. Diminishing returns to scale is present.

“Q Group Panel Discussion: Looking to the Future,” by Martin LeibowitzAndrew LoRobert MertonStephen Ross, and Jeremy Siegel (Financial Analysts Journal, July/August 2016). This roundtable discussion featuring a panel of industry experts was held April 19, 2016, and the transcript was published a few months later. I believe that their wisdom about the most important issues in finance as well as the issues pertinent to practitioners is valuable for you. Here are some highlights:

Andrew Lo: Regulation is not reflecting the best financial thinking in the financial industry now. Technology, especially computer science, has brought about a genuine revolution, for example, robo-advising, which needs our attention. Financing society’s different challenges as a result of the rapidly growing world population is urgent in the future.

Robert Merton: Financial services, like financial advice, are inherently opaque and the only cure is trust. Robo-services can work better in processing activities but cannot replace advice from financial advisers. Goal-based investing will become very important in the next decade. The future is offering greater services by knowing the clients, understanding their needs, getting the clients to identify their actual goals, and designing dynamic strategies to achieve their goals. Globalization should guide your design solutions. A good way to design your solutions is to incorporate finance principles, because finance principles apply everywhere. Replicating a dynamic trading strategy with a security is likely to happen in the future.

Stephen Ross: We need to make a social case for the value of finance. A variety of ways is needed to let structures, theories, and empirics of finance better this world.

Jeremy Siegel: As Robert Shiller finds, 6.7 percent is the annualized long-term real return average. S&P 500 P/E is about 20 now, which suggests a future return of 5.0 percent, about a point-and-a-half under the long-term average. Two reasons can explain why the real return is going to stay low. One is increased risk aversion, which brings down the safe rates, and the other is slow growth, which is about 2.0 percent, compared to 3.5 percent real GDP growth in the post-war period. Future returns are expected to be lower in stocks and bonds and probably much lower on bonds than on stocks. 

“The Evolution and Success of Index Strategies in ETFs,” by Joanne M. Hill (Financial Analysts Journal, September/October 2016). This viewpoint piece is a response to John Bogle’s viewpoint article in the same journal (“The Index Mutual Fund: 40 Years of Growth, Change, and Challenge,” in the January/February 2016 Financial Analysts Journal). The author does not agree with Bogle on ETFs as a “betrayal of the original concept of indexing” and that ETF trading should not be “at a frenzied pace.” I believe this article will offer you useful perspectives on ETFs. Some of Hill’s key points include:

ETFs are not a perversion of the original concept of indexing; rather they are a product innovation of indexing, which brings together long-term investors, short-term investors, and speculators with different motivations. High trading activities should be viewed as a positive feature, as investors want liquidity and low trading costs when entering the market.

The initial purpose of ETFs was to provide all types of investors with access to baskets of stocks trading on an exchange, not for stock traders and speculators as Bogle asserts. Tradable index futures facilitated index investing well before the ETF came out, but ETFs eventually took over.

ETFs have now expanded to cover a big range of equity indexes, risk factors, as well as other asset classes. ETFs can also be used for top-down active management, which goes beyond buy-and-hold investing. ETFs are typically used for long-term holdings, not for speculation and market timing as Bogle asserts. ETFs are now more used for the strategic purpose of obtaining core exposures. Empirical evidence can be found from a late 2015 survey from Greenwich Associates.

ETF turnovers are seen to be at a reasonable level after a close look at the statistics, not as frenzied as Bogle’s assertion.

The causal relationship between ETF trading and volatility is hard to evaluate. However, as top-down and bottom-up investors dominate the market, those investors will reevaluate their asset allocation and rebalance when the market outlook changes. Those investors indeed traded more ETFs.

“Are Cash Flows Better Stock Return Predictors Than Profits?” by Stephen Foerster, John Tsagarelis, and Grant Wang (Financial Analysts Journal, forthcoming in 2017). As we all know, factor investing is gaining popularity in the current investment profession. Since 1993, different factors like size factor, value factor, and momentum factor have been used for fund construction and portfolio design. By introducing this paper, I would like to bring your attention to the latest well-documented factor: the gross profitability factor. Although profitability or earnings have already been employed to pick stocks for some growth mutual funds since 2008, Robert Novy-Marx’s paper, “The Other Side of Value: The Gross Profitability Premium” published in the April 2013 Journal of Financial Economics, empirically found that the gross profitability factor can generate similar excess returns as the value factor does. And Fama and French, in their 2015 paper “A Five-Factor Asset Pricing Model” published in the Journal of Financial Economics, incorporated operating profitability factor into their five-factor CAPM. Following the research topic of profitability factor, the Foerster et al. paper finds that direct cash flow measures are better stock return predictors than indirect cash flow measures and the gross/operating profitability or net income.

“The Shiller CAPE Ratio: A New Look,” by Jeremy Siegel (Financial Analysts Journal, May/June 2016). The estimates for long-term future stock returns are critical for financial planners, because this key return is the basis of asset allocation strategy in investment planning. The Shiller CAPE ratio has done a good job of forecasting long-term future stock returns.

The CAPE model predicts 10-year future returns based on the current CAPE ratio, which is current price divided by the simple average of the last 10 years of real earnings. A significantly negative correlation exists between the two: consequently, a higher CAPE ratio predicts a lower future return.

However, the recent elevated CAPE ratio and unusually low projected future return estimate is something that investors and planners should pay attention to. A few reasons for the current elevated CAPE ratios are discussed, and those reasons include: unduly bullish expectations of future earnings growth; the higher earnings growth rate; a dramatic fall of real yield on bonds; a lower equity risk premium; and a lower dividend payout.

This paper provides an alternative explanation for the elevated CAPE ratio and suggests that an adjusted CAPE ratio can provide consistency across time. Because of changes in accounting practices since 1990, GAAP earnings (or GAAP reported earnings), which are used for the standard Shiller CAPE calculation, have been reduced more during economic downturns than in the earlier period of Shiller’s sample.

With this consideration, this paper tests the CAPE model using three earnings measures: GAAP reported earnings, GAAP operating earnings, and National Income and Product Accounts (NIPAs). Two alternative earnings measures improve the R2 of the model and have lower CAPE ratio, then a higher future return.

General Financial Planning Principles