ETFs can be a powerful and cost-effective instrument in executing a wide variety of investment strategies. However, sometimes it can seem like all the attention is focused on just one strategy — momentum investing.
That’s a mistake, says Joel Dickson, global head of investment research and development and a principal in Vanguard Investment Strategy Group.
“Studies have shown that it can be very difficult to implement momentum investing strategies in a way that adds value over the long-term,” says Dickson. “We believe financial advisors have a greater chance of adding value for their clients by using ETFs as part of a holistic approach to wealth management via financial planning, discipline, and guidance, rather than by trying to outperform the market.”
In fact, recent Vanguard research quantified the value an advisor can add using such an approach at about 3%.
Using low-cost ETFs as the core to client portfolios can enhance simplicity and transparency, Mr. Dickson says. These features can be used to anchor expectations and to help keep clients invested when headlines and emotions tempt them to abandon the investment plan.
It’s a long-term application of ETFs seemingly at odds with momentum investing, he says.
“Investors tend to exhibit momentum characteristics regardless of whether they are actually investing in momentum,” Dickson told WP
. “We have a long history that you see cash flow go towards investments that have done well recently, and cash flow go away from investments that have done poorly recently.”
It is one major reason why investors see big differences in the returns of time-weighted returns or the funds return versus the dollar-weighted or the investor’s return in the fund, says Dickson.
“Typically investor returns are below the fund returns, because they tend to buy high and sell low, which is what kind of momentum investing you hope doesn’t happen, but that is the risk,” he says, “buying securities that have gone up in price, in the anticipation that they will keep going up in price.
But historically, what we have seen in mutual fund behaviour and ETF behaviour is that, investors tend to buy those types of investments that have performed well recently, then don’t hold on to them during periods of bad performance, locking in poor performance, instead of capturing a premium that might happen over the long run."
Another problem with momentum investing is that today’s winners may not be tomorrow’s winners.
“Ultimately what happens is that you get a lot of turnover, as you are constantly chasing performance,” he says. “And those transaction costs can eat into the potential return.”
Financial advisors have a much better chance of achieving success for their clients by focusing on behavioral coaching, says Dickson. Because investing evokes emotion, advisors need to help their clients maintain a long-term perspective and a disciplined approach.
“Combining this approach with the use of low cost ETFs can be very powerful,” says Dickson.