Did you still hold your Bitcoins or do you only hold fond memories?

Do you remember Bitcoin? Probably, but do you spend as much time thinking about it as you did earlier this year? I’m willing to bet not, and if that’s the case maybe now is a good time to reflect on the lessons learned. Maybe the biggest value Bitcoin has provided to date is the lessons it taught us in behavioral finance. Remember that neighbor who would recite for you daily the price trajectory of Bitcoin? Have you heard from him on the subject lately? This doesn’t mean that Bitcoin is not destined for a big increase in the future. Bitcoin’s market dominance is now back over 50% of the cryptocurrency market, which has resulted in even bigger declines in the alternative cryptocurrencies. If you were excited about its prospects when it was priced at $17,000, you likely should be much more so now at $7,000. However, given the recent experience, it’s not unlikely that Bitcoin suddenly feels inappropriate for your risk tolerance. If your appetite drops off significantly just because an investment pulls back, then chances are your initial decision making may have been influenced by some very common behavior biases. To name a few: Trend Chasing - In December and January when Bitcoin was topping out, maybe that also happened to coincide perfectly with when you were developing your view on it as an asset. If that was your reason for being a purchaser then, you likely made a well-disciplined investment decision. However, if your decision was based solely on the expectation that it would continue its recent performance, you were likely a victim to trend following. There’s a reason why the first disclaimer on any investment document you receive is “Past performance is not a guarantee of future results.” A great lead into this behavior can be a Hindsight Bias, believing that somehow the prior results were perfectly predictable. You think you should have anticipated these results at the time and participated in the stellar performance up to this point. You remember reading the word “Bitcoin” in an article in 2015, but never bought any. But certainly you won’t be that foolish again, right? Regret Aversion - Maybe you weren’t concerned with achieving the performance, but rather you were afraid of being the only one who didn’t participate. It seemed like everyone you knew was buying Bitcoins, and you couldn’t bear to be the only one who didn’t. You couldn’t watch the news at the gym or make small talk in the elevator without touching on the subject. Just imagine how awful the social interactions would be if you were left out. We all know there are plenty of reasons for social events to be awkward to begin with, but your investment decisions should never be one of them. Sunk Cost Fallacy - Do you know people that still hold their bitcoins? The key question is do they still do this because of their continued bullish outlook, or because they already have a big loss in the position. If it’s the latter, this behavior is not one that leads to making good investment decisions going forward. Smart investing involves having a steadfast procedure for decision making and regularly revisiting it. Virtually no long-term investor is going to make it a lifetime without their own “Bitcoin Experience.” Some will learn that such investments are well outside their risk tolerance. Others may even learn that they will have a profitable future by weathering highly volatile assets. But what is most important is that all investors are also learners. There is almost nothing more detrimental to your overall financial well-being that consistently succumbing to behavioral traps.

My Thoughts on Old News

Volatility has reentered the stock market, and suddenly our old friend is interesting again. Everybody forgot about last month’s sweetheart. This is all too often the case, with the valuable lesson being ignored in lieu of the latest hysteria. Meanwhile, I’ve been waiting for the above chart to finally write down my thoughts on Bitcoin. I (like every financial advisor) have been wrangled into a discussion of the subject countless times with clients, family, friends, acquaintances, cab drivers, et al. over the past few months. This is not an “I told you so” about the price coming down, because I didn’t know that. Rather this my opportunity to finally illustrate the point I’ve been making all along, any investment decision begins and ends with risk tolerance. The fact of the matter is, there are very few people (myself also excluded) who have the tolerance for the experience listed above. How many people who purchase Bitcoin in December are feeling sick to their stomach now? I’m not saying that over a longer time horizon it may not still perform well, but to experience that day when it comes you will need to be there. I don’t think as many people are signing up for that right now. This is the very message I echo over and over to clients when the guy they play golf with has a hot stock tip or their grandaughter’s classmate’s barber’s twin brother has a new startup for them to invest in. These investments are way, way outside the scope of most risk tolerances. Because to succeed in them, you have to be able to suffer the period like the year to date and still be willing to not just hold on but add your hard earned dollars to such strategies. Without this commitment, you’re doomed to failure. This doesn't just pertain to cryptocurrencies. There will always be a million reasons why the next hot investment you hear about is “nothing like Bitcoin”, but the reality is there is nothing proving that its volatility will be any different. I often get asked to review these ideas, and when I do I suspect people think I give a canned response shooting them down. The reality is, one of the first steps to a successful client relationship is a proper understanding of risk tolerance. Once that work has been done, it doesn't take long to identify what investments are in and outside of it.

Identifying Equity Asset Classes to Employ Active Management Using Alpha

By Dann Ryan, CFP®
Senior Manager, RCL Advisors, LLC

The debate of active vs. passive management is unlikely to see a conclusion in the near future. However, if you adopt a neutral viewpoint you can quickly see applications for both strategies. In investment management practice, by being objective about your own search criteria, it may be possible to create a quantitative search process that enhances your success for qualitative active manager selection. These selection criteria need not be particularly restrictive, but rather just reflective of your actual investable universe. For many typical individual investors this universe could be expressed by the mutual funds which are covered by Morningstar’s database.

Using this as my source and for purposes of my analysis, I’ve employed the below search process:

Fund Share Class Criterion

To limit the duplication of manager data, one share class per fund was selected based on the following preference:

  1. Institutional Class
  2. Lowest Annual Report Net Expense Ratio
  3. Lowest Maximum Management Fee
  4. Oldest Performance Start Date

Obviously expense ratio impacts net-of-fee to manager performance, so it is important to be selective with the share classes which are included in the investment universe. If you are an institution or large advisor with access to preferential share classes, this should be reflected. Conversely, if you are an individual you may be limited to investing in the more expensive retail share classes.

Fund Universe Selection Criteria

The funds were then searched and screened by the following criteria:
  1. Morningstar Category (US Open End Mutual Funds)
  2. Minimum of 5 years performance history
  3. Minimum of 5 year R-squared of 90 to the relative benchmark
  4. No Index Funds

The Decision to Use Alpha

Alpha as a statistic attempts to quantify an investment manager’s ability to add value adjusting for the systematic risk (beta) of the asset class. Inherent in this performance is the fund’s expenses, which are critical to the client’s experienced benefit. By this definition, index funds would be expected to have a negative alpha. Furthermore, by restricting the search to funds with high R-squared, you are helping to increase the integrity of the alpha calculation by improving the accuracy of the beta. However, it is important to note that alpha is not synonymous with outperformance, but rather excess risk-adjusted returns. This definition seems sufficient, as there are certainly instances when you wish to implement less than market risk strategies for a given asset class.

The Data

After defining the investment universe by applying the share class selection criteria described above, I then pulled rolling twelve month time periods stepped monthly for the last 10 years ending December 31, 2013. This attempts to identify the likelihood of any one fund adding value over a 12 month period, given reasonable adjustment for persistence of returns.

As a secondary test against time period anomalies, I also ran these criteria for the five years prior ten year period ending December 31, 2008. Admittedly, this introduced a small amount of survivorship bias as it excludes managers that may have gone out of business since, but would have been part of your investable universe five years ago. Although this period was one of great outperformance for growth style managers, I otherwise found overwhelmingly similar conclusions to the data from the most recent ten years.

Conclusions

The process attempts to find asset classes in which managers had the highest incidence of generating alpha. As an investment professional with an established due diligence process, including qualitative factors, I believe that picking an active manager that could succeed at providing benefit to my clients in that space.

The results were as follows for the following categories:
Morningstar Category
(US OE Mutual Funds)
Index
# of
Funds
# of
Observations
%
Positive
Foreign Small/Mid BlendMSCI EAFE Small Cap NR141,42262.94%
Small ValueRussell 2000 Value TR576,35661.34%
Foreign Large ValueMSCI EAFE Value NR676,97561.16%
Small BlendRussell 2000 TR14015,19960.02%
Foreign Large GrowthMSCI EAFE Growth NR475,19959.55%
Small GrowthRussell 2000 Growth TR15117,03458.31%
Foreign Large BlendMSCI EAFE NR14014,51253.18%
Diversified Emerging MktsMSCI EM NR858,52750.05%
Large ValueRussell 1000 Value TR21023,48547.86%
Mid-Cap GrowthRussell Mid Cap Growth TR14516,58546.05%
Large GrowthRussell 1000 Growth TR31435,53544.87%
Large BlendRussell 1000 TR26729,45243.13%
Mid-Cap ValueRussell Mid Cap Value TR697,39942.92%
Mid-Cap BlendRussell Mid Cap TR646,90536.02%
Source: Morningstar Direct

Foreign equity managers offered much more alpha generation opportunities than US equity managers. This may be attributed to the United States equity markets are some of the oldest and most efficient and this reduces managers opportunity sets. This international benefit was most pronounced for managers in the Mid-Small capitalizations; however the same size of funds was also lowest here. Perhaps this is attributable to market inefficiencies or simply immaturity of the asset class.

In general, there seemed to be a noticeable advantage to mangers who employed a growth/value bias as opposed to those with a blended approach. With the exception of Small Cap Growth, style-specific plays always produced more benefits than their blended counterparts. The US Mid-Capitalization manager space provided very little opportunity for value addition. Especially for blended strategies, a strong case can be made that you are best to index this space.

Emerging Markets have typically been a space in which a strong argument has been made for delineation amongst investments. Certainly there is a great breadth of variance in the economies of the respective countries, and conceivably this offers managers a great opportunity to add value playing on macro themes and valuation discrepancies. However, by this alpha generation metric there simply doesn’t seem to be that strong of a case for active management.

This article tends to describe a process to give you confidence in the ability to identify value adding managers in categories where the majority (>50%) of time periods managers are generating alpha. Also, it identifies spaces where alpha generation is much harder to produce and therefore you might just obtain the asset allocation diversification benefits of these classes through a low-cost index mutual fund of ETF.

Certainly as clients investment constraints change, so does their investable universe, and so the selection benefits may change drastically. Therefore my results may not be appropriate for everyone’s practice. It’s important to be accurate in your search criteria so not to overstate your success, or else you may likely be better off to employ passive management entirely.