The Most Important Component In Any Long-Term ETF Strategy

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Ask a room full of experts what the most important part of a successful investment strategy is and you will likely get a range of candid responses. Most would gravitate towards answers like security selection, position size, time, or cost as their primary recommendations.

Those characteristics are certainly important and should not be overlooked. However, the data behind ETF asset flows and fund returns continues to signify a tremendous deficiency in net performance for individual investors. Much of this gap can be attributed to behavioral choices – i.e. buying high or selling low.

The following table of popular smart beta ETFs demonstrates the difference between time-weighted returns and dollar-weighted returns.

Source: Bloomberg LP, courtesy Eric Balchunas – Senior ETF Analyst posted via Twitter on 1/19/17.

Time weighting simply refers to the actual performance of the investment over a certain time frame. In this case, the table is sorted by one and three-year increments. Dollar weighting accounts for the internal rate of return for actual dollars invested over time. Thus, dollar weighting is lower in this instance on account of investors pouring in money after much of a performance gain has already been made.

As you can see, a popular fund such as the iShares MSCI USA Minimum Volatility ETF (USMV) demonstrates a 25% difference on a 3-year lookback between these two statistical measures. Fund flow data from indicates that USMV took in more than $4 billion of its $12 billion in total assets just last year. That’s one-third of the fund’s entire asset base in a twelve-month period.

The obvious driver of that tidal wave was strong relative returns, an attractive cost structure, and the right story to fit the current market. Nevertheless, a large percentage of the underlying asset base is late to the performance party. Those fresh dollars are hoping that the trend extends indefinitely into the future, but may ultimately come up short in their efforts to chase gains.

The same can be said for more traditional core holdings like the iShares Core High Dividend ETF (HDV). This dividend-oriented fund has been a perennial favorite among income investors as demonstrated by its steady year-over-year inflows. Nevertheless, the math doesn’t lie in that much of the gains have come prior to the bulk of current assets participating in the longer-term move.

Many studies have proven these same results on the downside as well. Investors are typically exiting funds or strategies in large volume right before a turning point of momentum occurs.

This brings to the forefront the psychological aspect of trading and investing that is often downplayed. Investors tend to become more confident as stocks are rising and more fearful as they are falling. The same can be said for factor-based or smart beta ETFs that experience cycles of underperformance and outperformance. The money tends to follow only after an investment has “proven itself” with a high level of strength versus its peers.

A counterintuitive mindset is a strong ally in the fight to achieve these time weighted returns. The ability to stick with a single strategy through thick and thin or seek out underperforming factors with the potential to rebound are difficult objectives. However, they can also be the most fruitful over a long time horizon.

Remaining emotionally agnostic in your investment efforts is a daunting task under the best of circumstances. The market has a way of confirming our biases or dredging up our worst fears. Often, the task of selecting the perfect investment vehicle is of far less importance than controlling emotional buy and sell triggers.

The strength of character to recognize and overcome those reactions can go a long way to achieving a successful outcome in your ETF portfolio.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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