Factoring in Behavior

Factoring in Behavior

Mike Fardy, National Sales Manager, CIMA, FlexShares

“Not For Use with Retail Investors”

For Use with Financial Intermediaries Only

Global Equities Performance

Source: Northern Trust Investment Strategy, Index data for the various return calculations above are as follows: U.S. is the MSCI U.S. Equities IMI; Emerging Markets is the MSCI Emerging Market Equities Index; Dev. ex-U.S. is the MSCI World ex-U.S. IMI; Global Equities is the MSCI ACWI (All Country World Index) and is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. Indexes are gross of fees and indexes cannot be invested in directly. Past returns are no guarantee of future results. Charts are as of December 31, 2017.

-60

0

60

120

180

240

300

Dec-08 Dec-11 Dec-14 Dec-17

Re

turn

(%

)

U.S. Dev. ex-U.S. Emerging markets Global equities

For Use with Financial Intermediaries Only FlexShares.com 2018 | 2

Global Equities Had Historically low Volatility in 2017

Source: Northern Trust Investment Strategy, Bloomberg. MSCI ACWI (All Country World Index). Indexes are gross of fees. Past returns are no guarantee of future results. Data through 2/15/2018


“The study of Psychology as it relates to the economic decision-making processes of individuals and institutions” *

What is Behavioral Finance?

2002 Daniel Kahneman wins

Nobel Prize in Behavioral Economics

2017 Richard Thaler wins Nobel

Prize in Behavioral Economics

Image Source: https:www.rolandberger.com/en/Blog/Buying-into-simplicity.html Image Source: http://content.time.com/time/magazine/article/0,9171,2099712,00.html


FlexShares.com 2018 | 4


The Market Cycle of Emotions

Source:https://www.elphoscapital.com/single-post/2016/11/09/Understanding-Market-Cycles-The-Key-to-Successful-Investing


Why Should You Care?

Source: Harvard Business Review, “The Value of Keeping the Right Customers,” October 29, 2014

a 5% increase in customer retention

produces more than a 25% increase in

profit

Acquiring a new customer is anywhere

from 5 to 25 times more expensive

than retaining an existing one.


Common Pitfalls Your Clients Face

Anchoring

Status Quo

Cognitive Overconfidence

Overchoice

Herd Mentality (aka “FOMO”)

Endowment Theory

Regret Aversion


Common Pitfalls Clients Face

Framing

Sunk Cost

Confirmation

Disposition Effect

Risk Aversion

Selective perception

“Recency” Effect

Guessing at Patterns


The Problem

Are you and your clients buying and selling at the wrong times due to behavioral biases?

Information Ratios during Manager Life Cycles

1.08

-0.11

0.97

Before Manager Hired After Manager Hired After Manager Fired

For Illustrative Purposes Only: Source Norther Trust data dervied from Goyal, A. and Wahal, S., “The Selection and Termination of Investment Managers by Plan Sponsors,” Journal of Finance 63(4) 1805‒1847, 2008 Data based on 3400 plan sponsors between 1994 and 2003

Before Manager Hired-

Previous 3 Years After Manager Hired- Next 3

Years

After Manager Fired-

After Manager Fired- Next 3

Years


The Solutions

SMAs / Multi Asset Class

Solutions Factors

ETFs

Defining Factor Investing

Quality Value Low

Volatility

Dividend

Yield

Size Momentum

Factor investing seeks to identify and target these drivers of return through systematic strategies

that can be implemented in risk-controlled portfolios.


ACTUAL INVESTOR PORTFOLIO EXAMPLE

Strategies Growth Value Momentum Size Volatility

Small-Cap Value – + – + –Small-Cap Growth + – + + –Small-Cap Growth + – + + –Mid-Cap Value – + – – –Mid-Cap Growth + – + + +Large-Cap Value – + – – –Large-Cap Value – + – – +Large-Cap Growth + – + – +Aggregate Portfolio

Exposure 0 0 0 0 0

Consequences of Cancellation

Note: “+” denotes an addition to factor exposure, while the “–” denotes a detraction from factor exposure.



Factors Have Driven Mutual Fund Excess Returns For 50 Years

Northern Trust. Decomposition of mutual fund excess (monthly) for top performing mutual funds over time derived from

Source: For Illustrative Purposes Only. Carhart, Mark M. “On persistence in mutual fund performance.” The Journal of Finance 52.1 (1997): 57–82.

6.6%

-1.6%

5%

Skill

“Stock Picking”

Annual

Excess Return

Common

Style Factor

Exposure



ETFs


Factor-based

Outcomes-Focused

Traditional

Index

Management

Traditional

Active

Management


Deploy factors to stave off effects of behavioral concerns

3 Actionable Items


Be cognizant of your client’s risk tolerance AND how they behave

Become dispassionate…. about your positions


Focusing on Factors in Foreign Markets


Do Factors Work?



Research has been clear for some time…

1960’s

Expected Return = Risk-free Rate + (Market Beta * Market Premium)

1992

Expected Return = Risk-free Rate + (Market Beta * Market Premium)

+ (Size Beta * Small Minus Big)

+ (Value Beta * High Minus Low)

Source: Eugene Fama & Kenneth French, “The Cross-Section of Expected Stock Returns”, The Journal of Finance, June 1992.



…But behavior makes it difficult

Source: Northern Trust Quantitative Research, cycle lengths as determined using spectral analysis, Dec 2016

0

20

40

60

80

100

120

Low Volatility Dividend Yield Momentum Value Size

Average Factor Cycle Length

# of Months



Should I Even Bother with Factors?



We are all factor investors

FactSet. Data as of 2/28/2018 from the Barra USE3L risk model – factor exposure subject to change.

USEarnings

YieldUS Value

USVolatility

USLeverage

USEarningsVariation

USDividend

Yield

USMomentu

m

USGrowth

US Size

Factor 0.07 -0.05 -0.10 -0.13 -0.07 0.03 0.02 -0.06 0.36

-0.20

-0.10

--

0.10

0.20

0.30

0.40B

arr

a F

acto

r E

xp

osu

re

S&P 500 Factor Exposure as of 2/28/2018



Return assumptions declining

7.20%

7.40%

7.60%

7.80%

8.00%

8.20%

8.40%

State & Local Pension Plan Return Assumptions

Return Assumption

Source: Public Plans Data. 2001-2015. Center for Retirement Research at Boston College, Center for State and

Local Government Excellence, and National Association of State Retirement Administrators. National data

averages, weighted by plan size.



Why international?

Source: FactSet P/E Ratios, Monthly data through 2/28/2018. Indices are the MSCI USA Index, MSCI World Excluding United States Index and the World Excluding United States

Index begins 1/31/1997, MSCI Emerging Markets Index 10/31/1999. Normal range is +/- 1 standard deviation from median

8

10

12

14

16

18

20

8

10

12

14

16

18

20

United States Developed ex US Emerging Markets

Global Equity Market Valuations

Normal Range

Median

Current

Past performance is no guarantee of future results. Periods greater than one year are annualized except where indicated. Returns reflect the reinvestment of dividends and other earnings and are shown before the deduction of investment management fees, unless indicated otherwise. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved



Breaking Bad Factor Habits



The temptation of factor timing

Source: Bloomberg, as of 7/3/17, FlexShares Market Signal dated July 2017

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

-10.00

-5.00

0.00

5.00

10.00

15.00

Retu

rns,

%

Flo

ws, $ B

illio

ns

U.S. Listed Small Cap ETF Flows and Returns

Monthly Net Flows Russell 2000 Performance - Russell 1000 Performance

Past performance is no guarantee of future results. Periods greater than one year are annualized except where indicated. Returns reflect the reinvestment of dividends and other earnings and are shown before the deduction of investment management fees, unless indicated otherwise. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved

Russell 2000 Index Return- Russell 1000 Performance



Are more factors better than fewer?

Momentum Quality Dividend Yield

Volatility Value Size



The Importance of Implementation



Evolution of factor investing

Smart Beta 1.0 Fundamental/

Alternatively Weighted

Smart Beta 2.0 Single Factor

Strategies

Smart Beta 3.0 Multi-Factor

Strategies



Refined factor models

How efficiently is the factor captured?

Unintended factor exposures

Sector, country, industry biases

Broad universe vs. sector neutral

Factor maximization or incremental exposure

How are factors combined?

Target each independently, then combine (sub-index approach)

Apply each in succession (step-through approach)

Apply all factors in concert (optimization approach)

Smart Beta 4.0?



Using the factor cycle to drive design

Source: Northern Trust Quantitative Research, cycle lengths as determined using

spectral analysis, Dec 2016

0

20

40

60

80

100

120

Low Volatility Dividend Yield Momentum Value Size

Average Factor Cycle Length

# of Months



Holding period matters

Source: Ken French Data Library, monthly observations, Dec 2017

U.S. Growth Index is Fama/French U.S. Growth Index (ex utilities), provided by Fama/French. U.S. Value Index is Fama/French U.S. Value

Index (ex utilities), provided by Fama/French. Indices are not available for direct investment. Their performance does not reflect the expenses

associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Values change frequently and past

performance may not be repeated. There is always the risk that an investor may lose money. Even a long-term investment approach cannot

guarantee a profit. Economic, political and issuer-specific events will cause the value of securities, and the portfolios that own them, to rise or fall.

Because the value of your investment in a portfolio will fluctuate, there is a risk that you will lose money. Indexes are referred to for comparative

purposes only and do not represent similar asset classes in terms of components or risk exposure; thus, their returns may vary significantly. U.S.

Growth Index measures the performance of U.S. stocks with higher price-to-book ratios. U.S. Value Index measures the performance of U.S.

stocks with lower price-to-book ratios.

1-year 3-year 5-year 10-year 15-year 20-year 30-year 40-year

Value Wins 62% 75% 83% 96% 100% 100% 100% 100%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Perc

en

tag

e

Value Win % Over Growth US Equity, 1926 - 2017



Complimentary factors ARE Key

Multifactor data provided by http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. SmB and HmL research factors.

Past performance is not a guarantee of future results. Values change frequently and past performance may not be repeated. There is always the risk that an invest may lost money. Securities of small firms are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Even a long-term investment approach cannot guarantee a profit. Economic, political, and issuer-specific events will cause the value of securities, and the funds that own them, to rise or fall. Because the value of investments will fluctuate, there is a risk that investors will lose money.

1930 1940 1950 1960 1970 1980 1990 2000 2010-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

1930 1940 1950 1960 1970 1980 1990 2000 2010-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

Five Year Moving Average of U.S. Value Factor: 1926 to 2017

Five Year Moving Average of U.S. Size Factor: 1926 to 2017



Factor tilt: different than factor weighted

“Tilting” is a nuanced approach to factor investing that seeks to generate the targeted, systematic exposure through weighting adjustments to its holdings.

• Total market ownership: exposure to entire investable universe – even large cap growth

stocks

• Targets a specific exposure to size and value in an effort to enhance returns while

maintaining a consistent level of risk to those factors across entire product suite

• By targeting specific levels of factor exposure and rebalancing to those exposures at

reconstitution, there should be less drift compared to other methodologies

• Lower turnover compared to other factor-based strategies

• Lower tracking error to the market

Design of a tilted approach



Questions?


Built by investors, for investors

Twitter@FlexSharesETFs

LinkedIn.com/FlexShares

FlexShares.com

1.855.flexetf (1.855.353.9383)


https://twitter.com/flexsharesetfs?lang=en

https://twitter.com/flexsharesetfs?lang=en

https://www.linkedin.com/company/flexshares

http://www.flexshares.com/

FlexShares.com Your Advisor Portal

A redesigned advisor site gives you unique access to performance information,

in-depth commentary and fund analysis


The FlexShares mission is to provide exchange traded funds that serve as the building blocks for outcome-oriented portfolios. This focus on “investing with purpose” is at the heart of our unique brand of ETFs.


Important Information

Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest.

Foreside Fund Services, LLC, distributor.

An investment in FlexShares is subject to investment risk, including the possible loss of principal amount invested. Funds’ returns may not match the returns of their respective Indexes. The Funds may invest in emerging and foreign markets, derivatives and concentrated sectors. In addition, the Funds may be subject to asset class risk, small cap stock risk, value investing risk, non-diversification risk, fluctuation of yield, income risk, interest rate/maturity risk, currency risk, passive investment risk, inflation protected security risk, market risk and manager risk. For a complete description of risks associated with each Fund please refer to the prospectus.


Factoring in Behavior

Documents

Transcript of Factoring in Behavior