Academic Research Archives

Are you a Trader or Investor?

February 11, 2022 by Justin M. Follmer, MBA, CFP®, AIF®

In a world with constant information overload, sometimes it’s best to take a step back from financial news feeds to focus on core topics that drive home the fundamental components and experiences of being a long-term investor. I don’t need to explain to anyone that it isn’t easy being an investor. However, I believe it’s much harder to be a trader.

Allow me to explain.

A trader tends to rely on short-term, one-off theme-based events to drive their portfolio allocation decisions. They rely on timing the market with the goal of outguessing, and thus outperforming, a benchmark.

An investor tends to view those same events as statistical data and routine (standard) deviations. I, and many others, simply call it noise. An investor typically doesn’t allow this short-term “noise” to drive portfolio allocation decisions. Naturally, I’m making some generalizations since not all traders and investors fall into these categories.

Trading requires constant attention with an ability to guess accurately and consistently over time. Volumes of academic research exist to counter the belief that someone can accomplish this profitably. Trading and market timing strategies must be correct more than just once. An example of this would be selling at the depths of the COVID slump during March of 2020 with the goal of preventing further losses. But when does one buy back in…weeks or months later when things seem better? The 2nd worst performing day of 2020, March 12th, was immediately followed by the 2nd best performing day of 2020 (source). Think about that for a moment…by the time the trades settled the next day, one would have missed the rebound. Missing just a few of the best performing days, days that typically occur shortly after the worst performing ones, can significantly impact portfolio performance and value (source).

Investing is an opposite strategy because it relies on the belief that current market prices reflect all available information and expectations of the future. By that definition, it means that it is impossible to outguess the direction of the markets. Our Investment Philosophy is based on these beliefs. As advisors to our clients, we strive to not let the daily noise of markets impact how we design, implement, and rebalance their portfolio(s). It is the reason why our clients remained invested during March of 2020 and the various market corrections we experienced before then and since (i.e. January 2022).

Because we believe there’s no accurate way to guess which way the markets are going to go, we rely on decades of academic evidence to guide portfolio design. This belief, combined with individual investment and financial goals, time horizon, and appetite for risk, make up the toolkit we use in our daily approach to managing our clients’ investments and the advice we give.

Does this mean we ignore current events? Absolutely not. There are fundamental shifts that occur over time that help guide certain parts of the portfolio. One example of this is how our expectation of future interest rates impact the types of fixed income securities we recommend. During periods when rates are expected to rise (the current view), we strive to stay on the shorter end of the yield curve to lessen the impact of declining bond values while seeking unique areas of the fixed income market with positive correlation to rising rates.

We know last month was challenging for investors. The S&P 500 lost -5.47% of its value during January alone. With that in mind, was it challenging being an investor during 2021 when the same index gained 28.68% (source)? Obviously, no. But as investors, we must take the good with the bad since we rely on our commitments to an investment philosophy to smooth out the short-term noise.

The future is always uncertain. Many potential events are currently shaping the investing landscape. Yesterday’s 7.5% CPI (inflation) reading was a negative surprise, but one that makes sense given the Omicron surge of late December and January. The markets are digesting this number to price in what they believe the reaction from the Federal Reserve will be in March and the remainder of the year. Will the Fed increase rates by 0.25% or 0.50% and how many times this year? Will quantitative easing turn into quantitative tightening? If so, when? Does Russia invade Ukraine? Is there another COVID variant lurking around the corner? These are some of the uncertainties we face right now.

While I don’t know the answers above, I do know that markets are resilient and always forward looking. I know that corporations have an unwavering ability to flex in response to current events with the goal of increasing shareholder value. And I know that the future remains bright, albeit, challenging at times. The one constant lesson that investors know is that conviction matters: “time in the markets is better than timing the markets.” – old adage.

If you’re the type of investor who is seeking a partner to help you through the next few chapters of your life, consider getting in touch with us today. We’d love to learn more about you and how we may be able to team up.

IPOs, SPACs, and Direct Listings

July 6, 2021 by Justin M. Follmer, MBA, CFP®, AIF®

Investors are flooded with information, options, and little guidance when choosing what investment vehicles to put in their investment accounts. During and post-Pandemic, many of these options became household names as some investors worked from home and became quasi-day traders in their free time. The rise of popular MEME stocks via Reddit and access to free trading platforms, like Robinhood, resulted in the rapid rise of certain stocks, more interest in SPACs and IPOs as investors looked for the next best thing, in my opinion. However, an understanding of SPACs, IPOs, and Direct Listings would serve investors well before they allocate their hard-earned dollars. Many of our clients’ portfolios include the mutual funds and exchange-traded funds managed by Dimensional Fund Advisors. For that reason, we thought it would make sense to get their take on SPACs, IPOs, and Direct Listings. Here’s their approach:

Investors have long recognized that the reasons why companies elect to go public include access to greater fundraising opportunities, improved liquidity for investors, and/or a lower cost of capital. More recently, however, investors have considered the implications related to how companies go public. Historically, the most common path to enter public markets was through an initial public offering (IPO), and while IPO activity remains vibrant, entryways such as direct listings and special purpose acquisition companies (SPACs) have drawn fresh attention. Consequently, investors have been forced to evaluate what, if any, impact these roads less traveled may have on investment decisions. We examine IPOs, SPACs, and direct listings and show that, although each route is characterized by unique terrain, regardless of the path to public markets, the end result is a new public company trading in competitive and liquid equity markets.

Traditional IPOs

In a traditional IPO, the company issuing new equity hires an investment bank to provide underwriting and advisory services for the offering. The investment bank helps pitch the company to potential investors, commonly via what’s known as a roadshow, in an effort to introduce the company to investors, drum up demand for the shares, and subsequently formulate an initial offering size and price that reflect investor interest. Investors awarded an allocation purchase shares through a primary market transaction, following which the shares are listed on an exchange and available to trade.

IPOs represent the most familiar portal to public markets, and while activity levels can vary with market conditions, they remain a popular thoroughfare. Our research highlights a few IPO features that can impact aftermarket pricing, such as underwriter pricing support and shareholder lockup agreements. At Dimensional, we avoid purchasing IPOs for up to one year to alleviate the potential impact of such post-offering activities.

SPACs

SPACs are a modern version of a “blank check” company designed to use cash raised in an IPO to merge with or acquire an operating company. When the target is a private company, the transaction works like a reverse merger, allowing the private firm to enter the public market. While the vehicle has been around for decades, SPAC activity rose to new heights in 2020 and continued to outpace historical levels through the first quarter of 2021. For example, Exhibit 1 shows that SPACs raised over $150 billion in total capital across more than 500 SPAC IPOs during the 15-month period ending in March 2021. To put those figures in context, the recent SPAC activity levels exceeded those of concurrent common stock IPOs in both volume and proceeds, as well as the aggregate SPAC totals over the preceding 10-year period.

The current fad has placed SPACs under the spotlight, but the use of blank check companies as a path to public markets has also been in vogue at various times in the past. Therefore, it is important that investors understand the vehicle’s mechanics and the associated price discovery process, regardless of whether current activity levels are sustainable. First, unlike a traditional offering where issuers hold discretion over the use of funds, the money raised in a SPAC IPO is held in a trust until a target company is identified and a subsequent business combination, or the de-SPAC transaction, occurs. Following shareholder approval of the transaction, the SPAC operators can access the capital to help fund the acquisition or merger. If no deal occurs within a specified period, typically two years, the SPAC is liquidated and the cash held in the trust is returned to shareholders.

Another common SPAC feature allows investors to redeem their shares in exchange for the initial offering price plus interest prior to the completion of the proposed de-SPAC transaction, effectively serving as a backstop for the share valuation. As a result, SPACs typically trade near their IPO price until a deal is announced. Once a deal is completed, SPAC shareholders’ ownership in the shell company is swapped for a stake in the new public operating company, and the shares trade subject to the same pricing mechanisms in effect for the broader public equity marketplace. At Dimensional, SPACs are not eligible for purchase in our portfolios until the SPAC combines with an operating company and the stock represents equity in an operating business. Consistent with our approach to investing in traditional IPOs, we also require the expiration of any price support activities and lockup agreements before the new public entity is eligible for purchase.

Direct Listings

Another avenue used to enter public markets is a direct listing, in which a private company lists its equity shares directly on an exchange without conducting an underwritten offering. Recent modifications to the eligibility requirements by both the NYSE and NASDAQ served to expand access to the direct listing corridor. This notably allowed for a few well-publicized new listings, like Spotify and Slack, though there have only been a handful of direct listings in total in recent years. However, the direct listing process continues to evolve, and new innovations, such as the ability to raise capital via a direct listing, have emerged that may attract additional entrants. Therefore, it is important that investors be cognizant of the direct listing process and the relevant pricing mechanisms to allow for informed decision making.

Before shares are made available to trade on a public exchange, the direct listing company and its financial advisor work together to establish the initial reference price based on a recent private-market transaction or an independent valuation. The reference price is then used in an auction process coordinated by a designated market maker on the first day of trading, similar to the way each stock opens for daily trading. Prior to December 2020, direct listings were not permitted to raise capital and the initial liquidity was provided exclusively by early investors and employees. As a result, lockup provisions have not been common, but that may change if firms leverage the direct listing process to raise new capital.

Choosing the Optimal Path

Private companies must evaluate and choose their desired path depending on their targeted objectives and constraints. Companies may choose to go public via a traditional IPO to allow investment banks to pitch the company to a diverse set of potential investors, while other companies may choose to merge with a SPAC to expedite the listing process or because the company believes the SPAC operators provide an additional source of value to the company. Alternatively, companies that don’t want or need underwriter services may choose a direct listing to cut down on the costs associated with going public. Exhibit 2 summarizes the key path characteristics that companies may use to differentiate between the available options.

Implications for Investors

The paths to public markets have come into focus of late due to increased activity in nontraditional entryways, such as SPACs and direct listings. No matter the vehicle chosen to navigate the transit, once a company enters the public marketplace, it becomes subject to the same interactions between the supply and demand for securities that shape equity prices each day. We remain sensitive to the relevant price discovery process associated with IPOs, SPACs, and direct listings, and account for characteristics such as lockup agreements in our eligibility guidelines. However, beyond those considerations, we can apply our systematic process to extract information about expected returns for new listings just as we would for any other publicly listed security. Hence, investors can take solace in the fact that, whether a company takes the road less traveled or follows the beaten path, we can rely on the drivers of expected returns—size, relative price, and profitability—to point the way forward. Interested in pursuing an investment strategy backed by decades of academic research? Get in touch today.

Disclosures:

Article written and published with permission by Dimensional Fund Advisors with edits by Coastal Wealth Advisors, LLC.

Is the Stock Market Divorced from Reality?

September 15, 2020 by Justin M. Follmer, MBA, CFP®, AIF®

By Weston Wellington, Vice President of Dimensional Fund Advisors, LP.

I have been sheltering in place on a former dairy farm in rural New Hampshire—surrounded by more Scotch Highland cattle than people—and relying on my iPhone and Microsoft Surface Pro to keep in touch with the office via email and Zoom video. I haven’t sat in a restaurant in six months, so my dining out costs are close to zero while my grocery bill is sharply higher. I venture out every 10 days or so to stock up on supplies (Hannaford supermarket, Walmart, Tractor Supply, Home Depot) and order frequently online. Judging by the traffic on my dead-end dirt road, I’m not the only one whose habits have changed. It’s only a small exaggeration to say every third vehicle going up or down the hill is a FedEx or UPS truck making another delivery, most likely from Amazon.

For many of us, the daily routine has changed dramatically from a year ago. This writer is no exception. I customarily travel extensively for business, with well over 100 airline flights and dozens of hotel stays over the course of a year. Since March 18, the number is zero on both counts, and the near future offers little reason to expect any change.

With this shifting landscape in mind, it shouldn’t be surprising that some companies have prospered during this upheaval while others—especially travel-related firms—have struggled. From its record high on February 19, 2020 the S&P 500 Index¹ fell 33.79% in less than 5 weeks as the news headlines grew more and more disturbing. But the recovery was swift as well: from its low on March 23, the S&P 500 Index jumped 17.57% in just 3 trading sessions, one of the fastest snapbacks ever among 18 severe bear markets since 1896. As of August 18, 2020 the S&P 500 Index had recovered all of its losses and notched a new record high.

Many individuals are puzzled by this turn of events. For those under the age of 75, the news headlines are likely the grimmest in memory: Millions have found themselves suddenly unemployed, and storied firms such as Brooks Brothers, Neiman Marcus, and JC Penney have entered bankruptcy proceedings.

How can stock prices flirt with new highs while the news is so discouraging? One financial columnist recently observed that the stock market “looks increasingly divorced from economic reality.”²

Is it? Let’s dig a little deeper.

The stock market is a mechanism for aggregating opinions from millions of global investors and reflecting them in prices they are willing to accept when buying or selling fractional ownership of a company. Share prices represent a claim on earnings and dividends off into perpetuity—current prices incorporate not only an assessment of recent events but also those in the distant future. In some sense, the stock market has always been “divorced from reality” since its job is not to report today’s temperature but what investors think it will be next year and the year after that and the year after that and so on.

Moreover, the universe of stocks does not march in lockstep. At any point in time, some firms are prospering while others are floundering. This year’s wrenching economic turmoil has inflicted great hardship on some firms while opening up new opportunities for others. Based on this admittedly abbreviated list, it appears the stock market is doing just what we would expect—reflecting new information in stock prices.

Past performance is not a guarantee of future results.

No one could have predicted the tumult we have seen this year in financial markets. But investors would do well to focus on what hasn’t changed.

1. Markets are forward-looking, so focusing on today’s economic data is akin to looking at the rearview mirror rather than the road ahead.

2. Broad diversification makes it more likely that investors capture market returns that are there for the taking—including companies that do far better than expected.

3. Since news is unpredictable, a strategy designed to weather both expected and unexpected events will likely prove less stressful and easier to stick with.

Bottom line: read the newspaper to be an informed citizen, not for advice on how to navigate the financial markets.

¹S&P data © 2020 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
²Matt Phillips, “Repeat After Me: The Markets Are Not the Economy,” New York Times, May 10, 2020.

Outguessing the Market

July 8, 2019 by Justin M. Follmer, MBA, CFP®, AIF®

Try outguessing the market. Over the course of a summer, it’s not unusual for the stock market to be a topic of conversation at barbeques or other social gatherings. A neighbor or relative might ask about which investments are good at the moment. The lure of getting in at the right time or avoiding the next downturn may tempt even disciplined, long-term investors. The reality of successfully outguessing the market, however, isn’t as straightforward as it sounds.

OUTGUESSING THE MARKET IS DIFFICULT

Attempting to buy individual stocks or make tactical asset allocation changes at exactly the “right” time presents investors with substantial challenges. First and foremost, markets are fiercely competitive and adept at processing information. During 2018, a daily average of $462.8 billion in equity trading took place around the world.² The combined effect of all this buying and selling is that available information, from economic data to investor preferences and so on, is quickly incorporated into market prices. Trying to time the market based on an article from this morning’s newspaper or a segment from financial television? It’s likely that information is already reflected in prices by the time an investor can react to it.

Dimensional recently studied the performance of actively managed mutual funds and found that even professional investors have difficulty beating the market: over the last 20 years, 77% of equity funds and 92% of fixed income funds failed to survive and outperform their benchmarks after costs.³

Further complicating matters, for investors to have a shot at successfully timing the market, they must make the call to buy or sell stocks correctly not just once, but twice. Professor Robert Merton, a Nobel laureate, said it well in a recent interview with Dimensional:

“Timing markets is the dream of everybody. Suppose I could verify that I’m a .700 hitter in calling market turns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.”

TIME AND THE MARKET

The S&P 500 Index has logged an incredible decade. Should this result impact investors’ allocations to equities? Exhibit 1 suggests that new market highs have not been a harbinger of negative returns to come. The S&P 500 went on to provide positive average annualized returns over one, three, and five years following new market highs.

Exhibit 1. Average Annualized Returns After New Market Highs S&P 500, January 1926–December 2018⁴

CONCLUSION

Outguessing the market is more difficult than many investors might think. While favorable timing is theoretically possible, there isn’t much evidence that it can be done reliably, even by professional investors. The positive news is that investors don’t need to be able to time markets to have a good investment experience. Over time, capital markets have rewarded investors who have taken a long-term perspective and remained disciplined in the face of short-term noise. By focusing on the things they can control (like having an appropriate asset allocation, diversification, and managing expenses, turnover, and taxes) investors can better position themselves to make the most of what capital markets have to offer. If you’re looking for a better investment experience, please contact one of our advisors today.

Written by Dimensional Fund Advisors, LP with edits by Coastal Wealth Advisors, LLC
In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Daily averages were computed by calculating the trading volume of each stock daily as the closing price multiplied by shares traded that day. All such trading volume is summed up and divided by 252 as an approximate number of annual trading days.
Mutual Fund Landscape 2019.
In US dollars. Past performance is no guarantee of future results. New market highs are defined as months ending with the market above all previous levels for the sample period. Annualized compound returns are computed for the relevant time periods subsequent to new market highs and averaged across all new market high observations. There were 1,115 observation months in the sample. January 1990–present: S&P 500 Total Returns Index. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. January 1926–December 1989; S&P 500 Total Return Index, Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago. For illustrative purposes only. Index is not available for direct investment; therefore, its performance does not reflect the expenses associated with the management of an actual portfolio. There is always a risk that an investor may lose money.

Investment Fads

March 4, 2019 by Justin M. Follmer, MBA, CFP®, AIF®

Investment fads are nothing new. When selecting strategies for their portfolios, investors are often tempted to seek out the latest and greatest investment fads and opportunities. Over the years, these approaches have sought to capitalize on developments such as the perceived relative strength of particular geographic regions, technological changes in the economy, or the popularity of different natural resources. But long-term investors should be aware that letting short-term trends influence their investment approach may be counterproductive. As Nobel laureate Eugene Fama said, “There’s one robust new idea in finance that has investment implications maybe every 10 or 15 years, but there’s a marketing idea every week.”

WHAT’S HOT BECOMES WHAT’S NOT

Looking back at some investment fads over recent decades can illustrate how often trendy investment themes come and go. In the early 1990s, attention turned to the rising “Asian Tigers” of Hong Kong, Singapore, South Korea, and Taiwan. A decade later, much was written about the emergence of the “BRIC” countries of Brazil, Russia, India, and China and their new place in global markets. Similarly, funds targeting hot industries or trends have come into and fallen out of vogue. In the 1950s, the “Nifty Fifty” were all the rage. In the 1960s, “go go” stocks and funds piqued investor interest. Later in the 20th century, growing belief in the emergence of a “new economy” led to the creation of funds poised to make the most of the rising importance of information technology and telecommunication services. During the 2000s, 130/30 funds, which used leverage to sell short certain stocks while going long others, became increasingly popular. In the wake of the 2008 financial crisis, “Black Swan” funds, “tail-risk-hedging” strategies, and “liquid alternatives” abounded. As investors reached for yield in a low interest rate environment in the following years, other funds sprang up that claimed to offer increased income generation, and new strategies like unconstrained bond funds proliferated. More recently, strategies focused on peer-to-peer lending, cryptocurrencies, and even cannabis cultivation and private space exploration have become more fashionable. In this environment, so-called “FAANG” stocks and concentrated exchange-traded funds with catchy ticker symbols have also garnered attention among investors. And now that FAANG has had some considerable weakness during 4th quarter 2018, the next investment fad appears to be LUPA – a new acronym for 2019 IPOs of Lyft, Uber, Pinterest, and Airbnb.

THE FUND GRAVEYARD

Unsurprisingly, however, numerous funds across the investment landscape were launched over the years only to subsequently close and fade from investor memory. While economic, demographic, technological, and environmental trends shape the world we live in, public markets aggregate a vast amount of dispersed information and drive it into security prices. Any individual trying to outguess the market by constantly trading in and out of what’s hot is competing against the extraordinary collective wisdom of millions of buyers and sellers around the world.

With the benefit of hindsight, it is easy to point out the fortune one could have amassed by making the right call on a specific industry, region, or individual security over a specific period. While these anecdotes can be entertaining, there is a wealth of compelling evidence that highlights the futility of attempting to identify mispricing in advance and profit from it.

It is important to remember that many investing fads, and indeed, most mutual funds, do not stand the test of time. A large proportion of funds fail to survive over the longer term. Of the 1,622 fixed income mutual funds in existence at the beginning of 2004, only 55% still existed at the end of 2018. Similarly, among equity mutual funds, only 51% of the 2,786 funds available to US-based investors at the beginning of 2004 endured.

WHAT AM I REALLY GETTING?

When confronted with choices about whether to add additional types of assets or strategies to a portfolio, it may be helpful to ask the following questions:

1. What is this strategy claiming to provide that is not already in my portfolio?
2. If it is not in my portfolio, can I reasonably expect that including it or focusing on it will increase expected returns, reduce expected volatility, or help me achieve my investment goal?
3. Am I comfortable with the range of potential outcomes?

If investors are left with doubts after asking any of these questions, it may be wise to use caution before proceeding. Within equities, for example, a market portfolio offers the benefit of exposure to thousands of companies doing business around the world and broad diversification across industries, sectors, and countries. While there can be good reasons to deviate from a market portfolio, investors should understand the potential benefits and risks of doing so.

In addition, there is no shortage of things investors can do to help contribute to a better investment experience. Working closely with a financial advisor can help individual investors create a plan that fits their needs and risk tolerance. Pursuing a globally diversified approach; managing expenses, turnover, and taxes; and staying disciplined through market volatility can help improve investors’ chances of achieving their long-term financial goals.

Fashionable investment fad approaches will come and go, but investors should remember that a long-term, disciplined investment approach based on robust research and implementation may be the most reliable path to success in the global capital markets.

Article written by Dimensional Fund Advisors, LP with edits by Coastal Wealth Advisors, LLC.