Common Investor Errors...

Early last week, Barry Ritholtz outlined what he believed were the top ten most common investor errors:

Here is my short list:

1. High Fees Are A Drag on Returns
2. Mutual Fund Are Inferior to ETFs
3. Reaching for Yield is Extremely Dangerous
4. Asset Allocation Decisions matter more than stock selection
5. Passive is usually better than Active Management
6. You must understand “The Long Cycle”
7. Behavioral Issues Are Costly
8. Cognitive Errors as well
9. Understand your own risk tolerance
10. Pay Guys Like Me For the Right Reason

While I think this is an interesting / solid list, I don't necessarily agree with a number of them. In his post I responded with the following:

Can we disagree on some of these?

2. Mutual Fund Are Inferior to ETFs: Too broad a statement. Some mutual funds are great (inexpensive, track indices almost exactly, prevent owners from day trading [see your #7] behavorial issues being costly), while many ETFs are very poor (broad tracking error, expensive, leveraged inverse ETFs)

3. Reaching for Yield is Extremely Dangerous: Everything is based on appropriate compensation for the risk an investor takes… 5 years ago an investor sitting in cash received [a 4-5%] risk-free return. 0% [yielding] cash is now return-free risk. An investor “reaching for yield” now may actually now be a risk reduction exercise.

4. Asset Allocation Decisions matter more than stock selection: agree, but by definition asset allocation decisions are “active” decisions, hence….

5. Passive is usually better than Active Management: seems in conflict with #4

Diving right into my point #2 (because ETFs seem to be uniformly praised these days) is that mutual funds are not all inferior to ETFs (stating ETFs are superior is too broad of a statement). This is especially true for sectors / asset classes where the underlying securities are less liquid and the ETF itself trades with minimal volume (volume isn't nearly as important if the underlying securities are liquid... a point for another day). In these instances, it is more likely that the price of the ETF can move significantly from the ETF's net asset value "NAV" (the actual value of its holdings) and the bid/ask spreads widen, both of which can be negative to an investor.

One example can be seen year-to-date with Muni ETF MUB performance relative to that of a muni mutual fund. I am not vouching for the Fidelity fund below (it was the first to come up when I looked for a national muni fund with roughly 7 years of duration).

In addition to the underperformance of MUB, the volatility is 3x higher at 6.8% vs 2.2% due to the widely fluctuating ETF price vs the underlying NAV which hit a 4% premium in February (i.e. someone buying that day paid 4% more than the securities were worth).

Source: Yahoo Finance

(Almost) All Assets up in the First Half

Despite a volatile second quarter, risk assets (actually all assets with the exception of commodities) performed quite well in the first half. Leading the pack were REITs (up both quarters) on demand for income, a potential inflation hedge, and CHEAP real estate financing.

Source: Yahoo

(U.S.) Relative Strength

Despite the recent turmoil, unlike when I showed this chart last August (a time when the dollar was selling off and gold / commodities were roaring), the ETF's showing the least strength are all currency or real assets. I believe this accurately reflect the current (relative) strength of the U.S.

Source: Yahoo Finance

April ETF Performance Recap

In a month where market pundits made it seem like we were experiencing a sell-off we have never seen before, markets were only slightly in risk-off mode, while EVERYTHING (except long treasuries) is now up for the year.

The question for investors is whether the risk-off environment was simply a pause following a sharp rise in risk assets in Q1 (i.e. just the temporary mean reversion seen below).

Or the beginning of a European crisis induced broader sell-off that is a continuation of Q3 2011 (as seen below).

Source: Yahoo Finance

YTD Performance

The WSJ details:

Treasury and gold investors were rocked out of their recent torpor on Wednesday as a series of large trades in the futures markets sent prices tumbling.

At the Chicago Mercantile Exchange, an unusually big sale of more than 100,000 futures on U.S. government debt cascaded across traders' screens shortly after 10 a.m.

The selling spread to the cash markets where 10-year Treasury yields, which rise as prices fall, spiked to 1.99% from 1.93% in minutes.

The trades came just after the release of congressional testimony from Federal Reserve Chairman Ben Bernanke. Some traders said Mr. Bernanke appeared less focused on the prospect for a third round of asset purchases, known as QE3, than the market expected.

Not a good day for gold bugs.

Despite the huge sell-off in gold shown above (the largest in 3 years), gold (and other asset classes) are doing just fine. The only asset down year to date that EconomPic regularly reports on is long Treasuries (which were up more than 30% in 2011).

Source: Yahoo Finance

Whipsaw

What was down (risk assets), was up, then down again. What was up (Treasuries), was down, then up again. Below is an assortment of sector ETFs sorted by three month performance (Long Treasuries are up the most, EM Equities down the most).

Source: Yahoo Finance

The Month that Was...

Source: Yahoo Finance

Positioning for Oil's Slide

Regular readers of EconomPic shouldn't be surprised that I believe oil will trend lower in coming months (see here and here for a few posts on the subject). While I in no way believe that history always repeats itself, there are many parallels between sentiment now and as it existed last summer before last year's crash (concern over inflation causing investors to pour money into commodities / the belief that the worst is behind us).

Not surprising then that the path of oil in 2009 has followed the path we saw in 2008 (hat tip Hugh Hendry in his June commentary for the chart).

But it isn't only my view on oil that has been the cause of my increased short position in USO (U.S. Oil Fund ETF) via puts. The additional reason is that USO performs poorly when there is contango in the oil market. As detailed in the USO prospectus via Market Folly:

in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.

And this is exactly what has happened so far this year. The market was in extreme contango (a post on contango more generally is here) which resulted in the ETF underperforming the actual spot price by 40%!



And while no longer extreme, the market does remain in contango.



In addition, this offers an explanation as to why the recent drawdown in crude isn't necessarily good news for oil bulls. Stephen Schork (via FT):

The market is paying you to build supplies by virtue of the discount on nearby material. If the recent run-up in price was based on real demand for wet barrels, then this discount would disappear, i.e. the market would be moving from contango toward backwardation. That is not the case at this time. Thus, the ongoing drawdown in U.S. crude oil supplies (outside of Cushing) is not demand driven, but rather a function of lower domestic production and fewer imports. In other words, refiners, as any good grocer would tell you, are aggressively emptying the shelves, as it were, of surplus material.

With all that said, there is still reason for concern that the price level will continue to rise. Away from additional investor flows into the asset class, large commodity players are in such control of the price, that regardless of the economic conditions that could be cause for a drop in price, the price may remain elevated. The Oil Drum sums it up eloquently:

The manipulation in the oil market is taking place at a different “meta” level to the Leesons and Hamanakas. The Goldman Sachs and J P Morgan Chase's of this world do not break rules: if rules are inconvenient to their purpose they have them changed.

The Market is the Manipulation.

Deep...

Source: EIA