Exchange traded fund investors should, like the Oakland Athletics, focus on the numbers to avoid strikeouts in today’s market.
“The ‘mother of all risks’ [is] the risk caused by human behavior, but to be clear we are not talking about behavioral economics. That is a completely different subject altogether. We are talking about a risk created by human behavior that impacts stock prices specifically that leads to loss and, unlike firm specific risk, cannot be diversified away. Failure to understand this risk is an epidemic problem within the asset management business, which leads investors to mismanage their portfolios and lose money,” Julian Kosk, co-founder and chief investment officer at New Age Alpha, said in the recent webcast, How Moneyball Principles Can Protect Your Portfolio.
“This risk is being exacerbated with the rise of retail trading and the gamification of markets; the risk from human behavior has become more prevalent than ever before,” he added.
Taking cues from the success story of the Oakland A’s, or what some may know as Moneyball, Andy Kern, senior portfolio manager at New Age Alpha, argued that investors should avoid sexy and expensive superstars and focus more on the best on-base percentages that can help reduce the randomness of outcomes.
Kosk explained that people have an imperfect understanding of where alpha comes from.
“In order to pick a winner, you need to have knowledge of the future, and the future by definition is unknown, and the more you forecast the unknown future, the more you increase the likelihood you will be wrong and invest in a loser,” Kosk said.
“We have built an investment process around deliberately avoiding the losers, and to do this… we have divorced ourselves from traditional portfolio management ideas and drawn on both the actuarial principals of both the gaming and insurance industries.”
Specifically, Kern pointed out that investors lose money when a stock is overpriced as market information is not perfect, so humans tend to impound vague and ambiguous information into stock prices. Consequently, companies are at risk of being unable to deliver the growth implied by its stock price.
Over the long-term, avoiding losers can generate improved alpha and enhanced risk-adjusted returns. For instance, since 2002, a portfolio of low human factor quintile investments generated annualized returns of 14.7% with a Sharpe Ratio of 0.86. In comparison, a portfolio of high human factor quintile investments showed an annualized return of 10.7% with a Sharpe Ratio of 0.49.
Koski explained that the human factor identifies priced risks like Fama-French, beta, style, size, momentum, other modeled risks, unexplained idiosyncratic risks, and explained idiosyncratic risks.
This act of avoiding losers also provides an uncorrelated source of returns. The human factor has no more than 0.43 correlation in either direction with any of the nine common factors, with a high of +0.36 correlation to volatility and a low of -0.43 correlation to momentum and value. After adjusting for all nine factors, the human factor returned 0.18% per month in alpha, and the combination of all nine factors only explained 39% of the return of the human factor.
Investors who are interested in avoiding the losers can look to New Age Alpha’s latest ETF offerings, including the AVDR US LargeCap Leading ETF (CBOE: AVDR) and the AVDR US LargeCap ESG ETF (CBOE: AVDG). These strategies offer an actuarial approach with an uncorrelated source of return.
Starting with a known investment universe, the S&P 500, AVDR identifies and removes the 450 companies with the highest human factor score to create a portfolio of 50 stocks with the lowest human factor.
Similar to AVDR, AVDG aims to outperform by avoiding low-rated ESG companies that the firm believes are most likely to fail to deliver the growth implied by their stock price. Starting with a known investment universe, the Refinitiv U.S. Total Return Index, AVDG applies negative screening to remove all but the highest-rated ESG companies and stocks with the lowest human factor to create a portfolio of 50 highly-rated ESG stocks that provide the potential to outperform.
Financial advisors who are interested in learning more about a rules-based investment strategy can watch the webcast here on demand.