In the recent webcast, How to Avoid Gambling and Gamification in Your Portfolio, Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha, warned that too many investors act like gamblers trying to pick winners. Instead, he argued that the goal shouldn’t be to pick winners but avoid losers as a way to maintain long-term alpha.
“A loser is a stock that is overpriced – caused by human behavior. It’s not about beta or volatility. It’s not growth or value investing. It’s about overpricing. The world’s greatest company is unlikely to be a good investment if you pay the wrong price for it,” Koski said.
Koski argued that human behavior leads to overpricing, which can create an idiosyncratic risk. 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 14.2% with a Sharpe Ratio of 0.76. In comparison, a portfolio of high human factor quintile investments showed an annualized return of 9.9% with a Sharpe Ratio of 0.39.
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 uncorrelated source of returns. The human factor has no more than 0.46 correlation in either direction with any of the nine common factors, with a high of +0.36 correlation to volatility and a low of -0.46 correlation to momentum.
Human behavior is already embedded in traditional factors. For example, the covariance of stock returns with the market, variance of the market, market value, stock price returns, standard deviation of stock returns, market cap, and stock price are all affected by the human behavior. Only quality and profitability are not affected by human behavior.
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). The 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 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 an effective tool for the current market environment can watch the webcast here on demand.