During the past few months, I frequently came across story after story about record flows to exchange traded funds (ETFs) that track the S&P 500. Such ETFs include SPY, VOO, and IVV. The main reason for these record flows is obvious -- the U.S. stock markets have been doing very well this past year.
But why are investors particularly flocking to ETFs that merely track an index? There are two reasons. First, these ETFs are pretty cheap. Second, when stock markets are rallying, it seems easy to make money investing. All of a sudden, we may even feel like investment pros. In psychology, the tendency to think we are better than we really are is known as an overconfidence effect. The way this effect can manifest itself in investment decision-making is that we may misattribute our current success in the stock markets to our investing skills, when in fact most of us probably do not know much about investing. A lot of research has been conducted on overconfident investors. In the long run, they do not perform well. Here’s a study on overconfident investors in the United States. Here’s a study that I did on overconfident investors in China.
I became curious about these recent ETF flows and so I decided to check out them out for myself. I went to www.etf.com to find information about ETF flows, and I chose to look at flows to the SPY ETF simply because it is probably the most well-known, largest, and oldest ETF that tracks the S&P 500. During the past year, from August 1, 2016, to August 1, 2017, about $16.7 billion flowed into SPY ETFs. I wasn’t sure if this was a large amount, so I kept going backwards, looking at August-to-August annual SPY ETF flows, and discovered that yes, $16.7 billion was a pretty big annual flow, but then I came across the SPY ETF flow from August 2007 to August 2008. It was over $30 billion. Was this an outlier, or was this normal? I continued to go back to 2000, and discovered that no other year’s flow to SPY ETFs came close to the $30 billion flow that occurred from August 2007 to August 2008. I became curious, and so I decided to look at August-to-August annual S&P 500 returns. I discovered that during the year prior to $30 billion flow to SPY ETFs, the S&P 500 had a 13.1% return, which at that point was the largest August-to-August annual S&P 500 return since in the turn of the millennium.
What’s my point? Well, it seems that people do gravitate to low-cost ETFs that merely track an index when markets are rallying. But we all know what happened immediately after August 2008 -- the stock markets crashed. By the end of 2008, the S&P 500 fell by over 35 percent since August 1, 2008. The S&P 500 continued to crash in January 2009. So, those many investors that bought $30 billion worth of SPY ETFs lost a lot of money from the market crash if they didn’t immediately sell those ETFs. In fact, if investors purchased a SPY ETF during the market peak in 2008 and finally sold it less than a year later at the market bottom in 2009, then those investors lost about half their money. Yep, half.
So, what should investors do when markets are at all-time highs? They should probably be cautious. After all, what goes skyrocketing up can come crashing down. This past year, I have personally witnessed a lot of investors gravitating to tactically managed or actively managed portfolios (in the investments profession, “tactically managed” and “actively managed” are often used interchangeably), instead of to passively managed portfolios or to ETFs that merely track indexes. Why are they doing this? Tactical money managers usually attempt to protect their investors from stock market crashes. So, many investors and their financial advisers who are leery of the current record-high stock market valuations are now searching for “downside protection.” If you are an older investor, someone who is nearing, or is at, retirement, then it may be prudent for you to seek actively managed portfolios that can offer you protection from market downturns.
You are now probably wondering if tactical money managers are good at what they do. This Federal Reserve Board study, coauthored with finance professors at the University of California at Irvine, finds that actively managed portfolios can successfully protect their investors from market downturns. Here’s an excerpt from the study:
“Using data from 1980-2008, we find that the most active funds outperform the least active ones by 4.5 percent to 6.1 percent per year in down markets after adjusting for risk and expenses… A further investigation of the sources of fund performance suggests that active funds show better stock picking skills in the down markets. The results are robust to different measures of fund activeness and definitions of up and down markets.”
So, it seems that on average, active money managers can protect their investors from stock market crashes.
By the way, if you’ve read some of my previous Forbes columns, then you know that I am not a fan of mutual funds. I’ve previously described their huge costs, some of which are hidden, and their sneaky behaviors. So, how can you invest in a tactically managed portfolio if you don’t want to invest in a mutual fund? I’ve previously describe the many benefits of separately managed accounts (SMAs). You might think that SMAs are usually reserved for the super-rich. That used to be the case. But today, some investment firms are offering non-wealthy investors the opportunity to invest in SMAs with small account sizes. So you no longer have to be super rich to invest in an SMA. And in case you’re wondering, investors in SMAs did better than mutual funds during the 2008 stock market crash.
So, is it time for you to invest in a tactically managed SMA? I don’t know you, so I don’t know. You should talk to your financial adviser. They know your personal financial situation, circumstances, risk-aversion, and goals. And they should know a thing or two about investing.
I get similar results if I use January-to-January annual SPY ETFs flows and January-to-January annual S&P 500 returns. I just picked August because that’s the current month, and I wanted to go backwards in one-year increments.