Behavioural ETFs look to profit from other investors’ biases

This article appears in the March 2020 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Behavioural finance has helped advisors identify their own biases and coach clients toward better investment decisions. Now, the same insights are being applied at the fund level, as firms construct products to take advantage of inefficient markets and irrational investors.

The Purpose Behavioural Opportunities Fund from Toronto-based Purpose Investments launched in January 2018 as Canada’s first ETF built on behavioural economics insights. The active fund seeks pricing “inefficiencies” that result from human biases. One fund document describes the strategy more bluntly as “profiting from other investors’ emotional mistakes.”

These mistakes include mispricing caused by overreactions to news and company earnings. The way market news is regulated and communicated “creates a whole bunch of information that has to be consumed, analyzed and reacted to very quickly,” says fund manager Craig Basinger, chief investment officer at Richardson GMP. “And that causes overreactions.”

Basinger and his team analyzed five years of S&P 1500 data for cases where a company’s shares opened more than two standard deviations from its historical daily volatility. They found investors overreact to bad news but incorporate good news more accurately. They also found that companies with more analyst coverage and institutional ownership experienced larger moves from news.

Overreactions create opportunities for contrarians to move against the herd, Basinger says. This was the case with Shopify, which was added to the fund in February 2019 when it opened 10% lower after an earnings miss. The stock doubled over the following year.

“We use opportunities like these to add long positions in high-quality companies, taking advantage of others’ recency bias,” the February 2020 fund commentary says.

The management expense ratio (MER) is 1.14%, with an additional performance fee that’s 10% of the difference between the fund’s performance and its benchmark (a 50/50 blend of the S&P/TSX Composite and the S&P 500 indexes). As of Feb. 28, the fund’s one-year return was 4.75%, and it had $7.3 million in assets under management.

Basinger says many investors won’t adopt the fund’s novel approach without a longer track record. His team is focused on coaching advisors about behavioural strategies broadly, with minimal fund marketing until it reaches the three-year mark.

The SmartBe Global Value Momentum Trend Index ETF, from Calgary-based SmartBe Wealth, also has a behavioural component. Launched in January 2019, it uses value and momentum factors that seek to take advantage of pricing anomalies. Those anomalies are created by behavioural biases.

For example: loss aversion, the tendency to be more sensitive to losses than to gains, can lead to a disposition effect where investors hold on to stocks simply to avoid realizing the loss. The flip side is when investors take gains too early, a behaviour that impacts price discovery and contributes to the momentum anomaly — where stocks tend to continue trending in the same direction they’ve moved in the recent past.

Investors’ conservative bias plays into the value factor. “When new information comes in, people are not reflecting that information quickly enough,” says Prithy Serrao, SmartBe’s director of business development. This may lead to over- or undervaluing companies.

Investors’ attention is also limited and easily distracted by shiny baubles. Serrao refers to the frog-in-the-pan hypothesis, where information arriving in small amounts over an extended period attracts less attention than unusual, dramatic swings. This may lead investors to ignore a consumer staple company exhibiting momentum “in a steady and controlled way,” she says, and pay too much attention to a new biotech firm with splashy earnings.

The SmartBe ETF has $33.8 million in assets under management, and its MER is 0.93%. As of Jan. 31, its return since inception was -1.65%.

Serrao notes that 2019’s surging markets were not ideal for the strategy, which benefits from volatility and requires a longer-term approach. “If we see further downturns, we’re going to look much better,” she says.

The Purpose fund’s February commentary, published before fears about the coronavirus really hit markets, described the potential for “heightened emotional states” in the weeks ahead. “Luckily, we’ll be busy finding mispriced assets because of investors’ misbehaviour,” it said.

How funds capitalize on irrational investors

• Availability and recency bias: Investors overreact to earnings in the short term. Higher-quality companies generally recover quickly, while lower-quality companies often fall back after positive surprises, according to commentary on the Purpose behavioural fund, allowing for long-short strategies. Growth investors may also see an earnings increase and project it into the future when the gains are due to luck, therefore overvaluing a company.
• Herd instinct and overconfidence: There are opportunities for contrarians to use longer-dated options when everyone is betting on one outcome. Investors are often overconfident in their ability to value firms, leading to mispriced equities.
• Conservatism: Investors may be slow to change their views when presented with new information, leading to undervalued companies.
• The disposition effect: Investors may be inclined to hold losing stocks in order to avoid the psychological pain of realizing the loss.

Source: Purpose Behavioural Opportunity Fund commentary and Alpha Architect