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Oh, behave: How to make sense of behavioral ETFs

[October 26, 2017] By Chris Taylor

NEW YORK (Reuters) - Can you make serious money by capitalizing on human foibles?

Because of fear, greed and other emotions, most people are terrible at managing their own money. So fund managers are trying to figure out how they can use behavioral finance - proven insights about people's foolishness with finances - to select a basket of investments they can offer as a low-fee exchange-traded fund.

"A lot of investment nerds have thought this has been a long time coming," said Dave Nadig, chief executive officer of popular informational resource ETF.com. "And I think there will be more of these products going forward. But taking the insight that people make non-rational decisions and applying that to the markets is really tough."

If anyone can figure it out, it is probably economics Nobel Prize winner Richard Thaler, the reigning king of behavioral finance. Fuller & Thaler Asset Management, run by a team that includes Thaler and firm President Russell Fuller, does not offer a behavioral ETF, but it does offer the actively managed Behavioral Small-Cap Equity fund, which has reliably ranked in the top 2 or 3 percent of all small-cap funds.

A classic pick: Domino's Pizza, which many investors avoided because of bad college memories of subpar slices. But when the chain started churning out positive earnings surprises, Fuller & Thaler started ordering shares. They bought at $27 and got out at $112.

"We're all human, we're all imperfect, and we all have emotions," said Ed Stubbins, a partner at Fuller & Thaler. "Investors underreact and they overreact - and that's where we come in."

A BASKET OF BEHAVIORS

One of the foremost behavioral ETFs so far is Aptus Behavioral Momentum, which launched in June 2016. It has healthy year-to-date returns of 11.33 percent, although that lags the S&P 500's 14 percent gain. The ETF has drawn $40 million in investor assets so far - decent for a new product but still only a drop in the bucket of the $4 trillion in ETFs globally.

BEMO focuses on one particular behavioral hiccup: When a stock is on a tear and at a 52-week high, many investors tend to get nervous and sell. BEMO prefers to let its winners ride.

"We think there is a lot of irrationality around that price point," said John Goldsberry, managing director at Aptus Capital Advisors, who identifies Alpha Architect and Cambria Funds as competitors in this relatively new ETF arena.

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So how exactly does Aptus pounce on these investor fears? It sifts through the S&P 500 for stocks with plenty of price momentum that are at or close to their 52-week highs. The top 25 go into its portfolio.

Think of this strategy as the flip side of classic value investing. A deep-value investor might pick through the bargain bin for stocks that are being beaten up; BEMO hunts for a white-hot winner in order to keep riding that wave as investors pile in.

Behavioral ETFs are still limited to a handful of products - which often do not even have "behavior" in the fund title - including Alpha Architect's suite of five ETFs like ValueShares US Quantitative Value and MomentumShares US Quantitative Momentum.

Here is another option for investors: Take a step back with a so-called separately-managed account (SMA) with a behavioral focus. SMAs are not ETFs themselves, but invest in ETFs based on their own data-crunching and behavioral judgments.

That is what money manager AthenaInvest does, with impressive results. Its particular strategy is to examine what fund managers are thinking, organize them into "clusters," and then place bets based on where the market is likely heading - taking advantage of the herd mentality, so to speak.

So when virtually all fund managers were making positive noises about the market earlier this year, AthenaInvest's Global Tactical fund bet big on a leveraged S&P 500 ETF. That was very good news for its investors, who reaped twice the rewards of most market bulls. The $150 million fund boasts returns of 20 percent year-to-date, and roughly 20 percent annually since inception in 2010.

"We don't use modern portfolio theory at all - we're all behavioral," said Tom Howard, AthenaInvest's CEO and chief investment officer. "And we were thrilled to see Dick Thaler win the Nobel Prize. It makes us all more legitimate."

(Editing by Beth Pinsker and Leslie Adler)

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