Investors flock to ETFs amid flight to sentiment

PUBLISHED : Sunday, 29 August, 2010, 12:00am
UPDATED : Sunday, 29 August, 2010, 12:00am

It's hard to pinpoint exactly when this happened but the world's stock markets are now awash with amateur psychologists who spend most of their time guessing what other market players are thinking and how they will react.

This means they have abandoned all that difficult stuff involving fundamental analysis of how companies actually make money and given up trying to determine what listed companies are really worth.

This flight to sentiment has profound consequences for smaller investors who, quite sensibly, are concluding in growing numbers that it is almost pointless to spend time selecting individual stocks or even individual fund managers who claim to have superior stock-picking capabilities; instead they opt to buy markets as a whole and are flocking to invest in exchange traded funds or ETFs.

We'll come back to the ETF phenomena in a moment.

Nowadays what used to be dismissed as gossip is the very lifeblood of not just so-called stock analysts but their main customers, the fund managers. They live in fear of not doing what others do and of missing a trend and therefore finding that their performance is out of line with other practitioners of this trade. Armed with fancy degrees, these fine men and women feign great interest in so-called fundamental analysis but in practice spend far more time worrying how others are perceiving the same pieces of information they have and wondering how this will affect tomorrow's or maybe even the next hour's market movement.

Obviously market sentiment cannot be discounted and indeed it is sentiment that moves markets in the short term.

Moreover, as the big buying and selling power on stock exchanges becomes more concentrated, the sentiments that matter belong to a remarkably small group of people who come from similar backgrounds and hold a clutch of similar qualifications.

The fact of the matter is that they are little more than slightly sophisticated gamblers wondering whether the fellow on the other side of the table really has an ace in his hand or is bluffing? And like gamblers, they pay far more attention to what might be than what is actually happening.

Thus even when looking at hard historic data showing a company's performance, they much prefer looking at their own, or other people's, estimates of what they think a company might be doing in the future on the grounds that the future has little to learn from the past. The entire history of stock market investing indicates otherwise but ho hum, who is brave enough to admit an interest in history?

Benjamin Graham, the guru of fundamental analysis, famously said the stock market behaves like a voting machine, but in the long term acts like a weighing machine, meaning that in the long run its true value will be reflected in share prices.

He and his disciples, the most illustrious being Warren Buffett, urge people to disregard market noise and focus on the intrinsic value of shares.

Graham had said shareholders are neither right nor wrong because others agree or disagree with them; they get to be right because the facts and analysis are right.

Moreover, Graham argued that investors who focus on fundamentals were most likely to benefit from irrationality in the market.

As ever, there is uncertainty in world markets right now. There is talk of a double dip and even of a deep 'V'.

Optimists, however, are busy saying that profits are back on the up and that the benefit of recent events has been to shake a lot of dross out of the market.

The bottom line here is that no one really knows where the markets are heading but investors can't sit on the sidelines forever.

If it is right that sentiment is what really drives markets then it makes sense to invest in vehicles like ETFs, which simply average out market performance and ride along the crest of the wave or, if luck turns, plunge as the waves crash.

Many of Hong Kong's horde of so-called financial advisers are appalled by this suggestion and have any number of clever schemes for putting your money into special funds. They will maintain with a perfectly straight face that their fund managers have special ways of beating the market.

However, a small mountain of evidence shows fund managers rarely beat the average performance of the market as a whole and once their considerable fees are factored in, they almost never deliver better than average market returns.

So that leaves us with ETFs which are now available in all major markets but investors seem to focus on their local markets when considering investments in this vehicle.

In Hong Kong, that means investing in a market with an average historic price-earnings ratio of around 13 times and a yield hovering around 2.6 per cent. A PER at this level is high for Hong Kong although the yield is reasonable and way above most returns in the money markets.

However, by just looking at these two basic valuation metrics - yield and price-earnings ratios - it can be seen that better bargains are to be found in Norway's small but interesting market where the average PER is 11.5 times and yields are over 3 per cent.

Adventurous investors might like to try the Russian market which is trading on a very modest PER of just over 9 times, carrying a yield of above 2 per cent. A much smaller market, the Spanish bourse, is offering average yields of above 5 per cent and has a PER of just above 10 times.