“The most important quality for an investor is temperament, not intellect…. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd” & Warren Buffett, 1930 – present, American business magnate and investor

LET THE GOOD TIMES ROLL, BUT STAY DISCIPLINED In early February this year, New Zealand experienced one of the worst whale strandings in history. Collectively, more than 600 pilot whales beached themselves in two separate mass strandings along a 3 mile stretch of coastline on Farewell Spit, a thin arc of sand at the northern tip of the South Island. Conservation workers and volunteers braved challenging conditions to help refloat the surviving animals, yet despite their desperate rescue efforts, hundreds of them died.

Such mass strandings of cetaceans are fairly common on beaches in many parts of the world, yet few people had seen one of this scope before - it was New Zealand’s third-largest on record.

In the fourth century BC, Aristotle noted that ‘it is not known why they sometimes run aground on the seashore; for it is asserted that this happens rather frequently when the fancy takes them and without any apparent reason.” The Romans asserted that the whales had somehow offended Neptune and this was their punishment.

Since Aristotle’s time, many theories and hypotheses as to the causes behind these mass strandings have been proposed, yet there is little understanding of what exactly drives this puzzling behavior.

Pilot whales – which are actually members of the dolphin family - are highly sociable creatures that are connected by strong familial bonds and usually

travel in large matriarchal pods. These species get their common name from their behavior of following a single leader, the ‘pilot’, which is commonly believed to be the reason for these tragic mass strandings. Their tight social structure makes them vulnerable to herding.

In the animal kingdom,

herding refers to thetendency of some species of animals to seek safety in numbers. The

individual members of a group subvert their will to the added

safety, protection

and will of that group.

In the investment

world, herding is the

tendency to shun individual thought and blindly follow the actions (rational or irrational) of the crowd. It is characterized by a lack of individual decision-making – think ‘Nifty Fifty’ during the late 1960’s and early 70’s, or the ‘dot.com bubble’ of the late 1990s.

Herding is an influential and well-documented feature of human behavior in a number of domains, not just finance. All the way back in 1895, French psychologist Gustave Le Bon observed that ‘there are certain feelings that do not come into being, or do not transform themselves into acts, except in the case of individuals forming a crowd.’

We like to believe that each choice we make is based upon our independent assessment and best judgment. But unfortunately, that’s not always the case. As humans, we are naturally drawn to things that other

people like and find valuable: we tend to eat where other people eat, buy popular cars

because we see others driving them, and wear clothes that our peers are wearing.

Our desire to fit in with the crowd can even cause us to change our behaviors. In a study called ‘Social Defaults: Observed Choices Become Choice Defaults’ (2014), behavioral scientists observed that participants chose products that were clearly inferior simply because they were copying the people around them. Unquestionably, ‘conforming to the norm’ in everyday life is socially accepted and in many ways even expected.

In the investment world however, such a ‘group think’ mentality can be costly. Shunning individual thought and making investment decisions based on collective biases can put investors on a dangerous path towards chasing price gains that have already happened and selling after the markets have already fallen – not exactly a recipe for investment success.

The meteoric rise in the popularity of passive index ETFs that track a broad market benchmark, and the soaring interest in FANG (Facebook, Amazon, Netflix and Google) stocks appear to be the latest episodes of such herding behavior in the financial markets.

Passive Index ETFs: When the first U.S. ETF, the SPDR S&P 500 Trust (SPY) was launched with little fanfare in 1993, no one could have predicted theexplosive growth and popularity of the ETF industry. Today, there are literally thousands of ETFs to choose from and the U.S. ETF market recently surpassed the $3 trillion mark in assets under management (AUM).

ETFs are, in most cases, passively managed funds that trade intraday and provide an easy way for investors to diversify their portfolios in an efficient, transparent, cost-effective, and tax-efficient manner. In fact, our firm makes extensive use of them in our investment portfolios and offers our clients a range of ETF strategies.

Yet the rapid growth and widespread adoption of ETFs has created its own problems, which investors should understand.

By definition, passive investing ignores the business fundamentals and valuations of a specific security. Thus, when an investor buys an S&P 500 index fund, one buys all the stocks in the index – whether cheap or expensive.

At the end of the 1990s, passive indexing strategies accounted for less than 10% of total assets (mostly

mutual funds since ETFs were in their infancy). By 2016, that percentage had risen to 40%, with ETFs accounting for roughly half of that. This means that nearly half of all trading today is being done by investors who are in effect indifferent to price, i.e. they don’t buy or sell investments based on their specific fundamentals. Hence buyers of these passive instruments typically don’t do their due diligence.

The majority of ETFs track a broad stock market index, such as the S&P 500 or the MSCI World Index, which are constructed to be market-capitalization weighted. Under this methodology, shares in the largest companies comprise a disproportionate share of the portfolio, and their price moves have an outsized effect on the value of the index. As a result, the ETFs tracking these indices end up owning an overweight position in the riskiest, most expensive large-cap stocks.

Indeed, that’s exactly what we have been seeing so far this year: according to Barclays, the top 10 contributors in the S&P 500 have accounted for 47% of the index’s gain through May, significantly

above the 25-year median of 30% (see graph on this page) and more than double their market-cap representation of 17%.

Investors need to be cognizant that

market-cap weighted indices are top-heavy and actually much less diversified than they realize. Besides, no

strategy outperforms all the time. The very same

dynamics that caused passive strategies to outperform during the current bull market usually lead to substantial underperformance once the tide inevitably turns.

One last point: The authors of a recent academic paper empirically demonstrated that ETFs are causing volatility in the underlying equities to increase (Franzonni, and Moussawi [2015]). Why is that important? As we mentioned before, the U.S. ETF market recently surpassed the $3 trillion mark. By comparison, the total U.S. equity market capitalization is roughly $27 trillion. In other words, over 10% of the entire U.S. equity market capitalization is represented by ETFs.

During a market sell-off, when these ETFs begin to trade at a discount, they will need to reduce their exposure by selling the underlying securities and thus potentially facilitate a much larger decline than would have occurred otherwise. That’s exactly what happened in the ‘flash crash’ of August 2015 when many of the market’s biggest and most popular ETFs saw their prices plunge

far below the values of the indices they are designed to track.

FANG, FAANG, or sometimes FAAMG In the highly unlikely case that you are not familiar with these terms, FANG stands for the ‘Fab-Four” of Facebook, Amazon, Netflix and Google parent Alphabet. FAANG includes Apple, while FAAMG substitutes Microsoft for Netflix. No matter how you spell it, these acronyms represent a narrow group of tech titans that collectively have been responsible for much of the market’s gains this year.

According to Goldman Sachs, the FAAMG stocks are responsible for 40% of the S&P 500’s and 55% of the Nasdaq’s gains so far in 2017, while collectively adding a total of $600 billion of market capitalization this year, which is the equivalent of Hong Kong’s and South Africa’s GDP combined! In that same article, the bank’s analysts implied that “Wall Street’s love affair with the sector has led to a herd mentality [here’s that word again!], or fear of missing out (‘FOMO’), that may be coming to an end soon.”

The group has gained almost 30% YTD, compared to an 8.3% gain for the benchmark S&P 500 index. That breathtaking surge was fueled partially by a continued doubling down on momentum names by fund managers. A recent Bank of America Merrill Lynch (BAML) survey found that active managers owned the highest percentage of technology stocks on record, and a whopping 71% were overweight the FANG stocks!

Technology has been the best-performing sector in the first half of this year, rising more than 15%. The momentum-driven rally has catapulted the sector to a P/E ratio of 24 times, or 40% above its 10-year average. According to Research Affiliates, at current levels these popular, pricey stocks have poor odds of outperforming in the long run, even if they are shares of large, growing and profitable companies.

Only time will tell if the two-day tech rout in mid-June that erased nearly $126 billion in market capitalization was merely a pause or the start of a correction. As long as individual and institutional investors continue to double down on these investments, the FANGs (or whatever moniker you prefer) may scale even greater heights. Still, investors would do well to heed Russ Kinnel’s warning: ‘performance chasers may win from time to time, but they experience a 2.5% shortfall in the long run’ (Mind the Gap, Morningstar 2014).

It is tantalizing to be part of the crowd and partake in all the excitement, until the selling begins… Those pilot whales in New Zealand didn’t perceive that they were in any danger until the tide went out and left them high and dry.

As investors, we don’t have to become victims of such herding behavior – we can chart our own course!

The following steps will help you improve the odds of successfully reaching your long-term investment goals:

Have a plan and set specific and realisticinvesting goals.

Establish a suitable asset allocation by choosingan investment mix that will help you achievethose goals.

Maintain discipline even in the face of short-term market volatility. Asset allocation onlyworks if it is adhered to over time and throughvarying market environments.

Rebalance the portfolio periodically andsystematically to bring it back in line with the designed asset allocation. This is particularly important for certain holdings that have grown to outsized positions (FANG stocks come to mind), which can expose you to more downside risk than you had bargained for.

Manage your risk exposure. Risk is the potentialof a meaningful and permanent loss of capital.Investors need to make sure they are exposedto the least amount of risk required to achievetheir desired return.

In today’s integrated and dynamic environment,we believe that following a passive ‘buy-and-hold’ strategy is no longer prudent. Instead, werecommend a ‘buy-and-manage’ approachwhich allows for the portfolio to be evaluated onan ongoing basis and ideally delivers moreconsistent results over time.

If applicable, defer or reduce taxes

President John F. Kennedy once said: “The time to repair the roof is when the sun is shining.” In other words: it’s time for a mid-year portfolio review. The time to take a close look at your investment portfolio and make any necessary changes or adjustments is before a market correction, not after.

The current economic expansion is the third-longest in U.S. history, this bull market - at eight years old – is the second-longest in history, and the world’s central bankers are preparing the markets for tighter monetary policies. No bull market has ever made it to its 10th birthday. It’s time to repair the roof!

Planning for a successful financial future can be overwhelming for individuals that try to make informed investment decisions on their own. If you need assistance with designing, implementing and maintaining a well-diversified portfolio that is consistent with your financial goals, we invite you to contact us to speak to one of our trusted advisors.

Of course, if you are one of our valued clients, our dedicated team of experienced professionals is utilizing their broad investment experience to regularly analyze your asset allocation, review risk controls, systematically rebalance your portfolios and perform independent fundamental research for you.

We thank you for your continued support and wish everyone a relaxing and enjoyable summer! JULY 2017