Redwood ETF seeks to profit from investors' biases

Portfolio manager Richardson GMP employs multiple strategies to exploit price inefficiencies.

Rudy Luukko 17 January, 2018 | 6:00PM

Redwood Behavioural Opportunities, which seeks to profit by exploiting irrational investor behaviour, opened for trading today on the Aequitas NEO Exchange (symbol: BHAV). Sponsored by Redwood Asset Management Inc. and investing primarily in Canadian and U.S. stocks, the new offering is also available in two mutual-fund series.

Portfolio management will be carried out by Richardson GMP's asset-management division, Connected Wealth, which is led by chief investment officer Craig Basinger. "Investors' emotional mistakes are potentially one of the greatest sources of mispriced assets in the market," said Basinger in a release. "This actively managed, multi-approach strategy is a logical way to target -- and profit from -- the behaviours that cause the mispricing."

The Basinger-led team will employ a basket of different strategies to take advantage of behavioural tendencies and inefficiencies in market prices. According to the prospectus, the strategies are designed to perform independently of one another. Thus, the overall volatility of the portfolio will tend to be reduced, since some behaviour-related strategies work better in some market environments than others.

Each investment strategy relies on a quantitative model to help identify potential opportunities, which are then subject to fundamental and technical analysis. The assets held in each stock are based on risk, targeted profit-taking levels and stop- loss levels "to remove as much emotion from the investment process as possible."

The prospectus describes six primary strategies:

Emotional cascade: This strategy takes advantage of the bias toward more recent or widely available information, with investors overlooking the longer-term and potentially more rewarding outlook. "Such bias becomes especially acute when the quantity of new information increases due to a significant news event." This bias may cause stock prices to dramatically overreact, thereby creating opportunities for contrarian investors.

Earnings overreaction: This strategy also aims to profit from the bias in favour of recent and available information. "Higher-quality companies that suffer a significant price drop on bad earnings typically recover better than lower-quality companies. Lower-quality companies that enjoy a price jump on good earnings tend not to hold such gains for the long term."

Indexing bias: This strategy seeks to profit from inefficiency and mean reversion in the stock prices of companies that are constituents of major market-capitalization-based indexes. Companies added to these indexes tend to underperform, while those removed from indexes tend to outperform. Once a stock is included in an index, demand may increase from passive investors such as passively managed index ETFs. "Such aggressive buying may subsequently result in a regression back to a more accurate share price. The same process, in the opposite direction, often may occur for companies removed from an index."

Unloved to less unloved: This strategy targets confirmation bias and herd behaviour. For example, investors feel more comfortable investing in stocks that have a higher percentage of "buy" ratings from analysts. The Richardson team seeks to identify stocks that may increase in value soon after their analyst ratings have been upgraded.

Neglect: This strategy involves taking advantage of situations in which portions of a company that have been spun off are neglected or sold off by investors. Once the selling pressure dissipates, the share prices of spun-off entities may recover.

Crowded trades: This is another strategy that targets confirmation bias and herd behaviour. It is based on the notion that if all analysts expect one outcome, the reverse may actually occur.

Though investing mostly in North American stocks, the Redwood fund is permitted to invest up to 60% of its assets elsewhere. Richardson GMP also has the flexibility to make tactical decisions to shift into cash or fixed-income securities during adverse market conditions. Other tools in the managers' toolkit include derivatives for hedging or non-hedging purposes, limited short-selling and securities lending.

The management fee charged by Redwood is 1% for the ETF units and for the class F mutual-fund units for fee-based accounts. The class A mutual-fund units, which pay annual trailer commissions of 1% to commissioned brokers and dealers, are correspondingly more expensive at 2%. The management fees do not include operating expenses, all of which are charged to the funds.

Redwood, a wholly owned subsidiary of Purpose Investments Inc., has also concocted a performance fee. This fee kicks in if the fund's increase in net asset value beats its hybrid benchmark of 50% S&P/TSX Composite Index and 50% S&P 500 Index (C$). The performance fee is 10% of the return exceeding the hybrid benchmark in a calendar year. In the event of a losing year, no performance fees will be paid in subsequent years until any deficiency is made up.

The ETF and mutual-fund shares of Redwood Behavioural Opportunities were created from the former First Avenue Dividend Growers Class, which received prospectus approval in December 2016 but was never offered.

About Author

Rudy Luukko

Rudy Luukko  Rudy Luukko is a freelance writer who contributes to Morningstar.ca on topics involving fund industry trends and regulatory issues. He retired in May 2018 from his position as editor, investment and personal finance, at Morningstar Canada, where he had worked since 2004. He has also worked as an editor and writer for various general, specialty and institutional media, and he has co-authored courses for the Canadian Securities Institute. Follow Rudy on Twitter: @RudyLuukko.