About a century ago, back in Graham’s early days, if you wanted to build a diversified stock portfolio, the only way you could do it is select a good amount of stocks and buy them manually, one by one. If you wanted to invest in the Dow 30, you needed to open positions in each one of the Dow 30 stocks. As transaction fees were much higher than today, only the affluent few could do that profitably. Even though mutual funds had evolved in the U.S. through the ’20s, by 1929 only 5% of the capital was invested in them.
Fast forward to our day. Nowadays we have ETFs, Exchange Traded Funds – A low-cost way to invest in a broadly diversified portfolio of stocks, or other securities. Since the introduction of the SPY ETF in 1993, ETFs have grown in popularity, and by 2015, $2 trillion were invested in ETF.
There is no doubt that ETFs have unique traits that make them compelling for a multitude of investing objectives. Yet there are cases in which building an outright stocks portfolio is better. In this spotlight article, we shall discuss when and how investing in ETF is preferred, and when you may want to stick with direct stock investing.
The Merits of ETFs
Only in the U.S., there are about 1800 active ETFs. In the rest of the world, there are a few thousands more. There are ETFs for any type of asset class, investing style, stock factor, sector, industry, and region that you can think of. The possibilities of building a portfolio with ETF are endless.
Unlike mutual funds, ETFs trade like stocks. They have a quoted market price, which is affected by supply and demand, like any stock. Mutual funds can only be traded at the end of the trading day. Most ETFs are liquid, and show low bid/ask spreads, definitely if you compare them to stocks. If you are in need to dispose of units in an ETF, you can be certain that you will find buyers quickly. It is not so with some stocks, especially microcaps.
Since ETFs are a centrally managed pool of funds, their cost of diversification is low. Investing in the 3000 stocks of the Russell 3000 has never been easier…and cheaper.
ETFs provide an economical way to rebalance portfolio allocations and to “equitize” cash by investing it quickly. Instead of maintaining a portfolio of stocks, checking them periodically, rebalancing them every once in a while – simply buy one ticker.
For example, do you believe in investing in Value and Momentum, as we do? Simply buy VMOT and forget about it.
Well, if ETFs are so great, why bother with investing directly in stocks? Let us analyze that question. But before that, let us discuss how to select an ETF.
The FACTS Framework
The book “Do It Yourself Financial Advisor”, by Grey and Vogel, includes a very smart framework to perform fund selection, whether it is a mutual fund or an ETF.
Grey and Vogel call it the FACTS framework. Let’s see what it means.
The first parameter, Fees, is easy. You should invest in funds that have low fees. Fees are the silent killer of investment returns. They may not seem to be a big deal, but fees can eat up much of your returns over the long-term. So watch out for high fees.
The second criterion is Access. What it really means is – liquidity. When you need to withdraw from the fund, it needs to be accessible. That is usually the case for most mutual funds and ETFs. It’s not the case, though, for private funds or hedge funds. So what Grey and Vogel are actually saying, is that you should prefer liquid funds over non-liquid funds any day.
The next criterion is Complexity. Funds need to be transparent, and they need to be easy to understand. Don’t be tempted to invest in funds that implement fancy and shiny investing methods, that you don’t understand. When a fund is too complex to understand, you should beware.
Then there are Taxes. As individual investors, we care about after-tax after-fees returns. Therefore, any fund should be tax efficient. That criterion is an easy one to implement because all of the ETFs are tax-deferred. It means that you pay taxes only once you sell units in the ETF, but not when the ETF buys and sells its underlying stock holdings.
The last criterion is Search. What Grey and Vogel mean by Search, is knowing who stands behind the fund. You should be able to search and find the investment manager who is running the fund. There should be somebody with a reputation to preserve. If there isn’t, or the investment manager is replaced too often, be careful.
Fees, Access, Complexity, Taxes, and Search. Together – they are the FACTS framework.
Nowhere in the FACTS framework do Grey and Vogel mention past returns. Past returns should not be a criterion for selecting a fund. Yet that is exactly what most people do. They look at how the fund has performed during the last year, three years or five years. Seasoned value investors, like members of our private community, especially of the quantitative type, know that past returns are poor predictors of future returns, especially the shorter the look-back time frame is. The ETF companies are promoting that faulty behavior by ranking and scoring ETFs based on past performance. That rating may have historical value if you have an interest in how ETFs have performed, but little practical value to the investor.
On the contrary, due to the strong reversal effect, investing styles or sectors that have underperformed in recent years, are more likely to outperform in the next few years, and thus revert over time to average performance.
I mentioned above that there are cases in which investing directly in stocks may be an even better choice than investing in an ETF in certain cases.
Such is the case of the enterprising investor, young or old, who wishes to maximize returns. In the discussion below, I will consider the case of investing in VMOT directly, vs. Investing in a Value and Momentum stocks portfolio.
When you buy an ETF, you don’t always get what you expect.
Let’s say you know by now that Value and Momentum are great ways to invest, and you wish to invest in Value and Momentum ETFs.
Most Value ETFs use a simplistic approach to choosing Value stocks, such as selecting the stocks with lower P/B, P/E or other simplistic measures that may still work…or not.
For example, a popular Value ETF is the Vanguard Value ETF (VTV). If tracks the CRSP U.S. Large-cap Value Index, which states:
“CRSP classifies value securities using the following factors: book to price, forward earnings to price, historic earnings to price, dividend-to-price ratio and sales-to-price ratio.”
Is that how you really what you invest in 2019? P/B and P/E?
I mean, it’s good….but it’s definitely not great.
Our friends at Alphaarchitect.com has researched whether the P/B is still relevant as a sole value metric. In their article Factor Investing: Evidence-Based Insights they claim:
“Investors are faced with a serious challenge these days. Even if you have a Ph.D. in finance, it can be hard to identify what you are buying based on the marketing materials and analytical tools available in the market…factor models can be finicky, and changing how one defines the factors (e.g., the definition of the “Value,” or HML factor) can have massive impacts on the conclusions one makes.”
The situation is not materially different for Momentum ETF. Alpha Architect have dissected the most popular value ETF, MTUM, to see how well their picks comply to the academic definition of momentum, i.e., the relative price appreciation during the last year, excluding the last month (also called 2-12 momentum).
The figure shows the distribution of stocks for momentum (X-axis) and market capitalization (Y-axis). In orange, stocks selected based on high academic momentum are concentrated at the right edge of the chart. In blue, the actual holdings of the MTUM Momentum fund spread a large momentum range. It’s not a pure momentum fund, but rather, a large-cap fund with some concentration in momentum.
If you wish to exploit a stock factor such as Value or Momentum to its maximum, you should probably create your own stock portfolio, and not count on ETF companies to do it for you.
Nevertheless, I found a handful of ETFs that invest in Value and Quality with conviction. Naturally, the Alpha Architect’s fund are such – QVAL, IVAL, QMOM, IMOM and VMOT. Also, Cambria funds seem to take a similar approach – GVAL, GMOM.
Nevertheless, those ETFs are invested only in mid-caps and large caps. The smallest positions in Alpha Architect funds has a market cap of several $ billions. What if you would like to exploit the size alpha and invest in small caps or even microcaps?
Which brings us to one of the main advantages of building a barebone stocks portfolio rather than buying an ETF – Investing in small caps, or better – microcaps.
The smaller the stocks you allow to enter your portfolio, the higher the potential gain. I have written extensively on the size factor, or as it is called in academia, SMB (Small-minus-large). Here is a comparison of three Quantitative Value (QV) portfolio simulations over 19 years, mid-1999 to mid-2018:
One can see clearly, that the lower the Market cap minimum, the higher the average annual returns.
It is a similar case with Quantitative Momentum (QM) portfolios:
And the research shows that it is no different in other strategies as well.
If you do not mind investing in large-cap QV, and QM stocks, those with $5B, $10B and even $200B market cap, you may be fine investing in QVAL, IVAM, QMOM or IMOM.
The 0.8% management fee may be worthwhile to save you the hassle of creating a portfolio.
But if you’re after the highest returns possible, investing in small caps and microcap Value and Momentum, the only way to go about it is by building your own stocks portfolio.
But you may say, an ETF is more diversified.
How much diversification is needed – is a debated topic in value investing circles. On one end, Walter Schloss, the old-school Deep Value investor who delivered 15.3% per year over 4 decades of operation (vs. 10% for the S&P 500) usually invested in 60 to 100 positions. On the other end of the spectrum, Charlie Munger is known of claiming that you only need 4 stocks to be well-diversified.
“A well-diversified portfolio needs just four stocks”
“The idea that very smart people with investment skills should have hugely diversified portfolios is madness. It’s a very conventional madness. And it’s taught in all the business schools. But they’re wrong.”
— Charlie Munger
I believe that the balance should be such that diversification reduces the volatility of the portfolio to acceptable levels (on par or below the volatility of the benchmark), but not too excessive to impair expected returns by investing in sub-optimal stock selections. Dr. Wes Grey calls excessive diversification – de-worsification, as more and more positions only worsen the portfolio. His experience, as well as mine, shows that a good balance for quantitative portfolios is 20-40 stocks. QVAL, IVAL, QMOM, and IMOM ETF – each contains about 40 holdings. My Lion portfolio contains 30 QV stocks and 20 QM stocks.
Some investors are concerned that holding tens of stocks lead to high transaction fees for small portfolios (due to a minimum buy/sell fees imposed by brokers), and to a high portfolio maintenance effort (since many stocks need to be sold and bought). Those concerns are not valid to our quantitative portfolios. I personally invest through Interactive Brokers, which charges me a minimum of $1 per transaction. On a $2,000 position, that’s a minuscule 0.05%. Rebalancing only once a year (or twice a year for Quantitative Momentum) minimizes the maintenance effort.
And as for fees, no ETF can beat the 0% (zero percent) management fees that incur on a DIY stock portfolio.
ETFs have democratized intelligent investing and made it possible for individual investors, even those with small funds. Their liquidity, lower-than-ever management fees, variety and simplicity of use – have made them a compelling vehicle for investors of all types.
I, too, hold significant sums in ETFs. Mostly, I hold ETFs of asset classes which I am no expert on, yet I still want to be invested in, for diversification. Those are Real Estate (through VNQ), Commodities (through PDBC) and a few bonds ETFs.
Although there are some great active ETF choices out there (I especially like those by Alpha Architect and Cambria), most people select ETFs for the wrong reasons, such as past recent performance. Wes Grey had articulated the FACTS framework for intelligent selection of ETFs, but as usual, most people are unaware.
For the enterprising investor, willing to put just a little bit of effort, creating a DIY stock portfolio is a way to make even higher returns than the best ETFs. For those investors, I would suggest allocating some of their funds to that, while keeping the rest in ETFs. While ETF investing is versatile, simple and low cost, there are obvious advantages to investing directly in stocks. Such is the ability to invest in small size stocks and gain from the low-size factor, the ability to exploit stock factor (such as Value, Momentum, and Quality) to their fullest potential, without dilution; and the avoidance of management fees altogether. You should find your own balance.