There’s an incredibly strong argument that none of us knows or can control anything about the future of markets and economies. The only thing we do know and can control is that over-trading along with excessive fees are guaranteed to destroy our wealth. So in order to reduce the chances of fees and costs eroding our wealth we need to keep it simple and invest in broad funds such as global equity tracker funds.
For some people, this form of simple portfolio management works a treat, but is it possible to earn better returns by being a bit smarter with passive fund selections, choosing different factor ETFs over traditional market trackers?
Adding diversification
There is a significant school of research backed up by copious academic research which looks at how to break the global equity index into different factors. There are numerous factors out there, many tested to destruction and found wanting, but in my considered view only three remain standing – value and momentum plus small-cap stocks.
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There are plenty of ETFs out there incorporating factors into global stock indexes. The ETF giant iShares is especially active in the space, with the iShares Edge MSCI World Momentum Factor ETF and iShares Edge MSCI World Value Factor ETF being some of the largest offerings. Other issuers are also getting in on the act. I would draw particular attention to VanEck with its Developed Markets Dividend Leaders ETF (TDGB) and Fidelity Global Quality Income ETF (FGQD).
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The performance of these factor-focused ETFs has been mixed. Sticking with the funds offered by iShares, the momentum and value factor ETFs have returned 43.7% and 23.6% respectively over the past five years. That’s compared to the five-year return of 50% return for the basiciShares MSCI All Countries World Index ETF and 55.3% for the iShares Core MSCI World ETF (which tracks the performance of developed market indexes). Factor-focused ETFs are also more expensive with total expense ratios (TERs) of 0.30%, ten basis points higher than tracking ETFs.
I imagine most cynics will focus immediately on performance, but I would also argue that the last few years have been exceptional, with US mega-cap tech equities surging ahead due to the overall global reliance on cheap money and low-interest rates.
Take Nvidia. In the momentum index, its weighting is 6.7%, as you’d expect from a stock with such strong relative outperformance. However, Nvidia doesn’t even make the top ten of the Value ETF (its biggest holding Cisco followed by Intel). Another bell weather stock is Microsoft which is 1.91% in the momentum index, 1.91% in the world index and 1.73% in the ACWI index. Again Microsoft doesn’t even feature in the top 10 of the Value index.
Such large overweights will prove troublesome if the forces that have been driving the market higher over the past decade vanish. The different geographic weightings could also provide a level of protection against a change in the wind.
Both the momentum and the value ETFs have appreciably lower exposure to US equities. The Value version of the index has a massive overweight to Japanese equities (seen as cheap by many investors).
I’m not making any grand statements or predictions on which ETF or combination of ETFs will suit you best, but it seems to me there’s a strong case for using these factor ETFs as an alternative way of building a diversified portfolio. The iShares ETFs and those of its rivals are cheap and you don’t need to pay much more for the focused screening provided. Who knows they might even provide you with a more diversified risk exposure to global equities.
