SPGP - Our Core U.S. Fundamental ETFs

2023-11-08 15:55:06 ET

Summary

• Rules-Based ETFs for Core U.S. Fundamental Allocation.
• Fundamental Metrics vs SPY.
• Detailed Comparison of Investment Strategies.

Our portfolio design approach includes three key categories:

• Core holdings for the long term.
• Satellite holdings for the medium term.
• Tactical holdings for short-term opportunities.

These components can be customized to align with the unique needs and preferences of each client, as hypothetically illustrated in Figure 1. The Core can be any size relative to the whole portfolio, but preferably at least be the foundation on which a more complex portfolio is constructed.

FIGURE 1:

We share the perspective of David Swensen, the former CIO of Yale's endowment, who addressed the need for investors to understand and be comfortable with their portfolios in his 2005 book ' Unconventional Success: A Fundamental Approach to Personal Investment '.

He stressed the critical importance of considering investors' personal preferences to create an effective and durable portfolio. If investors do not have conviction about the long-term efficacy of their portfolios, they are likely to make detrimental changes when adverse short-term market conditions occur. He emphasized that investors need a portfolio core that they believe is suitable to hold through market ups and downs.

We emphasize to our clients the significance of understanding 'What' they own, 'Why' they own it, its 'Role' within the portfolio, and 'How' the investment works.

This is a discussion of 3 Core, rules-based, fundamental, US stock funds in our model.

While many investors aim to construct enduring portfolios with individual stocks, we advocate the use of carefully selected funds, particularly rules-based ones, over subjective active management. This approach is more likely to enhance long-term success and peace of mind.

Individual investors typically lack the information resources, expertise, and discipline for continuous management to build and maintain a portfolio of individual stocks long-term. That tends to lead to static portfolios that underperform.

Consider the scenario if you're nearing retirement or already in retirement, that you might become unable to actively manage your portfolio, or the portfolio becomes part of your estate. It's essential to evaluate the most suitable approach for such a contingency.

Would you prefer to leave behind a collection of individual stocks that you selected at a point in time, which might be challenging for your spouse or family to manage effectively? Alternatively, would you opt for a set of rules-based funds with well-thought-out strategies that can operate with minimal intervention?

Chances are your spouse or family may not have the same capacity or expertise as you do to manage a portfolio of individual stocks. In such a situation, you may want them to have the peace of mind that the portfolio can function effectively and independently for an extended period, without an urgent need to turn it over to someone else.

This consideration underscores the importance of having a portfolio that is not only designed for your financial goals but is also resilient and user-friendly for potential future situations where your active management might not be feasible.

Visualize your portfolio as a vegetable garden. Just as in gardening, you need to determine what you want to cultivate, allocate space for each type of plant, provide nourishment, maintain regular care, protect against pests, remove unwanted weeds, and harvest when the time is right.

Professionally managed funds operate similarly to your investment garden, ensuring that your investments are cultivated, nurtured, and maintained to generate good outcomes. This analogy illustrates how these funds can simplify the process of managing your investments, allowing you to enjoy the fruits of your financial labor.

We find these three rules-based US equity funds to be a sensible and prudent core of the fundamental allocation for US stocks in our portfolios:

• SPGP: Invesco S&P 500 GARP ETF.
• COWZ: Pacer US Cash Cows 100 ETF.
• SCHD: Schwab U.S. Dividend Equity ETF.

We can discuss our core rules-based US equity momentum ETFs and core nontraded stabilized US real estate funds in other articles.

Investors typically want to look at performance charts first. Here are those three ETFs over 3 years versus SPY (S&P 500 ETF) in Figure 2:

FIGURE 2:

It appears they have acquitted themselves reasonably well.

They are not designed to have blowout positive periods or to be immune from broad market drawdowns, but rather to achieve steady performance over time without being drawn into manias and bubbles or to suffer the catastrophes that may follow.

Looking at a series of metrics over the same time, they also look good in Figure 3.

FIGURE 3:

The red, yellow, and green shading helps highlight the relative strength of each ETF over several important dimensions.

The immediate observation would be that SPY shows a lot more red than the three core positions.

Over the past 3 years, SPGP, COWZ and SCHD had better total returns than SPY (S&P 500), less severe drawdowns (price change from peak to trough), better Sharpe and Sortino ratios, and better Upside/Downside Capture.

The Sharpe ratio is basically a return in excess of 3-month treasury returns divided by volatility .

The Sortino ratio is the same as the Sharpe ratio except that it only includes downside volatility, based on the argument that upside volatility is attractive and downside volatility is not.

The Capture Spread Ratio is the percent capture of broad market upside moves minus the percent capture of broad market downside moves.

Getting down to why we find them attractive, Figure 4 compares their respective investment strategies from their prospectuses which should make their appeal clear.

FIGURE 4:

• SPGP focuses on GARP (growth at a reasonable price) which has long been held as a reasonable and effective way to select stocks. It's not a barn burner, but it makes logical sense which enables investors to sleep well at night.
• COWZ focuses on stocks that generate large amounts of free cash flow relative to their total enterprise value, which is the sum of their market and net debt. In a time like this where debt is expensive, and in some cases, difficult to refinance, companies with high cash flow are expected to have less need for debt, and more ability to take it on new debt or refinancing if needed.
• SCHD focuses on high dividends consistent with a history of dividend payment growth and the capacity to sustain dividend growth in the future. As most of our clients are in mature stages of life, dividends are an important part of total return expectations.

We hold these three rules-based core US fundamental ETFs in equal weight. The result is an approximate 30 basis point expense ratio. Although not as low as the under 10 basis point expenses of some broad market index funds, the logical appeal of the consistency of selected rules-based funds makes the additional cost reasonable, and still much less than most active funds. Active funds are more expensive, meaning they must consistently outperform their benchmark by their fee level, which all but a few fail to do in the long term.

With these three funds (SPGP, COWZ and SCHD), we maintain a diversified portfolio of 275 stock positions, providing robust diversification without compromising quality. These strategies steer clear of weaker stocks and focus on selecting promising stocks based on reasonably priced growth potential, free cash flow yield, and sustainable dividend yield.

There is some overlap, but not too much. The fact is we are encouraged by some overlap showing that at some level they converge on some common elements of value and growth.

Among the 275 stocks, 28 are held in common between SPGP and COWZ, and only 6 are held in common between all three funds. The degree of overlap in the specific stocks and sectors of the overlap will shift over time.

The clearly articulated stock selection and stock and sector waiting limits are in stark contrast to most active management funds, which provide virtually opaque but very wordy descriptions of their process. We would be hard-pressed to know what they actually do and how they do it, and as personnel change at the funds we cannot be sure which parts of the word salad in their investment process description will be emphasized, and we don't know how much style drift may be taking place from period to period.

There is a place in portfolios for active funds, but in our opinion, only when a rules-based fund cannot be found to serve the purpose. The need for an active fund would typically be in very specialized situations, not broad market situations.

In summary, we consider SPGP, COWZ, and SCHD to be a powerful combination of investment strategies suitable for a substantial portion of portfolios.

Disclosure: QVM has positions in SPGP, COWZ and SCHD as of the date of this article. We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article and are not compensated by Seeking Alpha in any way relating to this article.

General Disclaimer: This article provides opinions and information but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

For further details see: