VOO - Passive Indexing Alternatives | Part 2: Own High-Quality Stocks

2023-07-10 08:00:00 ET

Summary

• Passive index investing assures average returns to the market, whereas hedging a portfolio of common stocks with low-cost exchange-traded funds increases diversification and safety.
• When hedging a retail portfolio, the index ETFs from Vanguard Group are wise choices because, as a mutual-owned enterprise, it is immune to independent stockholders or outside owners.
• Quality-driven value investors buy slices of the best companies in the sector, reserving the entire universe for hedging.
• In part two of a two-part series, I'll explore the benefits of hedging a common stock portfolio with large baskets of domestic and foreign stocks using exchange-traded index funds for lower costs and less risk.

What is the best alternative to do-it-yourself, active investing?

The financial media suggests investing in passive indexes to guarantee that portfolios keep pace with the market. So what is the worst choice?

Joining the crowd and trading the shortsighted gimmicks churned by the Wall Street fee machine is inferior to buy-and-hold passive indexing and active common stock investing.

Nevertheless, it is typical for the proponents of passive investing to omit a reminder that indexes contain every company in the market, sector, or industry, translating to owning lots of poor-quality enterprises in addition to the few good ones. Thus, thoughtful investors limit the holding of index exchange-traded funds [ETFS] to hedging the common stocks in their portfolios with designs to achieve alpha over time.

This two-part series explores the general concept of portfolio hedging — albeit on the long side — and why it is essential to any active, long-term investment strategy.

Part two focuses on hedging a portfolio with domestic and foreign indexes and why quality-driven value investors pick the best stocks in the sector while reserving the entire universe for hedging.

Double-Down the Hedge

The Quality Value Investing ((QVI)) Real-Time Portfolios represent a select mix of common stocks purchased or available on the two major US exchanges: the Nasdaq Stock Market ((NASDAQ)) and the New York Stock Exchange ((NYSE)).

Covering the broader market, I sometimes benchmark the portfolios against the S&P 500, the citadel of publicly traded American enterprises. When deployed, the passive Vanguard S&P 500 ETF ( VOO ) represents the benchmark hedge of the QVI portfolios, including our concentrated family portfolio. At unpredictable times when the portfolio underperforms the S&P 500, VOO picks up the slack.

Although representing high-quality companies serving the globe, the QVI portfolio holdings, for the most part, are domiciled in the United States. Therefore, I prefer hedging the basket with the Vanguard FTSE All-World ex-US Index Fund ETF ( VEU ). The index captures the performance of major exchange-traded companies domiciled outside of the U.S., and as an independent investor, I never regret taking a globalist view.

My objective is to own an international index as protection against volatility in domestic stocks instead of an investment in and of itself. Therefore, the preferred ETF allocation for foreign hedging is Vanguard's VEU.

VOO and VEU are market-cap-weighted, the prevailing, if controversial, weighing mechanism. Market cap or capitalization-weighted indexes assign component value by the total market value of the outstanding shares against the cumulative market cap of the index. Thus, the highest market cap stock in the index has the maximum influence on the security's net asset value.

Other weighting mechanisms exist, such as price-weighted, equal-weighted, and fundamental-weighted. For example, the Dow Jones Industrial Average uses price weighting, where the higher-priced components receive the maximum weight. Equal weight, the mechanism used in the QVI portfolios, treats each constituent equally regardless of price or market cap. Fundamental weight employs metrics such as sales, book value, dividends, cash flow, and earnings. Active ETF investors seeking faster growth use alternative weighting methods to hedge risk.

In a market-weighted index, mega-cap companies dominate a significant portion. For example, in the S&P 500, it is normal for the top ten components to represent over 25 percent of the basket. On the contrary, the ten largest holdings in the FTSE All-World ex-US, such as VEU, represent about 10 percent of net assets.

Instead of owning as an outright equity investment, the objective of the foreign index is protection against the volatility of the concentrated portfolio of domestic stocks. Again, to be above-average investors, we must limit exposure to the S&P 500 or FTSE All-World ex-US indices to hedging. Index hedges are investments by proxy complete with inherent risks, including permanent loss of principal. On the other side of the risk/reward equation, we also take profits from the distributions of the index ETFs. Nevertheless, each is foremost a hedge on the long side.

Disciplined value investors are less concerned with NAV — net asset value — or premium discounts on ETFs exploited by arbitrage traders seeking a short-term mispricing edge than a more suitable long-term inflation protection or market hedge.

Assets under management in index ETFs have ballooned in recent years. The phenomenon concerns market pundits who believe sizable derivative-driven ETFs such as passive index funds — and perhaps more the speculative leveraged ETFs — will implode or outright trigger a catastrophic financial event in a market correction. Remember that index ETFs are safer as opposed to safe.

Personal Values Drive Politics

Dollar Values Drive Portfolios

Along with owning U.S. companies, whether domestic or multinational, a sound portfolio strategy includes hedging with foreign-based companies.

The stock holdings of international companies, such as those represented by the Vanguard VEU ETF, are a wise global hedge against US-domiciled publicly traded companies.

The recent populist sentiment toward protectionism and nationalism provides a feel-good platform to generate votes on Election Day with heated debate in online news feeds and social media comments. Nationalism and protectionism in the near term aside, globalization and its multinational product and service demand indeed prevail in the long run.

Carrying a conviction of nationalist sentiment to our portfolios sabotages investment opportunities in the global markets. Or, at the least, hedging strategies to protect against our inherent bias toward the stocks of US-based companies. Warren Buffet has promoted a strong bull market case for S&P 500 components over the long term, and I advocate international exposure as a protection against potential U.S. bear markets in the near term.

Politics sometimes validates our values, including emotional attachments to the domestic bliss of American exceptionalism. However, our portfolios are best served by rational thinking and accepting globalization as a sound diversification strategy.

Indexing is for Passive Investors

From an apparent noble concern for Main Street investors and despite active participation in the markets, Wall Street gurus often advocate 100% passive investing — via mutual or exchange-traded funds — as the best overall strategy for retail investors.

Indexing is appropriate for passive investors with less interest in self-directed investing or limited trust in the alternative of fee-and-bonus-focused money managers. For retail-level investors, passive indexing guarantees their portfolio performance averages to the market, at best. In the spirit of quality-driven investing, using index ETFs to hedge an active portfolio strategy instead of an outright investment is perhaps the best route for total return from capital gains and dividends.

Laser focus on major exchange-traded, common stocks. Avoid the speculative risk associated with illiquid micro caps, defined as lower than $1 billion in market capitalization. In the FOMO-influenced post-Great Recession bull market, micro caps represented over 70 percent of publicly traded companies on the exchanges, both major and over-the-counter [OTC]. OTC is defined as traded via a broker/dealer network instead of a centralized exchange.

At best, investing in OTC issues — predominated by foreign-based enterprises — is speculative. Passing on the unnecessary risk forces investors to miss out on an international staple or two; however, the OTC listing represents the underlying security more than the actual business operation. Perhaps savvy individual investors open a brokerage account that allows the purchase of primary common stock on the major exchange of the country where the company is domiciled. However, such an approach invites the challenge of currency exchange rates.

Owning U.S. exchange-traded common shares representing predominantly dividend-paying companies far outweighs the risks of perceived fast money opportunities from the micro caps and OTCs. Consider keeping major exchange-traded, non-dividend-paying growth stock allocation to a minimum. Quality dividend stocks compensate us now with regular payouts and reward us later with compounding capital gains. Nonetheless, discipline is an absolute necessity in dismissing trend-following and momentum stocks. No one enjoys watching the prices of familiar yet unowned tickers go up with abandon, as in an epic bull market. The solace lies in the exuberance of upticks countered by the stomach-turning volatility of downslides.

Many unknowing investors lose principal when those speculative stocks, unsupported by sound fundamentals or attractive valuations, take sudden steep price drops. Like the enthusiastic casino gambler, retail investors who chase fast money brag when winning. Yet, unlike the veiled poor gaming results, the vulnerable securities tickers dance across televisions, desktops, and mobile screens.

We increase the chances of tooting our horn more often by owning slices of quality companies with compelling value propositions that predominantly pay sensible dividends and keep us compensated in the short term as we wait for capital appreciation of the underlying stock over the long term. Then, when the entry prices are attractive, hedge those capital gains and dividends with quality passive index ETFs, such as VTIP, VEU, and VOO from Vanguard.

Buy the Highest Quality Stocks

Don't buy the market, sector, or industry. Instead, buy the highest quality stocks in the market, sector, or industry.

Allocate investment cash to the mispriced stocks of companies with high-quality business models rather than an equity index or intermediate or long-duration bond fund other than for hedging.

Use equity ETFs as hedges against single-company holdings for a market cycle's expected ups and downs. However, avoid using equity index ETFs to hedge against a stock market crash or a prolonged downturn, as each will race to the bottom along with the broader market.

Others promote commodities, precious metals, cryptocurrency, bonds, and complicated instruments designed to hedge inflation. On the contrary, FDIC-insured cash remains an ideal hedge against market capitulation. Cash is the safest alternative to equities, but too much cash guarantees we become below-average investors. Therefore, focus on bottom-up equity analysis, finding value in mispriced stocks of enterprises deemed the best in their market, sector, or industry.

To Index or Not to Index

The universal suggestion for 100% passive indexing on Main Street emanates from others than just Warren Buffett.

Advisories to passively index often come from professional investors who share their exploits in public discourse. Each buys or shorts stocks, funds, fixed income, options, futures, and derivatives, writes about such ventures following a winning trade, and then tells the reader to buy an index. It's as if the professional has a special Wall Street VIP card.

And this is where Buffett and his wisdom come back to center court. If these pundits, to whom he offers the more eloquent constructive criticism, beat the market consistently, the perceived contempt of the investing elite appears as sincere good advice. But, unlike the Oracle of Omaha, since most underperform, it confirms their feeble attempt at covert prose instead of overt results.

Nevertheless, if retail investors find comfort in the safety of average returns, limiting portfolio holdings to the ever-prevalent passive index funds remains a wise choice. However, if achieving alpha is paramount, instead of attempting to time the market, consider hedging a portfolio against the likelihood of an irrational herd mentality or less predictable events such as hyperinflation and economic downturns. In that regard, these words of wisdom from legendary value investor Howard Marks speak volumes:

Following the beliefs of the herd will give you average performance in the long run and can get you killed at the extremes . [1]

First, buy high-quality, reasonably-priced stocks from sectors within our circle of competence. Second, hedge the portfolio with low-cost, passive index ETFs. Third, achieve alpha from compounding capital gains and dividends over a long-term holding period.

* * *

1. Howard Marks, The Most Important Thing (New York: Columbia University Press, 2011), 97, original quote published in Marks' memo to clients of Oaktree Capital Management, L.P.: "The Limits to Negativism," October 15, 2008.

Copyright 2023 by David J. Waldron. All rights reserved.

For further details see: