Some of my favorite posts are spawned from readers asking questions that challenge my thesis in one way or another. Often, it’s the result of decisions or preferences that don’t conform to their methods of analyzing investments. This topic is no exception as I received an inquiry regarding a recent post on how investors can overcome the obstacle of owning thinly traded ETFs.
My explanation was based on the real-world experience of purchasing the SPDR MSCI USA StrategicFactors ETF (NYSE:QUS) for my clients. To which a reader promptly challenged:
“Who in their right mind would buy QUS when it has underperformed SPY over the last two years?”
It’s a completely valid question and one that I’m sure many investors would presuppose as well. The reader is accurate in that QUS has underperformed SPY by a little over 3% on a two-year look back. The charts are roughly similar, but you are see how the smart-beta index has started to diverge more prominently since the beginning of the year.
To put things in context, we need to compare the two indexes to understand what they offer. The SPDR S&P 500 ETF (NYSE:SPY) is the penultimate benchmark of U.S. stock performance. It is a market-cap weighted representation of the 500 largest stocks domiciled in the United States as chosen by the index committee at Standard and Poors. It’s also the largest and most heavily traded ETF in the country.
Virtually any stock-only ETF is going to be (rightly or wrongly) judged against this index at some point throughout its history. Whether you love it or hate it, it’s just the way the investment community has been trained to measure the relative success of any equity strategy.
QUS is comprised of a basket of more than 600 U.S. stocks chosen based on multiple factors that include value, low volatility, and quality. The way this is implemented is by equally blending a single composite index from three separate MSCI methodologies. The stocks with the highest scores in each category ultimately make the cut. Its broader interpretation of the investment universe also ensures that mid-cap stocks are fairly represented alongside their large-cap peers.
QUS charges a net expense ratio of 0.15%, which is not all that much more than the 0.10% expense ratio of SPY. Expense always plays a role in the investments we choose for clients, but a variance of 5 basis points will almost never make for a final decision breaker.
Now that we know the players, let’s talk about implementing the strategy in real life.
We chose to buy QUS not based on its past performance, but our expectation for its future returns.
Read that last sentence again. I’m not buying a past track record. I’m buying something with the expectation that it will prove to be a stronger value proposition in the days, weeks, and months to come.
We chose QUS because of the following criteria:
- It complemented the existing positions in our portfolio and filled out a spot in our equity sleeve for diversified U.S. company exposure.
- It has an attractive cost structure that fits within our objective of keeping expenses minimal.
- It has a rigid index construction methodology with the ability to adapt to changing conditions over varying time frames.
- It carries factor methodology that we believe to be an important driver of future returns.
- Its past performance variance relative to alternative strategies is within acceptable tolerance levels.
- We aren’t trying to track the S&P 500 Index.
The mistake that many investors make is that they are always chasing past performance. I could easily do a screen of ETFs that have beaten the S&P 500 on a two-year time frame and come up with 100+ funds on the list. Half of them are probably going to be technology-focused or overweight in some way.
That may continue to be a huge driver of growth in the years to come or it may not. What I do know is that those who continually seek out strategies based on short-term performance are going to experience weaker long-term results. The ability to understand this dynamic and turn it on its head is what separates mediocre investors from successful investors.
Disclosure : FMD Capital Management, its executives, and/or its clients June hold positions in the ETFs, mutual funds or any investment asset mentioned in this article. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.