Long-Term Investors? These Are The Best ETFs For You


The Best ETFs For long term investors
Did you ever notice?

Almost every mutual fund or ETF comes with a disclaimer stating that past performance may not be indicative of future performance. As the bull market in US equities approaches its ninth year, that statement may be truer than ever.

To top it off:

Many of the top performing broad market ETFs of the past decade have been market capitalization weighted. If you look at the returns over five years to March 2017, the market cap weighted S&P500 SPY fund beat nearly all the funds that are weighted using other criteria.

But that’s the key:

Market Cap weighted funds have a built-in momentum bias. The stocks with the highest momentum grow the fastest and therefore dominate the performance of the ETF. This has worked very well in the last two bull markets but might prove to be a dangerous strategy in the future.

Let me explain:

Janet Yellen has reiterated the Fed’s intention to unwind its balance sheet. If the current bull market was driven by quantitative easing, then surely quantitative tightening will do the opposite. And if that happens, surely the strategies that have performed well in the past are likely to be the ones at risk.

The following is a common-sense analysis of three ETFs long-term investors should consider:

For International Exposure:

JPMorgan Diversified Return International Equity ETF (JPIN)

Expense ratio 0.43%   |   Asset under management: $1.13 billion   |   Number of holdings: 355   |   Largest holding: 0.89%   |  Download Factsheet

For international exposure, investors often turn to the cheapest ETF, and don’t think enough about the index construction. Most of the indices that the popular international ETFs track are very large, and weighted by market cap. That can dilute performance, and it can also mean missing out on key sectors and regions.

Want to know a secret?

When US investors invest offshore, they must try to get exposure spread across the countries, regions, and sectors that count. An international fund should have exposure to China, Japan, Europe – and in particular to resource counters. US indices tend to have very low exposure to commodity producers.

2017 – JPMorgan Diversified Return International Equity ETF (JPIN)

The JPIN ETF selection process has two steps. Firstly, the strategy seeks exposure to the factors that have historically led to outperformance. In the case of this fund, that means the emphasis is on value and momentum over market cap. For example, the fund’s holdings have an average PE ratio of 14.57, vs the iShares MSCI world index fund’s 20.26.

Great Risk Profile

Once the stocks have been selected, a risk is allocated across regions, countries, and sectors. The fund holds 400 shares across 4 regions and 10 market sectors. The result is that 46% of the fund is exposed to Europe, 42% to Asia Pacific, 11% to the rest of Asia and the remainder to other territories. The highest sector weighting is 13% for industrial stocks, while most sectors, including basic materials, have exposure of 8 to 10%.

Here’s the point:

JPMorgan’s Diversified Return International Equity fund has a great risk profile. There is no concentration in a particular region or sector, and the stocks it holds are reasonably valued and have upward momentum.One of the largest holdings is BP Plc, a stock which is now recovering after an eight-year correction. The focus on midcap companies means there is more room for growth – 34% of the fund is allocated to stocks with market caps below $10 billion.

And it’s great.

This approach gives the fund exposure to strong returns, by focussing on lower market caps and momentum, while also diversifying risk. The fee at 0.43% is a little higher than one wants to pay – but I think its justified given the intelligent selection process.

For Earnings Quality:

iShares Edge MSCI USA Quality Factor ETF (QUAL)

Expense ratio 0.15%   |   Asset under management: $3.9 billion   |   Number of holdings: 126   |   Largest holding: 5.97%   |   Download Factsheet

We should consider that in the age of disruption, the companies that have turned the global economy on its head may themselves be disrupted. Companies like Amazon, Apple and Google are trading at high multiples and have massive market capitalizations. By owning ETFs with large weightings in these companies, you are betting that they can continue growing $100+ billion revenues at high growth rates.

2017 – iShares Edge MSCI USA Quality Factor ETF (QUAL)

I’m not suggesting the FAANG stocks are about to crash, I’m just suggesting that if you want pick to an ETF to hold for the long term, you may want to diversify away from purely market cap weighted indices.The objective is not to avoid large tech stocks, but to avoid being stuck with those stocks if market conditions change.

Here’s the thing:

iShare’s QUAL fund invests in stocks with high-quality earnings. This is done by using ratios like return on equity, earnings variability and debt-to-equity in the selection process. These factors have historically led to market outperformance AND to lower volatility than the average stock.

Outperformed The S&P 500

While the fund still has significant holdings in companies like Apple, Microsoft and Starbucks, if market conditions change it will not be stuck with those positions. The fund also has significant positions in stocks that are often overlooked during bull markets, yet tend to generate very strong long-term returns. The fund counts Altria, Mastercard, Gilead Sciences and BlackRock amongst its largest holdings.

What’s more?

This fund is more concentrated than the S&P500 or the Russell 2000, so performance is not diluted by companies with marginal profitability. In fact, the fund has outperformed the S&P500 by 14 percent since its launch in 2013.

Finally, the expense ratio of 0.15% is a bargain when one considers how this fund could perform through a wide range of market conditions.

For High-Quality Dividends:

FlexShares Quality Dividend Index Fund (QDF)

Expense ratio 0.37%   |   Asset under management: $1.8 billion   |   Number of holdings: 142   |   Largest holding: 3.3%   |   Download Factsheet

Dividend investing is very popular. A simple search for US dividend ETFs reveals 144 dividend issues. Very often, dividend-paying funds use the dividend yield as the primary factor to select stocks. But chasing high yields in a low-interest rate environment can end badly.

When companies are in trouble, their share prices fall, and consequently, their dividend yields increase. That’s okay until they can’t make a dividend payment. There is no point holding a stock with a dividend yield of 7 percent if you are risking of a 25 percent drop in the share price.The share price of General Electric is currently under pressure over concerns that the company will cut its dividend. Anyone who bought the share at $28 for the 3.5% dividend, is already down twice that on the share price.

2017 – FlexShares Quality Dividend Index Fund (QDF)

What could be more important?

The FlexShares Quality Dividend Index Fund looks at a company’s ability to increase and pay its dividend rather, than using historical dividend yields. The dividend yield is 2.8%, which is lower than most, but there’s far less chance of the NAV crashing. In fact, the fund can generate impressive capital gains over time.

While stocks in the fund are weighted according to the quality of cash flows, the resulting sector breakdown is very similar to the S&P500. But, where the S&P500 holds around 500 shares, the fund holds 142. So, in many ways, it’s a version of the S&P with many of the riskier stocks filtered out.The strategy has worked well, and the fund has only underperformed the index by 9 percent since inception in 2012.

Summary

These three funds have delivered perfectly acceptable returns in the current market. But they are not funds for the past. These are funds that invest in companies with strong fundamentals, which can withstand the tough market conditions that will arise sooner or later.

Also, these funds are not stuck with stocks based on market capitalization. If a company’s fundamentals deteriorate, the stock will be replaced. Together these funds can give an investor exposure to international markets, strong US cashflows and sustainable dividends.

 

 

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Richard Bowman

Richard Bowman is a trader, investor, analyst and writer based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense. He covers global equities, ETFs, currencies and indices.

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