The Problems With ETF’S, Part II: Junk in the Trunk

We write a lot about return dispersion with respect to stocks – the phenomenon whereby stocks either all move together, or begin to act distinctly. Dispersion comes and goes; when it disappears, like it did eight years ago, passive investing makes a great deal of sense. The return of dispersion in 2017 has been a boon to active managers, who are benefiting from it and other similar factors allowing for positive spreads vs. the market. No surprise then that through Q1 2017 more than half of all active mutual fund managers have beaten their 2017 benchmark.

Dispersion is the mother’s milk of active management, and skilled active managers can significantly enhance returns during such periods, highlighting a shortfall of passive investing and so-called “smart-beta” ETF’s. Our partners at FlowPoint Capital create research models that highlight dispersion opportunities at the market, sector and stock level. One of their methodologies we track closely is FlowPoint’s Trend1 model, a trend-following system that categorizes stocks into four groups: A, B, C and D. The graph below shows the performance of Russell 2500 stocks in these categories since 1990. These data highlight (1) amplitude and duration of the four categories’ share price performance over time, and (2) the power of a systematic approach to portfolio construction.

The Problems With ETF'S, Part II- Junk in the Trunk

Source: FlowPoint Capital

But for a brief “worst-to-first” run such as in 2008, stocks in the C and D categories are serial capital destroyers. Bull markets, bear markets, risk-on, risk-off, no matter – C’s and D’s are to be avoided. Well, guess how many stocks in the S&P 500 are in the C and D categories today? Eighty-six, or almost 25%. To be fair, many C-rated stocks have positive returns YTD, but the number of D’s with positive YTD returns can be counted on one hand. This in a year when the market is up 10%. So why own them? Well, you do. In your ETF. If you are holding your ETF and its C’s and D’s because you’re waiting for 2008 again, we should talk.

Today, D’s include a heavy representation of Consumer stocks and to a lesser extent, Energy. The carnage in the Consumer space has been well documented, with more than 35% of that sector negative for the past year, and Consumer is a 21% weight in the S&P 500. Nearly 100% of the Energy holdings in the S&P 500 are down YTD, though 100% of FlowPoint’s A-ranked energy stocks are positive for the year. More than 20% of FlowPoint’s category D stocks are down at least 30% YTD, more than a 40% return dispersion from the market’s. You can do the math many different ways, but what your return could have been by eliminating known risks like C’s and D’s is material.

That’s the opportunity cost with passive vehicles. You have to take the D’s with the A’s – like buying a car with a motion activated lift gate but having to also pay for the sun roof you don’t want. This risk is presumably what “smart-beta” ETF’s reduce. But smart-beta is a misnomer. Tilting portfolios toward lower-beta stocks, or high dividend payers, is one way to reduce portfolio volatility or enhance yield, but that simplistic approach doesn’t go far enough.

Take a hard look at your ETF’s. Then, build, buy or rent ranking systems that work and give your ETF an x-ray. See what’s inside. Your portfolio will thank you for it.

Crow Point would like to thank its intern, T.J. Pavone, for his help in compiling this post. It was TJ who did most of the research and analysis here. He has redeemed, somewhat, the millennial generation with his hard work. May he be an example to others.