3 Smarter Investing Alternatives to ETFs
Better asset management means saying “no” to mindless investing
|Written by Tom Yeung, CFA | CDFA
Investment Advisor & Fund Manager, Jurnex Financial Advisors
Summary: This article examines the issues to ETF investing, and proposes the 3 top alternatives for smarter investing.
Over the past decade, it’s become almost the status quo to invest in low-cost ETF’s rather than mutual funds or individual stocks. The evidence for doing so seems frighteningly obvious:
Since 2017, 83% of domestic US funds failed to outperform their benchmarks over a 15-year period, according to the American Enterprise Institute. Individual investors fared little better, averaging 4.5% lower than market returns, according to Dalbar, Inc, a research firm.
What’s wrong with this picture? Mindless ETF investing is still … mindless
Just like investing in the 1990’s tech bubble (the web will rule the world!) to the 2000’s real estate bubble (real estate can only go up!), mindlessly investing in ETFs substitutes good judgment for herd mentality. So even though ETFs are a highly useful tool in an investor’s portfolio, investing 100% of your portfolio in them goes overboard.
How to invest smarter? Use ETFs, but only for their intended purpose.
If you want to invest smarter, this article is for you. In this article, we examine the key issues of ETFs and explore smarter investing alternatives.
Firstly, this article will cover the problems with blindly investing in ETFs. Next, we’ll look at three better asset management techniques. Finally, we’ll wrap up with how you can create a plan to move forward with smarter investing. By the end of this article, you should have a good idea of how to balance between stock and ETFs.
Why the benefits of ETFs are overstated
There is a saying in the financial world. Every bubble begins with a grain of truth. In the case of ETFs, this grain of truth was this: they are low-cost. In fact, some are almost free, with expense ratios of just 0.03%. It’s basically a rounding error. And thanks to that cheapness, they have outperformed mutual funds handily by 1.5-2.0% over the long run
The quest for ever-lower expense ratios is a fine endeavor. But at a certain point, investors and asset managers can both miss the big picture.
It’s like diligently building a house, brick by brick. You might spend months getting every tile lined up precisely. But what if you suddenly realize you’ve built that house in the wrong place?
ETFs have this problem too: they’re only as good as the index they track. It’s great to lower expense fees by that last 0.01%, but this has blinded investors to the bigger picture. In fact, 3 of the 4 largest ETFs now track the S&P 500, sharing almost a half-trillion dollars between them.
Reason 1. No one decided that the S&P 500 is the right benchmark for you.
The S&P 500 weighs companies by one single metric: market capitalization. While certainly a good first step, the advent of the S&P index was done more out of convenience rather than with any sound investing principals in mind.
A brief history lesson might be in order. In the mid-1980s, mutual fund customers began wanting to know how their funds compared to others. Thus, Morningstar was born. This was a service that compared mutual fund returns to each other. But in the 1990s, people began to realize that mutual funds should be compared to their investment universe instead. Thus the rise of indexing.
But which companies to include in the index? The S&P500, for example, uses a committee to select 500 US-based companies. The stocks are then weighted based on market cap. A 10% move in Apple, for example, would have 20x the effect on the S&P 500 than a company 1/20th the size, such as FedEx.
Indexing has a significant problem, however. Inclusion into the S&P500 suddenly means all index funds are forced to buy shares in the incoming company and sell those of the departing company. In fact, some studies show stocks getting a 15% boost in share price the moment the S&P announces the stock’s entry into the S&P 500.
Reason 2. When you buy an ETF that tracks the S&P 500, you get both the good and the bad companies.
Simply because the S&P 500 exists doesn’t mean that it is a good investment. These were simply companies selected by a committee that have sufficient size and liquidity. There are plenty of poor companies in that index.
To put it another way, imagine you wanted to invest in some real estate. If you were an experienced real estate investor, you might identify a particularly attractive property and know roughly what kind of return you can expect.
Let’s now imagine that instead of a single property, that neighborhood had an association where they would select 500 houses in the neighborhood for you. You could buy a portion of ownership in all 500 of these houses, but you would be forced to buy both the best and worst houses.
If you take a step back for a moment, you may realize that neither investment is inherently better than the other. The single property may carry more specific risk, but the neighborhood association investment may give you properties that are worse on average. Investing in 500 houses also doesn’t eliminate total market risk. An economic downturn will still lower the price of all houses.
Similarly, ETF investors often forget to consider the shortfalls of following broad-market indices. The S&P 500 is a popular index, but it doesn’t make it a good index.
Three better asset management alternatives to ETFs
If mindless ETF investing can produce unintended results, what does smarter investing look like? And should you do it yourself or hire an asset manager?
1. Factor-based ETFs (Smart Beta)
Sensing a deficiency in market-cap indexes like the S&P 500, companies started developing factor-based indexes. These indices are also known as “smart beta and strategic beta” ETFs. They follow a more complex set of rules for inclusion and weight and use metrics such as profitability, value, and growth.
Studies have shown that:
- Profitable companies tend to outperform unprofitable ones
- Growing companies tend to outperform shrinking ones
- Cheaper companies tend to outperform expensive ones
These insights are incorporated into factor-based indices. It’s certainly a big step forward compared to the S&P 500, which only weighs companies by market cap.
ETFs that invest in these special indices maintain the benefits of regular ETFs, such as low cost and low tax rates. Yet, it also allows investors to get exposure to higher-potential investments. It doesn’t totally eliminate the risks of ETF investing, but it does help eliminate the worst houses in the neighborhood.
Still, investors need to be careful. You have to study how the underlying indices are constructed, and whether its construction fits your risk profile. In fact, these are the basic tenants of smarter investing!
Benefits of factor-based ETFs
- Low-cost. Many factor-based ETFs have expense ratios of just 0.25%.
- Tax-advantaged. Investors don’t have to pay taxes for rebalancing.
- Smarter investing. Factor-based ETFs use historic data to determine asset allocation
2. Investing in a handful of high-quality stocks
A second way to smarter investing involves studying companies carefully and investing heavily in the ones you believe in. A good rule is to limit yourself to 12 investments at a time.
Back to the example of buying a house versus shares in a Homeowner Association: if you had the skills to identify a great property, there’d be no need to invest into shares of 500 houses. Instead, wouldn’t you use them to buy the top 8-12 houses in the neighborhood?
That’s why great asset managers throughout history have concentrated their bets among a handful of names. Great investments don’t come around very often. So when they do, the best asset managers will act decisively.
You too can educate yourself about smarter investing. By following several simple rules, it becomes easy to outperform the market over the long run. Once you learn the basics, there’s nothing complicated about identifying a great company in an industry that you know well.
Benefits of long-term investments in high-quality stocks
- Low-cost. Zero holding cost for stocks
- Tax-advantaged. Long-term holdings mean pushing out capital gains tax into the future
- Smarter investing. Waiting for the right investment takes discipline, but can pay off hundreds of times over.
3. Find a good asset manager who believes in #1 and #2
*Ahem, might we introduce ourselves?*
At Jurnex, we ourselves use a combination of factor-based ETFs and concentrated stock purchases. That’s because we will never settle for mediocre.
Jurnex invests in just 8-12 companies at a time
Here at Jurnex, we believe differently. Why invest in mediocre companies just to stay in-line with the market? As asset managers for both our clients and our employees we follow smarter investing principals and put money into companies we truly believe in.
There are few asset managers who dare step outside the box. A study by the Financial Times found that the average mutual fund manager on the portfolio of 90 stocks. The 20% of fund managers with the most diversified portfolio on an average of 228 stocks.
But like Warren Buffett and his contemporaries, we believe that great investments don’t come around very often. So when they do, we act decisively in investing. And we keep an eagle-eye watch over companies to make sure nothing fundamental changes in its business.
Jurnex uses smart-beta ETFs for diversification
We’ve found that factor-based ETFs are an excellent way to diversify holdings. The combination of low fees and low taxes fits well with our philosophy of holding great investments for the long-run.
Great individual stock ideas don’t come around too often.
Benefits of quality asset management
- Low-cost. 1% or lower asset management fees (with no layering of fees-on-fees)
- Tax-advantaged. Long-term asset managers help reduce portfolio turnover
- Smarter investing. Studies show that smaller asset managers can still outperform thanks to their size and speed.
Bringing it together
How you can achieve better asset management
Now that you have seen the three alternatives to ETF investing, how should you yourself move forward with smarter investing?
1. Use your current brokerage firm
Changing your portfolio doesn’t have to be done overnight. If you want to invest in factor-based ETFs and individual stocks, make sure you take the time to study each investment. Often, Warren Buffett’s 20-punch card rule rings true:
“Improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches — representing all the investments that you got to make in a lifetime.”
Take the time to understand why each investment should outperform
There are many reasons to buy investments. But the key reason should be to earn a sufficient risk-adjusted return.
That’s why the best asset managers understand why each of their investments should outperform. I suggest taking an index card and finishing this sentence: “This investment will outperform because…” If you can’t explain in 2 sentences or less, you should skip the investment and move on. There’s little reason to diversify for diversification’s sake. That’s what factor-based ETFs are for.
2. Find the right asset management firm
Finding the right asset management firm is key to your financial success. I’ve been in the practice for more than a decade now, and I can tell you investment management has just as much to do with the fit as with performance.
Find an asset manager that fits your goals
A retiree might reconsider hiring an asset manager who specializes in high-risk leveraged bonds. Even if the asset manager can outperform or the long run, short-term swings might destabilize a retiree’s cash-flow.
Similarly, Jurnex focuses on long-term investing with low turnover. We run concentrated portfolios of 8-12 stocks and aim to hold them as long as possible. This both reduces taxes and gives time for great companies to give great returns. We want to find companies that will become leaders in their fields. Those that will return hundreds of times on investment. Because it’s worked for us the past decade, and we believe that a concentrated, contrarian style of investing will continue to work in the long-run.
Find an asset manager that fits you
Asset management can also be about personal fit. That’s why many asset managers, like us, also offer financial advisory services to all asset management customers. Finding the right mix of factor-based ETFs and individual stocks depends on both your ability and willingness to handle risk. And only by understanding your own goals will an asset manager (or yourself) have a good sense of the proper mix.
Smarter investing means eschewing mindless-ETFs. While ETFs have their uses, they aren’t a substitute for informed decision-making.
Where to find more resources
If you’re looking to revamp your stock portfolio, there’s no better time than now. All it takes is a phone call.
That’s because I’ve invested client money for over a decade in the same old-fashioned way: seek out great companies in good industries, that can be purchased at a discount to their fair value. Sounds too simple to be true? Give me a call today and I’ll show you that it’s still possible after all these years.
About Jurnex Financial Advisors
At Jurnex Financial Advisors, we have the securities backing of Charles Schwab. Yet we retain our operational independence from any third party. This means you can have the confidence your money is safe with one of America’s best brokerages and still receive knowledge and advice from an independent firm focused on YOU.
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