How to Choose an ETF

The recent trend toward ETF investments has heightened the importance of making wise decisions. The “lazy” portfolios use broad-based ETFs which drag inferior and over-valued stocks into your account. Why not attempt to be more selective?

Almost everyone has opinions about favorite ETFs, often highlighting some as cheaper than others. The approach they employ to valuation can also be used to find the most attractive stocks within a sector. This contrasts nicely with the “standard” approach.

The Popular Approach

Investors approach the investment decision the same way they would buy a refrigerator: Price and past performance.

These criteria are both fact-based and established. Many sources advocate this method, despite the ubiquitous warning about “past performance is not an indication of future success.”

The biggest flaw in this approach? It does not work!

  1. Short-term performance is a classic, money-losing technique.
  2. You never reach the “long run.
  3. Too many things change
  4. Time is not a good measure
  5. Fees are a consideration, but the significance depends on what value is added.
  6. There is no provision for risk recognition and control.
  7. Few investors are willing to deal with volatility – even of the ordinary level.

The Dangers

Most concepts of an “all-weather” portfolio require tremendous discipline. Few investors have the market savvy to deal with this.

  1. 20% drawdowns are normal. Those wanting to make “defensive moves” based upon normal market variation are “selling low.”
  2. Buy and hold sounds good in principle but is widely hated after any decline. Investor attitudes change dramatically after a big downturn like 2000 or 2008.
  3. There is a constant barrage of gloom and doom. This noise level prevents investors from identifying genuine danger. A valid risk indicator is important for successful investing.

A Stronger ETF Selection Method

While I emphasize individual stock selection – more effective if you know how to do it – I do use ETFs as a supplement and often recommend them to young investors building a portfolio. Here are my own criteria.

  1. The investment process. The track record is not long enough and never will be. You must know how to analyze an underlying benchmark or index. How is it constructed? Does the fund manager make any adjustments? Is there any effort to emphasize the stronger stocks?
  2. Does it fit a need? Any portfolio begins with an asset allocation of broad market choices. Is something important left out? This topic will be treated in future posts.

Foundation ETF Candidates

Here are three interesting funds that meet my suggested criteria. Their markets are not yet very liquid. You need to buy carefully, and you should not expect to sell out instantly on some whim. That is probably an advantage! I personally own shares in each.

CAPE

This is the sector rotation program based upon Dr. Robert Shiller’s Cyclically Adjusted Price Earnings approach. Most people use this as an overall market indicator, which has not worked very well. The Barclay’s version of his approach, which he has endorsed, does not use CAPE as a market-timing method. Instead, the market sectors are ranked and reviewed. The analysis combines the current CAPE ratio with its historic average. It also identifies sectors with price momentum.

This is a sound method, reflecting both value and current strength. While there is not a complete market exit to control risk, the system finds the cheapest sectors in any market.

PLCY

The managers of this ETF have an excellent method. They combine strong fundamental research on stock fundamentals with their insights from likely changes in national policy. Their expertise has been established, their contacts are valuable, and the conclusions are sound. Most importantly, focus on policies not politics – just as I try to do in my regular analyses. The managers also have a disciplined hedging process which permits them to short the market or sectors. This is an unusual and potentially valuable method of risk control

CWS

This innovative ETF, based upon the work of Eddy Elfenbein, allows investors to participate in his recommended portfolio. It is revised only once a year, but his analysis is updated constantly. There is no approach with more transparency. Eddy also has a great long-term record of success. But that is not what sells me. It is my confidence in his stock-selection process. I admit that it is like my own and that we often share several holdings. When we do not, I always look seriously at his ideas.

Last week Eddy provided a great illustration of the power of his approach:

Our philosophy of investing is to focus on great companies and hold them as long as we can. This has two important benefits. The first is that it’s less work, which is always nice. But more importantly, it’s a superior system because it removes us from the irrationality of the day-to-day market. I often stress this, but we got a good lesson recently from Ross Stores (ROST).

I’m a big fan of Ross, and it’s been part of our Buy List for several years. The deep-discounter reported earnings on May 24. They beat expectations, but their guidance wasn’t that hot. Well, that’s what Ross always does, so I paid it no mind. I thought the earnings report was just fine, but the market gods were not pleased. Shares of ROST dropped nearly 7% the next day.

In last week’s issue, I wrote, “I’m not at all worried about Ross Stores.” Sure enough, Ross has rallied six times in the last seven days. The stock closed Thursday at $85.09. Not only did Ross make back everything it lost, but the stock is even higher than it was going into earnings.

I will freely admit you that I had no idea Ross would snap back so quickly. Of course, I was puzzled by the drop in the first place. But this is the reality of stock investing.

Conclusion

The ETFs I cite here are all good choices with sound processes, but my main objective is helping people build their portfolios.

It is tempting to use whatever solid information there is, usually fees and recent performance. If the most important information is not readily available, it is ignored. It is usually right to do some research. If you had a serious medical condition would you seek out the cheapest doctor you could find? How important is your financial future?

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