Investing Notes
04/18/2023
This is the latest in the occasional ‘Investing Notes’ posts. These will sometimes be on individual companies, and sometimes on more asset allocation-related things. None of it will be a recommendation to buy or sell anything, but it’s something that I hope will add value to subscribers that either invest their own or other people’s capital.
In today’s note, we’ll post some thoughts about ETFs, so this post is more geared toward those that invest in ETFs for themselves or for clients.
Disclosure: I am a portfolio manager at Sorfis Investments, LLC (“Sorfis”) and clients of Sorfis may own shares of stock in a company, companies, or other securities mentioned in either the post below or links associated with the post below. I may in the future buy or sell shares for myself or clients and am under no obligation to update those activities. This is for information and entertainment purposes only, and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision, or consult a qualified financial advisor.
When it comes to investing in Exchange Traded Funds (ETFs), or any fund for that matter, there are a couple of things to keep in mind:
Fees are incredibly important and should be a major point of focus when investing in a fund.
Fees shouldn’t be the only point of focus when investing in a fund.
Before the rise of passive investing during the last couple of decades, which was accelerated post the 2008-2009 Great Financial Crisis, average investors would often have a significant portion of their capital in mutual funds charging somewhere between 1.00% and 1.50%, and higher. Often, those mutual funds were so diversified that they basically matched the index, which, using the S&P 500 as a proxy, you can buy for a few basis points today using ETFs such as VOO or IVV, which charge 0.03%.
ETFs also have major tax advantages versus mutual funds because investors have more control over their tax bills. They can determine when to take gains, instead of the mutual fund manager, and can swap nearly identical ETFs for one another if they have a loss in one ETF in order to offset future taxes and not change their overall asset allocation (the word nearly is important to avoid the wash-sale rule).
As an example, suppose you invested in XLB, a materials sector ETF (with a fee of 0.10% per year) at the beginning of 2022 in a taxable account. As the end Q3 2022 approached in September of last year, you were down over 20% and decided that you wanted to realize your loss to offset future taxes. But you also wanted stay invested in the sector. So you sold XLB and invested the proceeds into VAW on September 30, 2022 (Vanguard’s version of the materials sector ETF, also with a fee of 0.10% per year). How would you have done from that sale until today (using April 17, 2023 as the end date)?
As you can see, these two ETFs basically tracked each other in lock-step. VAW pulled slightly ahead this year, but within a range of expected short-term randomness. The main point is that you would have kept your asset allocation as you wanted and received a tax benefit from the switch you made out of one ETF into another.
Now, onto the topic of fund fees not being the only thing that matters…
Suppose that, like myself, you consider yourself a value investor that also follows other value investors. And in 2021 you notice a value investor or two buying Olin Corporation (a company you would later read about in Chris Bloomstran’s 2021 and 2022 Annual Letters, and see that Bob Robotti was presenting it at conferences—both investors worth following).
Besides possibly researching the company directly, you’re also curious what ETFs might have Olin as a top-10 position and come across FXZ, an ETF with a 0.61% total expense fee that is also focused on investing in companies within the materials sector. Would that higher expense ratio have been worth it to buy an ETF that is a little less followed than the larger, more popular sector ETFs mentioned above?
If you’d have bought at the beginning of 2022 and held until today, you’d have been happy to pay the extra fee:
But 15.5 months isn’t that long of a timeframe if the materials sector was something that you wanted to invest in through a longer cycle. How did these ETFs compare if we go back further?
3-year performance:
5-year performance:
10-year performance:
In any of those time periods, you’d have been happy to pay the higher fees—in some periods more happy than in others. And there were some stretches when the higher fees weren’t worth it.
We can’t invest based on past returns, and past performance tells us nothing about the future. But it illustrates that higher fees are sometimes worth it. [Disclosure: I don’t personally own any of these ETFs, nor am I buying them for clients as of the date this is published.]
The risk embedded is how portfolios are constructed is also a factor that should be considered when comparing ETFs. Let’s look at the largest position of each ETF, and the amount of assets in each fund’s top-10 holdings as of today:
XLB:
Largest position: Linde plc — 19.45% of fund assets.
Top 10 Holdings — 64.61% of fund assets.
VAW:
Largest position: Linde plc — 14.34% of fund assets.
Top 10 Holdings — 49.01% of fund assets.
FXZ:
Largest position: The Mosaic Company — 4.90% of fund assets. [For reference to the above, Olin is 3.43% of assets and the 10th largest position, while Linde is 2.91% of fund assets.]
Top 10 Holdings — 42.94% of fund assets.
The biggest ETFs have to buy the biggest, most liquid companies. This can help to drive up the valuations of those companies well beyond historical levels while flows keep coming in and, should those flows ever reverse in a meaningful way, possibly drive them down more quickly in the other direction.
I don’t have an opinion on Linde and have never studied the company. Based on the numbers on my screen, it’s about a $180 billion market cap company that is trading around 44x trailing earnings and 5.8x EV/Sales. It doesn’t exactly scream cheap on the surface. Again, I haven’t dug deep on the company, so maybe it’s worth the premium multiple. But if one is buying an ETF like XLB that has nearly 1/5 of its assets in that single company, it’s probably a good idea to have an opinion on that company and its prospects, especially given the bright future its valuation implies.
For the most part, lower fees are better. At Sorfis, we want to construct portfolios in our Diversified Strategy that have low overall expense ratios (usually below 0.10% before our management fees). We would, probably, rarely go much more expensive than ETF like QQQE, which we mentioned last year, that has an expense ratio of 0.35%. But I think it’s important to remember that fees shouldn’t be the only thing used in making asset allocation decisions and managing risk.
This post is for information and entertainment purposes only, and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision, or consult a qualified financial advisor.