The Crucial Art That’s Lost With Portfolios On Auto Pilot

August 02, 2016

All ETFs Are Not Created Equal

Great architects pay close attention to the materials for the job. Imagine a beautiful marble structure built with plywood instead. ETFs are simply the best building materials available to portfolio managers who focus on asset allocation.

While certain active strategies may favor individual stocks, ETFs are the most prudent tool when trying to get effective exposure to a diverse group of asset classes.

ETFs provide a straightforward opportunity for portfolio managers to add value. Still, when giving presentations, I often make the statement, “All ETFs are not created equal.” While I am a big proponent of ETFs generally, there are some ETFs I would not invest in.

The process that experienced portfolio managers undertake to select the appropriate ETFs is essential to building quality portfolios.

Know Your Materials

When evaluating ETFs, it is important to look beyond the name of the ETF or the general index description, especially in ETFs that track nonfamiliar indexes.

With 14 years of experience managing ETF portfolios, we have had the benefit of witnessing the birth of most of the ETFs in the market today. Likewise, our resources enable us to understand each ETF very well before investing. Experience and resources are two ways we try to limit investing mistakes.

We can look at a few popular dividend ETFs as an example of how much “similar” ETFs may actually differ. For this exercise, we can use the Schwab U.S. Dividend Equity ETF (SCHD | A-90), the iShares Select Dividend ETF (DVY | A-67) and the Vanguard Dividend Appreciation ETF (VIG | A-76).

While all three of these ETFs would be considered dividend-focused, they are quite different and can lead to very different results. Exhibit 1 shows recent results of the three ETFs. As you can see, DVY has outperformed VIG by nearly 7 percentage points year-to-date.

Exhibit 1

Performance (as of 7/21/2016)

Source: Bloomberg

High Dividend Vs. Dividend Growth

While all three ETFs are dividend-focused, they are not all designed to get you the most current yield and/or highest return.

  • DVY is an ETF focused on companies currently paying higher dividends. The underlying index for DVY is designed to screen for stocks that pay a higher-than-normal dividend.
  • VIG, meanwhile, is designed to provide exposure to companies that have a history of consistently increasing their dividend.
  • SCHD combines screens for high dividends while seeking companies that have a record of consistent dividends and a tilt toward financial strength.

Looking at some important fundamentals in Exhibit 2 shows that the current dividend for DVY is about 1% higher than that of VIG, while SCHD is in the middle.

Exhibit 2

Source: Bloomberg

Potential For Very Different Exposure

When selecting ETFs that are noncap-weighted, such as dividend-weighted, it is particularly important to pay attention to underlying asset class and sector exposure. Due to the different methodologies outlined above, ETFs in the same grouping can have dramatically different underlying exposure.

 

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