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

August 02, 2016

Years ago, when studying for a degree in finance, I often pondered the idea of finance as an art and a science.

In one way, finance is scientific in nature. Without math, finance doesn’t exist as a discipline, and civilized society would arguably be nonexistent.

On the other hand, finance is undoubtedly an art. Without the ability to develop, interpret and use numbers, a student couldn’t pass Finance 101.

As professionals take knowledge of the discipline of finance and apply it to a career, the science hopefully becomes like second nature, and the marked value over time is added through the art.

The Game Is Faster Every Day

While certain rules of finance have existed for hundreds of years, the application of finance to the modern markets (in combination with unbelievable computing power) has supercharged finance and investing. As the rate of change compounds, we all have the benefit of living in the fastest period of development in history.

But despite the rapid evolution, we caution investors not to get too wrapped up in the science and skip the art.

Solutions such as oversimplified robo advisors, nonmonitored algorithms and generic portfolios are typically based nearly 100% on science, with little regard for the value of artistic human talent.

As the speed of the scientific aspect of investing has increased, we would argue the need for the artistic component has increased. Algorithms that made sense last month may not make sense this month. Therefore, it is important to be ready to exercise the artistic side of investing more frequently than in the past.

We use certain algorithms in some of our strategies; however, those algorithms are monitored, studied and adjusted (if necessary) regularly by highly skilled individuals.

Investing Is Similar To Constructing Buildings

Similar to finance, architecture can be described as an art and a science. Like an architect, a disciplined professional portfolio manager is trained in the science of investing and skilled in the art.

Some investors feel they can skip the architect or, worse yet, take out their pencil and redraw the plans. They often take well-thought-out plans and tweak them, like going to cash during a market pullback or buying the hot stock they heard about at breakfast.

Architects Are Essential

In architecture, it would not make sense for someone to mix four or five different classic architectural styles in one building. If investors are investing solely online through websites, they are likely to set up accounts with multiple different sites, especially with the low minimums many sites offer.

Therefore, even if the portfolio recommended by one fund family or robo advisor may make sense, the client’s total financial picture can make no sense, and potentially create overlap and additional risk.

 

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.

 

In Exhibit 3, we break down the market caps, styles and sectors. Of particular note is the tilt toward midcap stocks within DVY, and the overweight in sensitive stocks in SCHD.

Exhibit 3

Market-Cap Breakdown

Style Breakdown

Sector Weightings

Source: Bloomberg

Putting It All Together

Despite the recent wave of oversimplified computer investing solutions and generic portfolios, many designed to break investments down to 100% science, we feel there is inherent value in the artistic aspect of investing—a value that can be provided most consistently through a team-driven process.

The idea of a building that is built 100% by robots seems unappealing to us, especially if there is not a skilled team of architects there to consistently monitor the robots and adjust them if needed. Likewise, the recent wave of issues with self-driving cars and Pokémon games would lead us to believe humans should pay attention.

 

DVY, SCHD and VIG have been, may be and/or are currently held in several TOPS Portfolios. ValMark Advisers Inc. is a federally registered investment advisorf located in Akron, Ohio. ValMark and its representatives are in compliance with the current registration and notice filing requirements imposed upon federally covered investment advisers by those states in which ValMark maintains clients. For registration or additional information about ValMark, including its services and fees, a copy of our Form ADV is available upon request by contacting ValMark at 1-800-765-5201. For a complete list of relevant disclosures, please click here.

 

 

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