Low Risk, High Return ETF Trap

June 19, 2019

A recent MarketWatch article caught my attention. It said, “This actively managed ETF has a novel approach that can cut risk and lead to higher returns.”

I’m always looking for a higher risk-adjusted return, so I thought I’d check it out.

According to the article, the actively managed TrimTabs All Cap U.S. Free-Cash-Flow ETF (TTAC) was the answer. The article interviewed the ETF manager, Janet Johnston, and went on to say:

“Johnston’s stock selection begins with the Russell 3000 Index which includes large-cap, mid-cap and small-cap companies. She narrows the list to an equal-weighted group of about 100 companies using computer models to screen for various factors. The companies are limited to those that are expected by analysts to show large increases in free cash flow (FCF) over the next several years.”

Indeed, from inception on Sept. 28, 2016 through June 7, 2019, the article was correct in its assertion that TTAC outperformed the Russell 3000. But it seems the article compared the total return of this fund to the raw Russell 3000 index, stripped of dividends. The article also didn’t mention it had underperformed over the past year.

Logic Check

It’s not my intention to single out this one ETF or even the MarketWatch article, as I’ve heard claims like this literally hundreds of times. (To be clear, TrimTabs doesn't make the claims the reporter does.) 

Yet if you compare TTAC to a broad ETF like the Vanguard Total Stock Market Index ETF (VTI), you might wonder, as I do, how an ETF with expenses 17 times that of VTI (0.59% vs 0.035%), and about 3% of the holdings (100 vs. 3,574), boosts returns and cuts risk? (I attempted to contact the author but did not hear back.)

You decide which of these two ETFs will likely cut risk and boost returns over time:

 

 

Past Failures

The promise of higher returns with less risk is alluring and downright irresistible. But past failures, such as the following, offer important lessons we should consider:

  • Master limited partnerships (MLPs) were billed as safe alternative to bonds, as they collect tolls for oil and gas that must go through the pipelines. The Alerian MLP ETF (AMLP) has returned negative 4.62% annually over the five years ended June 13, 2019.
  • Equal-weighted funds like the Invesco S&P 500 Equal Weight ETF (RSP) boosts returns, as it doesn’t overweight large growth stocks. It has underperformed the S&P 500 cap-weighted return by 2.84 percentage points annually over the same five-year period.
  • Smart beta funds such as small cap value tilted funds are a free lunch. Small cap value has underperformed large cap growth by almost 10 percentage points annually over that five-year period.

Lessons Learned

Investing is about maximizing returns while minimizing risk. Here’s my definition of investing, in eight simple words: “Minimizing expenses and emotions; maximizing diversification and discipline.”

All of these so-called higher risk-adjusted return promises failed to meet this definition. They had far lower diversification and fees many times higher than low-cost alternatives. They outperformed on a back-tested basis, and investors lacked the emotional fortitude and discipline not to chase performance.

The next time you’re promised less risk with greater returns, ask yourself if it met the eight-word investing test.

My advice? If it doesn’t, don’t follow the herd.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He has been a nonpaid panelist at one of NGPF's conferences for high-school teachers, but is not part of its organization. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

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