Alternatives to Passive Indexing - 2
Alternatives to Passive Indexing - 2
Part 2 of 2: Own the Value Stocks of Companies with High-Quality Business Models
Summary:
Passive index investing assures average returns to the market, whereas hedging a portfolio of common stocks with low-cost exchange-traded funds increases diversification and safety.
When hedging a retail portfolio, the index ETFs from Vanguard Group are wise choices because, as a mutual-owned enterprise, it is immune to independent stockholders or outside owners.
Quality-driven value investors buy slices of the best companies in the sector, reserving the entire universe for hedging.
In part two of a two-part series, QVI explores the benefits of hedging a common stock portfolio with baskets of domestic and foreign stocks using exchange-traded index funds for lower costs and less risk.
What is the best alternative to do-it-yourself, active investing?
The financial media suggests investing in passive indexes to guarantee that portfolios keep pace with the market. So what is the worst choice?
Joining the crowd and trading the shortsighted gimmicks churned by the Wall Street fee machine is inferior to buy-and-hold passive indexing and active common stock investing.
Nevertheless, it is typical for the proponents of passive investing to omit a reminder that indexes contain every company in the market, sector, or industry, translating to owning lots of poor-quality enterprises in addition to the few good ones. Thus, thoughtful investors limit the holding of index exchange-traded funds (ETFs) to hedge common stocks in their portfolios with designs to achieve alpha over time.
This two-part series explores the general concept of portfolio hedging—albeit on the long side—and why it is essential to any active, long-term investment strategy.
Part two focuses on hedging a portfolio with domestic and foreign indexes and why quality-driven value investors pick the best stocks in the sector while reserving the entire universe for hedging.
Double-Down the Hedge
The Quality Value Investing (QVI) Real-Time Portfolios represent a select mix of common stocks purchased or available on the two major US exchanges: the Nasdaq Stock Market (NASDAQ) and the New York Stock Exchange (NYSE).
Covering the broader market, I sometimes benchmark the portfolios against the S&P 500, the citadel of publicly traded American enterprises. When deployed, the passive Vanguard S&P 500 ETF (VOO) represents the benchmark hedge of the QVI portfolios, including our concentrated family portfolio. At unpredictable times when the portfolio underperforms the S&P 500, VOO picks up the slack.
Although representing high-quality companies serving the globe, the QVI portfolio holdings, for the most part, are domiciled in the United States. Therefore, I prefer hedging the basket with the Vanguard FTSE All-World ex-US Index Fund ETF (VEU). The index captures the performance of major exchange-traded companies domiciled outside of the U.S., and as an independent investor, I never regret taking a globalist view.
My objective is to own an international index as protection against volatility in domestic stocks instead of an investment in and of itself. Therefore, the preferred ETF allocation for foreign hedging is Vanguard’s VEU.
VOO and VEU are market-cap-weighted, the prevailing, if controversial, weighing mechanism. Market cap or capitalization-weighted indexes assign component value by the total market value of the outstanding shares against the cumulative market cap of the index. Thus, the highest market cap stock in the index has the maximum influence on the security’s net asset value.
Other weighting mechanisms exist, such as price-weighted, equal-weighted, and fundamental-weighted. For example, the Dow Jones Industrial Average uses price weighting, where the higher-priced components receive the maximum weight. Equal weight, the mechanism used in the QVI portfolios, treats each constituent equally regardless of price or market cap. Fundamental weight employs metrics such as sales, book value, dividends, cash flow, and earnings. Active ETF investors seeking faster growth use alternative weighting methods to hedge risk.
In a market-weighted index, mega-cap companies dominate a significant portion. For example, in the S&P 500, it is normal for the top ten components to represent over 25 percent of the basket. On the contrary, the ten largest holdings in the FTSE All-World ex-US, such as VEU, represent about 10 percent of net assets.
Instead of owning as an outright equity investment, the objective of the foreign index is protection against the volatility of the concentrated portfolio of domestic stocks. Again, to be above-average investors, we must limit exposure to the S&P 500 or FTSE All-World ex-US indices to hedging. Index hedges are investments by proxy complete with inherent risks, including permanent loss of principal. On the other side of the risk/reward equation, we also take profits from the distributions of the index ETFs. Nevertheless, each is foremost a hedge on the long side.
Disciplined value investors are less concerned with NAV—net asset value—or premium discounts on ETFs exploited by arbitrage traders seeking a short-term mispricing edge than a more suitable long-term inflation protection or market hedge.
Assets under management in index ETFs have ballooned in recent years. The phenomenon concerns market pundits who believe sizable derivative-driven ETFs such as passive index funds—and perhaps more the speculative leveraged ETFs—will implode or outright trigger a catastrophic financial event in a market correction. Remember that index ETFs are safer as opposed to safe.
Personal Values Drive Politics
Dollar Values Drive Portfolios
Along with owning U.S. companies, whether domestic or multinational, a sound portfolio strategy includes hedging with foreign-based companies.