Value Investors - The Pendulum will swing back in favour

A recent blog posting over at Morningstar sniped at Professor Jeremy Seigel of Wisdom Tree, indicating that his firm's stock selection methodology and retention of assets depended on his call that a market bottom had been hit.

The post compared the performance of several Wisdom Tree ETFs to various total market benchmarks, showing relative YTD performance is lagging for Wisdom Tree dividend selection process. While true, it ignores the beating that all value benchmarks have taken since the credit crisis began in the summer of 2007.

As most value investors know, they aren't going to beat the benchmark every year - but it's going to happen often enough to outpace "growth" funds by about 2% annually over the long haul.

What's been unusual about this bear market is that it's the so-called value stocks leading the slump, whereas value stocks almost always outperform in weak markets.

Obviously, in this case, that's because the fact is that so many stocks that are usually labelled as value stocks, due to either low PE ratios, or relatively high dividend yields, have found themselves trashed and tarnished by the credit problems. That's because financial firms (whether retail or investment banks, stockbrokers and insurers), which usually have relatively low PE ratios and relatively high dividend yields - putting them squarely in the value camp - have been the epicenter of the credit and economic problems. Wisdom Tree's dividend selection process obviously weights orients a portfolio towards a value selection.

Comparing other value ETFs against growth ETFs show that this phenomenon isn't restricted to Wisdom Tree selections.

For instance, since just before the credit crisis began (I am using June 1 2007 as the date), the Barclays iShares products tracking growth or value indices show the following divergences:

- For international stocks, the MSCI EAFE (Europe, Australia, Far East)iShares index-tracking products shows that the growth product (EFG) has lost -13.2% of its value, compared to much larger -25.3% loss for the value product (EFV). In that context, Wisdom Tree's International Dividend Top 100 EFT (DOO) loss of -16.6% is pretty good.

- For large cap domestic stocks, the iShares growth product (IVW) has lost just -9.0%, while the value product (IVE) has lost -20.8% of it's value. Again, in that context, the Wisdom Tree Large Cap Domestic ETF (DLN) loss of -19.8% is understandable.

- Finally, for domestic small cap, the iShares growth product (IWO) lost 6.5%, while the value ETF (IWN) lost -17.2%. Here, the Wisdom Tree loss is larger at -23.2%.

Given that growth rarely outperforms value for any stretch of time, I believe that the relative outperformance of value must be just around the corner.

In summary, I'd suggest to all value investors in general, and Wisdom Tree ETF holders in particular, to hang on. Retail investors are notorious for dumping underperforming funds, not long before the corner is turned. Don't be one of those fools.



JW

The Confused Capitalist

Three Excellent Emerging Market ETF's

The other day, I posted about two popular emerging market ETF (EEM, VWO) choices. While you aren't likely to go too wrong adding one of these two major ETFs to your portfolio, I believe you can do better.

The three choices I examine here are all fundamental analysis ETFs, rather than based on old-fashioned market weighted capitalization like the prior two choices. What this means is the underlying stock choices are chosen on a rules-based entry system rather than how fat (or skinny) the valuations have gotten. I have written about fundamental analysis systems before, including here and here.

Wisdom Tree has used a dividend-rating system to select stocks most likely to outperform. This is based on back-testing that has shown that, firstly, dividend-paying stocks outperform their non-paying brethren, and secondly, that higher yields more often than not indicate relative undervaluation. Finally, Wisdom Tree's research shows that a basket of these stocks also have lower volatility than a comparable market-cap index.

The FTSE RAFI indexes, used in many Claymore and PowerShares products, uses four factors to weight stocks. These factors aren't related to the markets enthusiasm (or lack thereof) for the company itself, and extensive back-testing has shown these type of indexes outperform old-fashioned market cap indexes, such as the S&P 500, MSCI EAFE, and Dow Jones Industrial Averages. The factors are dividends, cash-flow, book value and sales.

The three choices we are looking at are Wisdom Tree and PowerShares products. They are the PowerShares FTSE RAFI Emerging Markets ETF (PXH), the WisdomTree Emerging Markets High-Yielding Equity ETF (DEM), and the WisdomTree Emerging Markets Small Cap Dividend ETF (DGS).

Let's take a look under the hood of these choices. Firstly, cost and turnover. On cost, none of them has a significant cost advantage, with DEM and DGS are 0.63%, and PXH at 0.85%. Turnover in PXH is 8% annually, with DEM at a remarkable 3% annual turnover. DGS does not have a reported turnover, but given that this is a small cap ETF, you can expect it to be relatively high, certainly higher than any of the choices I've discussed to date.

Let's look at the average company size and some of the top sectors in each product. In terms of average company size, these are all distinctly different products. DGS defines 92% of their portfolio as small cap, with the remainder as mid-cap. DEM is relatively agnostic for cap size, with 39% defined as large cap, 41% as mid-cap and 20% small cap. PXH, on the other hand, is primarily a large cap ETF, with 88% so defined, plus another 8% as mid-cap and a smattering of small cap.

In terms of the top four sectors, finance holds first or second place in all of them, and ranges from 26% in DEM to 19% in both DGS and PXH. Energy achieves one of the top four spots only in PXH, and there it holds first place with 26%. Information Technology holds down fourth spot in all the portfolios and range from 10-16%. Materials, at 14% is unique to DEM, while telecomm at 15% is unique to PXH. DGS has consumer discretionary in top spot at 19% (a unique top four holding) and industrials in third spot at 17% - again a unique top four holding.

Stock concentration is quite different among the three choices, with DGS holding around 400 stocks, and with the top four stocks holding 4.3% of the total portfolio value, and the top 20 companies accounting for 16% of the portfolio.

DEM holds around 300 stocks, with the top four stocks comprising 11% of the portfolio value, and the top 20, some 38%.

PXH is heavily concentrated by comparison to all of the choices reviewed so far: it holds around 160 stocks, the top four stocks account for a heavy 26% of the portfolio value while the top 20 stocks hold 60% of portfolio value. Essentially, this portfolio lives and dies with the top 20-30 stock choices.

Let's turn to country selection. In the Wisdom Tree ETFs, the top two countries represented in these ETF's are the same, with Taiwan holding top spot in both between 26-29%, and South Africa coming second at 11-15%. Brazil, Turkey, Malaysia, and Thailand fill out third and fourth spots at between 8-9% with the Asian choices in the DGS ETF.

The PXH ETF has China in top spot with 19%, South Korea with 18%, Brazil with 15% and Taiwan with 14%.

Finally, we turn to relative value measures of the portfolio. Dividends, as can be expected, rate high in the Wisdom Tree products, with recently reported yields of 7.92% (DEM) and 6.17% (DGS). The yield is not reported for PXH, but I'd say a reasonable guess, given portfolio size, and that consideration is given to firm size including dividends, would be in the 3-4% range.

PE ratios are attractive across the board, with DGS unexpectedly at the low of 9.3, DEM at 9.8 and PXH at 10.2. The price-to-book ratio varies from DGS, again at the low of 1.1, to 1.9 for DEM, and PXH at 2.7. Finally, the price-to-sales ratio is given only for DGS and DEM, at 0.71 and 1.21 respectively, which are both attractive, particularly the DGS.

Finally, let's look at the performance of these products year-to-date (note: DGS and PXH are less than one year old, hence the YTD comparison), compared to the iShares MSCI product EEM.

(Click to expand in size)



While PXH looks alot like EEM on the above chart, I believe that this is coincidental to some extent and the differences in the products will reveal themselves over time.

Looking at the products, DEM certainly appears to have low volatility, making it an easy choice for investors who prefer low volatility. Furthermore, the process for inclusion into the ETF also makes significant outperformance a reasonable possibility going forward.

DGS has relatively low volatility given its small cap orientation. I think of it as having just large cap volatility, but with the promise of small cap returns and a better selection process.

PXH is the large-cap ETF of the three. Offsetting to this usually comforting factor are the rather large bets on a relatively few number of firms, something you have to be comfortable with in order to be comfortable holding this ETF. On the other hand, the selection process is likely the most robust over the long haul for outperformance.

I lean slightly more toward the dividend approach in this instance, rather than other relative valuation measures, since other measures are more likely to be manipulated by accounting shenanigans, or simply poor disclosure practices. As the saying goes, "Dividends don't lie" ... and "Dividend investors sleep better". So for my money, I prefer the two Wisdom Tree products in this instance, although I have enormous belief that the PowerShares product will also prove itself over time.

In conclusion, I don't think the relatively low expense ratio of VWO is superior to the relatively low portfolio valuations offered by these three products and the superior selection process they employ, compared to both EEM and VWO. I believe the returns on all three of these products will outpace EEM and VWO over time.

Disclosure: Long positions in DEM, DGS.



JW

The Confused Capitalist

Emerging Markets Choices

Recently, some members of the investment business have suggested that emerging markets offer unusually good value.

This, of course, offers me the opportunity to once again explore one of my favorite topics.

According to one recent article, despite the growth of emerging markets to currently represent 13% of the world stock market capitalization, British investors have only 1.6% of assets in those markets. Presumably, American and Canadian investors are in the same boat.

This is all the more alarming given that these markets are widely forecast to achieve 50% of the world economy in 20-30 years time. That means that most investors aren't playing the largest visible theme of our times.

Given the growth in ETF's and mutual funds catering to this segment, there's no excuse for most stock investors with a 10-15 time horizon not to be in this market. This is a growth component that simply must not be ignored.

Having said that, I'd like to take a look at two of the most popular emerging market ETF market-capitalization choices, plus three ETF choices from purveyors who use a rules-based fundamental analysis to choose an emerging market basket.

The first two are choices from Barclay's iShares (EEM) and Vanguard (VWO). They are based on selecting on tracking broad-based market-capitalization based indexes. Market capitalization indexes (such as the S&P 500, MSCI EAFE, etc.) select the largest companies by market capitalization for inclusion into the index.

Critics argue that these type of indexes over represent over-valued companies, and under represent undervalued companies, and investors therefore leave some potential alpha on the table, while attracting unwanted volatility. On the other hand, supporters of these indexes argue that, despite these flaws, owning such an index proxy is still a reasonable way to participate in most of the stock markets gains, in a tax and cost efficient manner.

Let's take a look under the hood of both of these choices.

Firstly, cost and turnover. On cost, Vanguard (VWO) has it's legendary cost structure sliced to the bone, with just a 0.25% cost, while the Barclay's product (EEM) has a 0.74% cost. A 0.49% point advantage isn't to be sniffed at, but it't not the only item of consideration. Turnover for VWO is 9% annually, the second highest rate amongst the five products we'll look at. The iShares EEM has a turnover of just 5% annually. In a non tax-deferred account, these two cost and turnover factors are offsetting, with no clear winner. In a tax deferred account, the VWO is the better choice, if these were the only two factors under consideration.

Let's look at the average company size and some of the top sectors in each product. and company size. country choices. In terms of average company size, both are similar with Morningstar defining between 77-80% of the companies held therein as large or giant, and between 18-22% as mid-size. That means either fund has virtually no exposure to small cap stocks, and both can be thought of as large cap ETF's.

In terms of the top four sector allocations, both have financial firms (banks etc.) at between 18-22% of the fund, energy at between 16-20%, and materials between 18-21%. The only difference is for the fourth choice, which for iShares EEM is information technology at 14%, while for Vanguard VWO it is telecommunications at 12%.

In terms of individual stock concentration, the top four choices of EEM comprise some 16.2% of the portfolio value, while for VWO it is 12.2%. The top 20 choices comprise some 40% of the value of EEM, while for VWO it is 27%. EEM holds about 350 securities in total, while it's nearly 900 for VWO.

On these three later factors of market size, sector choice and stock concentration, there isn't that much to choose between these. So let's turn to country selection.

In both ETFs, the top four countries represented in these ETF's are pretty similar, with Brazil in first place representing 16-18%, and either China or South Korea in second or third place between 11-13%. The difference is in fourth place, where Russia represent 11% of EEM, while fourth is held by Taiwan in VWO, again with 11%. Overall, once again, very little to choose from between the two.

Finally, we turn to relative value measures of the portfolio. However, I have to complain about "the people's choice", Vanguard, long a champion of the individual investor. Their disclosure of valuation of the portfolio, in a word, sucks! The only valuation measure they offer is price-to-book (PB) ratio, wherein all of the other choices we'll look at provide at least the price-earnings (PE) ratio and the dividend yield of the portfolio, with some others also providing the price-to-sales (PS) ratio.

Having said that, the PB ratio of VWO is 2.8, compared to 3.7 for EEM. Morningstar calculates the dividend yield at 2.22% for VWO and 2.70% for EEM. Combining these two measures of relative valuation, suggest these portfolios offer relatively similar attractiveness from a valuation standpoint.

Yahoo calculates the PE of EEM at 11.9 (versus iShares own calculation at 18.0), and VWO at 13.0. Given the differences in PE calculations I've seen between Yahoo and ETF providers themselves, I don't think the Yahoo calculations are particularly reliable. On the other hand, Morningstar calculates the cash-flow ratio of both portfolios to be between 8.5 (EEM) to 8.9 (VWO). Therefore, there's little to choose from here, except to say that both portfolios appear relatively expensive, given the valuation characteristics of the three other product choices that I'll cover in a future posting later this week.

And, although no one looks at historical charts - given that we're all aware that past performance is no guarantee of future performance, let's see how the two products have performed against each other and the S&P 500 ETF (SPY) over the past year.



Given the similarity between the products, I'd say it's hard to pick a clear winner. Perhaps if Vanguard would get into the modern era, and provide its investors better information, as well as it's outstanding cost structure, it would be easier to make a choice between these two.

Later this week, I'll look at three fundamental analysis ETF choices.

Disclosure: No positions held.


JW

The Confused Capitalist

A superior index arises: just a better mousetrap

This can either be read as a stand-alone posting relating to why fundamental indexing is a better way to go than tracking a conventional index, or it can also be read as part two of two of a book review of "The Little Book of Common Sense Investing", by John Bogle.

As relayed in part one of my review, I found the evidence presented by Mr. Bogle to be almost overwhelming that investing in a low-cost index fund was virtually the only way for the average equity investor to outperform the broad market, like the S&P 500, over time. A very good method as the book clearly details.

However, in the book (chapters 12, 14, 15 and 16), Mr. Bogle suggests that some of the new fundamental indices (e.g. FTSE RAFI) aren't going to stand up to the test of time, as market capitalization-weighted indices (such as the S&P 500) have. He intimates that, having seen various "better mousetraps" come and go, so too will fundamental indexing (which back-testing shows has outperformed a cap-weighted by nearly 2% annually, a huge margin). This is essentially, he claims, just another method to part the foolish from their prospect of future returns.

He denigrates the back-testing of these fundamental indices as if that was somehow undesirable. I personally fail to see the difference between the back-testing done there, and Mr. Bogle's own back-testing that led him to the conclusion that low-cost index investing was going to beat the then conventional mutual fund of the day (an advantage that has continued to hold up to this day).

Mr. Bogle fairly asks the question of why these fundamental factors (fundamental factors are centered on accounting items, like book value, dividends paid [or dividend growth rates], earnings, revenues, etc.) have not been properly exploited by stock markets in the past? While there have been tons of academic studies pointing out that a stock-picking method using virtually any of the aforementioned factors as a major stock-picking factor would have outperformed the broader market, that still doesn't really answer the question.

The question is best answered by examining behavioural research. In other words, it has to do with the emotional nature of people, something that even mutual fund managers are subject to, as clearly evidenced by the typical 100% turnover on the conventional mutual fund. Certainly, they also appear to be "taken in" by a "good story", as much as anyone. For more insight on this issue, see the following (warning: large pdf file) commentary, Seven Sins of Fund Management. In short, the problem is, my dear Mr. Bogle, interference from human beings.

Just as Mr. Bogle was then a pioneer of the day, by exploiting something seemingly obvious and mundane (i.e. 1. costs matter and 2. don't get trapped by "the story") it seems hard to believe that no one can build a method for a relatively sustainable advantage over a conventional index. In the future, the building of these fundamental indices today will probably be seen as something that should have occurred much earlier, given their obvious superiority.

But getting back to the business at hand, if, as alleged by Mr. Bogle early in the book, that long-term investment returns more or less parallel the returns of the stock market of the underlying businesses, doesn't it make sense to construct an index which actually gives weighting to those factors, as opposed to the more temporary and whimsical valuations imposed by market activity?

Doesn't it make sense to try and limit or exclude the "speculative" return (positive and negative) he discusses, which is, essentially, the contribution (deduction) to (from) short-term returns from stocks becoming over (under) priced? Fundamental indices attempt to do that: exclude the most-egregiously over-priced stocks, by fundamentally examining the books of each company. Conversely, these indices also include more of the relatively undervalued companies. That these indices might succeed over the longer-term would be due to the rules-based inclusion of companies into the index. A fairly simple, but effective, way of eliminating or minimizing poor investment decisions: rules!

After a time, I think Vanguard, Bogle, and other indexers will recognize that these are superior indices. Then, more index funds will be created to track them. Because the basis of inclusion into these indices are the actual economic activity of the companies themselves, rather than the more capricious valuations assigned by the market activity of the moment, they can finally answer a question Bogle poses in the book: How to know which companies are over-valued in a conventional index? Effectively, the books of the companies themselves answer that question.

In the end, an index that examines the fundamentals of companies in some manner simply has to be better than one which only considers the temporary selling prices of their stocks. Vanguard and others will finally realize this, and bring the same ruthlessness to cutting costs that they did to tracking the S&P 500, for instance.

Whether these indices will continue to significantly outperform conventional capitalization-weighted indices starting twenty years from now, the answer is "probably far less" than current back-testing has shown was available. As the "rise of the machine" eliminates emotional interference (1, 2) from making "on mass" good investing decisions, these market inefficiencies will be exploited such that they will disappear over time. And while the costs are currently slightly higher for these ETFs (about 0.5% annually) than an extreme low-cost conventional index-tracker (about 0.19%), the cost/benefit equation seems to be worth it (i.e. you pay an extra 0.3% or so, to get about 2% more).

In the interim though, as these inefficiencies are finally properly captured over the next decade or two, it's possible that excess returns will even exceed that shown in back-testing. And any advantage that is likely to persist over ten to twenty years isn't something to be ignored, in my view.

Anyone with a broadband connection and who wants to really understand the multitude of reasons why these are superior indexes, are suggested to go to these two (one, two) video presentations, by Rob Arnett of Research Affiliates.


JW

The Confused Capitalist

Thinking About ETFs

As many readers here are aware, I'm a pretty big fan of ETFs, particularly as a solid foundation for a portfolio. However, I think that you have to drill down into the particular ETFs to consider what their chances of outperformance are.

Obviously, buying ETFs that have constituent companies with a high return on capital (or equity) and a low price (as in a low PE ratio), are likely to return greater capital to your wallet over the long term. That's why I try to drill down into these ETFs before I personally buy them.

One research firm that does this for you is AIR AltaVista Independent Research Inc. Its' methodology was recently highlighted in an interview with AltaVista Research President Mr. Michael Krause, by fellow blogger (here) James Picerno.

One thing that definitely caught my attention was ... statement in the later part of the interview relating to fundamentally-indexed ETFs ...

I am quite a fan of fundamental indexing. We’re getting new flavors and gimmicks in indexing all the time, but I think fundamental indexing is one of the most genuine and promising developments in a long time.

I have blown this horn fairly often in the past ... they appear to simply be a better way to invest. But whether you choose these fundamentally-indexed ETFs, or one of the many ETF allocations which still aren't fundamentally indexed, then researching your choices in relation to price and value measures is almost certain to improve your investing outcomes.



JW

The Confused Capitalist

My Investing Christmas List

Like any investor, I wish for the next year to be full of market-beating returns.

But, rather than wish for this directly, here's my list of products or things I'd like to see that I think could help do that job over the next year:

10. A fundamentally-indexed (broad-based, not just on dividends) BRIC ETF;
9. A fundamentally-indexed (broad-based, not just on dividends) Euro ETF;
8. A fundamentally-indexed (ibid) global bank ETF;
7. Finding a wonderful proxy investment on the cusp of a major breakout;
6. More quality screening tools, like Magic Formula Investing;
5. A fundamentally-indexed (ibid) Japanese ETF;
4. A fundamentally-indexed (ibid) global small growth companies ETF;
3. A complete proliferation of fundamentally-index (ibid) EFTs;
2. Double-leveraged ETFs of all of the above and, finally;
1. More patience, so that I may reap the rewards of proper analysis, rather than falling victim, as so many have over the years, to the following saying ...

A man may see straight and clearly and yet become impatient or doubtful when the market takes its time about doing as he figures it must do… the market does not beat them… they beat themselves, because even though they have brains they cannot sit tight.

Merry Christmas to all ... may you and your loved ones have a fabulous time this holiday season ... no matter your beliefs, nationality, or any thing else for that matter ...



JW

The Confused Capitalist

ETFs - Blow your horn

I've read a few articles around the net yakking it up about how many ETFs are, essentially, replicas of other ETFs already out there. And that the 200 or so, should be enough for anyone, right? Many have really puckered up to that trumpet, and are blowing hard.

There's about 8,000 mutual funds out there, and people think that 2.5% of that in ETFs is enough? Pulleeze!

I don't hear too many financial advisor's saying that the doors should be shuttered on the 90% of mutual funds which are essentially replica's of each other AND underperform the market. Would their silence on this issue be because of the juicy trailer fees that accrue with mutual fund recommendations, and their squawking about ETFs due to the limited to no trailer fees?

Before you believe those puckered up to blow on the "200 is too many" sheet music, check their knowledge, motives and whether they're protesting the outrageous number of mutual funds.

When I see an ETF for every industry type, for every single country, for every capitalization size, and for every type of outperforming back-tested fundamental and enhanced indexing style there is, using rules-based entry strategies, and virtually every combination thereof, TIMES TWO, then I might start to agree with those already puckered up on the "there are too many" trumpet.

Until then, ETFs, until then, blow your own horn baby. Blow sweetly and with all the range of melodies available in the investment world.


JW

The Confused Capitalist

Proxy Investing - ETFs

Given what I believe will be phenomenal growth in ETFs over the next decade, particularly those specializing in some sort of fundamentally-based ETFs (or enhanced ETFs), would an investment in Wisdom Tree Investments (the stock) as a purveyor of fundamental ETFs be a wise proxy investment decision?

The industry probably has a huge tailwind, as ETFs generally, and fundamental ETfs in particular, begin rapidly draining money away from both mutual funds and, perhaps, to some extent, individual stocks (which themselves were often previously used as an industry proxy).

Unfortunately, there are no recent SEC filings, so by buying this pink-sheet stock, you're buying a bit of a pig in a poke. Nontheless, given the heavy hitters joing this company (Siegel, Levitt) as owners and advisors, one has to think they wouldn't want to sully their reputation on a business without a viable future. Undoubtedly, provided this stock is at a reasonable valuation now, its return will be a leveraged bet on the ETF market generally.

Value, as always however, remains the key to a decent return.

JW

The Confused Capitalist

Fundamental Indexes & ETFs

Release the hounds! The hunt for positive alpha [or avoidance of negative alpha]).

I have just finished watching a presentation to the Toronto CFA society by Robert Arnott, Chairman of Research Affiliates. For anyone wanting a complete 60 minute education on new fundamental ETFs and indexes, I suggest that that you link up and watch the following two segments (only if you have broadband access however):

Claymore Investments 1
Claymore Investments 2

Mr. Arnott has many fascinating things to say, and many fascinating Power Point slides, all of which reinforce the superiority of fundamental indexing. For those in doubt, or those who'd just like to know more, I highly suggest this presentation.

Just one of the little nuggets he throws out there (and there are indeed, many), is that simply investing in the S&P 490 (don't invest in the 10 biggest S&P companies), would have produced an average outperformance over the S&P 500 (over the last 80 years), of about 55 to 60 basis points annually.

Even if you're a believer in the strength of fundamental indexes, as I am, there's still lots of good stuff here. Visit once, and you might be on your way to investing products from three of the larger fundamental ETF providers (Power Shares, Wisdom Tree, Claymore [USA or Canada]). Any strategy that produces 200+ basis points better annually than a conventional index, with lower risk, certainly gets my attention!

The one other fascinating thing to me, is the potential for these fundamental indexes to get a short-term boost over their usual outperformance, as more and more capital begins flowing into these companies over the next decade or so. I suspect the outperformance will be even starker over the next while, as this phenomenon unfolds.

John Bogle, thanks for the ride, but move over, the next great investment train is arriving!

JW

The Confused Capitalist

A low-maintenance simple portfolio

I am advising an older person on their portfolio allocation for the stock market portion of their investments. Although he's not as old as the still long-term investor, 105 year old Albert Gordon, he's still looking to the future.

And that's smart, because, given his heredity, he may well have another 20-30 years left. And the only thing that'll provide adequate long-term growth over that time, is participation in the markets. I've convinced him that mutual funds aren't the best ticket today, but he still needs broad diversification at his age. So we're looking to some ETFs to fill his ticket.

Readers here know my belief in the power of dividend-paying stocks to produce out-sized market returns, with lower volatility and risk. This has been well-documented in a variety of books, large and small market studies over lengthy periods of time, covering a variety of market conditions. Thus, most of the selections I suggest for this Canadian investor, will fit the mold of having dividend-paying attributes as prime amongst their selection criteria.

Because of potential tax implications, we'll seek suitable Canadian products where available.

We are going to use just four ETFs, a quartet, but this will provide ample diversification by geography and will eliminate individual stock risk. Given that they are ETFs, they will also eliminate so-called "style drift". Finally, we'll use products that use rules-based fundamental indexing where possible, to enhance returns and reduce risk.

Claymore Investments has three of the four products we'll need. Because he's Canadian, it's suitable to try and get returns denominated in Canadian funds if possible, on the basis that cost of living swings might mirror market activity. So here are the products I've suggested:

Claymore Canadian Dividend & Income Achievers (CDZ). Weighted to emphasize stocks that both have a relatively high yield, and also have a good track record of raising their dividends. It tracks the Mergent Canadian Dividend Income and Achievers (fundamental) index. Over the past five years, the index has posted a 15.1% annual gain, versus the S&P/TSX Index return of 11.1% annually. Over ten years, it posted an 18.1% annual return, versus an 11.0% return for the S&P/TSX Index. The underlying holdings are around 55-60 stocks typically. I'm suggesting a 40% weighting for this ETF.

Claymore US Fundamental Index, C$ Hedged (CLU). This ETF also tracks another fundamental index, which tracks the top 1,000 US securities by fundamental value, using the following four factors: cash dividends, free cash-flow, total sales, and book equity. This ETF is also attractive from my point of view, in that I think the US dollar will be lower in 10 years than now, but this ETF hedges against currency changes, meaning that we'll only trap the underlying changes in the index. Over five years, this index has returned a 7.0% rate annually, versus a -3.2% S&P 500 annual return (as converted to Canadian currency). The underlying holdings are around 1,000 stocks. I am suggesting a 20% weighting for this ETF.

Claymore BRIC (CBQ) is the final Claymore product, that portfolio manager Roger Nusbaum has also written about. This ETF isn't fundamentally indexed, but is designed to mirror the BNY BRIC Index, which tracks ADRs from Brazil, Russia, India and China, all powerful emerging economies. Over time, this should be a strong growth component, but one which will also be volatile in nature. This index has returned 33.2% annually over the past four years, versus the more widely known MSCI EM Index, which has returned 19.7% annually over the same period. The ETF has 75 underlying stocks with above average concentration in the first ten stocks, with about 53% of the value held therein. This isn't currency hedged or denominated in Canadian dollars, but this could be a plus if these currencies gain strength against the Canadian dollar over the next decade. I am suggesting a 20% weighting for this ETF.

Finally, for the fourth ETF, I'll suggest a product that trades on the American exchanges, a Wisdom Tree ETF product that tracks the Wisdom Tree International Dividend Top 100 Index (DOO). This is also a fundamental index, based on dividend yield of large and mega cap international companies. Currently, about 80% of the companies in the index are domiciled in Europe, with about 20% in Australia, Singapore and Hong Kong. The index has returned 16% annually over the past five years, as denominated in US Dollars. Conversion to Canadian currency over that time would have considerably diminished these returns to about 8.5% annually (which is still respectable, although not outstanding). While the currency issue may be slightly negative over the next decade, I don't think it's going to weigh down returns like it did over the past five years, or like it might for an unhedged US stock situation going forward. I am suggesting a 20% weighting in this ETF.

Well, that's it. A relatively simple portfolio, with ample geographic representation, and wide corporate representation. The one noteworthy thing about this portfolio is that it's definitely weighted to the financial sector, but I've never considered that a particular problem, since I consider this sector as the backbone of the entire economic system. My theory here is that if this sector suffers some sort of serious long-term decline, so will virtually every other sector of the economy.

Finally, the other noteworthy aspect is the ability of high-dividend paying stocks to resist market downturns, something that might make this particular portfolio even more attractive; certainly, it makes it easier to sleep at night.

In summary, I consider that these four components will produce robust and relatively reliable returns over the medium to long haul, all with overall reduced risk because of the weighting towards the various fundamental indexes.



JW

The Confused Capitalist

Agitation over enhanced ETFs

There's an unruly crowd hanging out on the 'net right now, at the corner of Financial Street and New Products Way.

Seems that this crowd is getting upset, persnickity even, over whether enhanced ETFs, are going to fare better in the long haul than conventional ETFs. That is, ETFs that track the standard market indices.

Of course, many in the crowd are muttering that no one can be absolutely sure they'll outperform, and therefore, *stay away*.

"These is dangerous times, friends, they say, and dangerous products. Beware."

But not to worry, friends, the sheriff has just pulled alongside, and told them agitators to cool down. The sheriff points out to them that most of these product concepts have been backtested and, anyway, many of the enhancements are simply based on writing rules for, and then computerizing, superior investment behaviour.

That is, he tells them ...

Exploiting market inefficiences, and doing things well-known to enhance returns, like buying stocks that have cheap valuation metrics. And this type of 'nvestment behaviour is likely to be rewarded long into the future. So calm down folks, calm down.

Remember, even the now lowly index funds were once considered newfangled and there were many who doubted their ability to outperform 'ventional mutual funds, despite extensive

the sheriff slows his speech to a crawl and gesticulates quotation marks for those slow in the crowd

"back-tested" research that showed that 80% of mutual funds didn't beat the index after just a five year period.

Investing in back-tested enhanced ETFs is jest smart 'nvesting. Jest smart 'nvesting. And there's nutin' wrong with that, is there folks?

The crowd disperses. Most walk away, figgering the party's over. A few walk away, muttering 'bout the good old days. A few go looking for the brains behind these new products ...



... and think they see him ...

But the wisest quietly head to the nearest internet cafe, for a quick round of research, and portfolio re-balancing with these new enhancements.

And thus things are as they always were ... angst over something newer AND better ... and the sheriff walks away ... peace restored once again.

Enhanced ETF - US example, Canadian example.


JW

The Confused Capitalist