How a professional picks an ETF
Morningstar’s Chief Investment Officer Matt Wacher shares his perspective.
Arguably, buying ETFs doesn’t come with the same set of challenges that individual stock picking involves. But that’s not to say there isn’t a process involved.
As an individual investor, my access to information and analysis is naturally limited. Luckily working at Morningstar has its perks. I have access to a plethora of research capabilities and professionals underpinning our investment process.
This week I sat down with our Chief Investment Officer, Matt Wacher, to walk us through the process of how his team pick ETFs and some of the key considerations surrounding portfolio construction.
The Morningstar method
Morningstar’s Investment Management team create and manage multi asset portfolios that are known for their valuation driven approach.
The graph below illustrates why the relationship between price and fair value is the principle that guides valuation-driven investing. Typically, over long periods of time, the fair value of a security or index increases gradually as underlying earnings grow (as represented by the red line). However, during this period, the grey line – the market price – moves around a fair bit.
Intuitively, when the market or security is trading above fair value the potential for returns is lower and the potential for losses is higher. This logic is flipped when something is trading below fair value. As we can see, the risk-reward is better when the market is trading below its fair value.
However, this doesn’t mean an investor should just purchase the cheapest assets available. In principle, if we want to buy quality businesses at prices below their intrinsic value, we must conform to the idea that we might be early to the party. A key challenge is that early and wrong can sometimes be indistinguishable in the initial stages. Further complicating a purchase decision is the fact that it is also possible to be both early and wrong if the nature of the asset changes over time.
Valuation driven investors also must accept that the cheap can get even cheaper, so often it isn’t enough to simply buy without additional layers of diligence. Buying unloved investments means there are no guarantees someone else will buy it next week, month or even year. Hence patience is key.
ETF investment process
They key goal is to build a portfolio that tilts to the best risk adjusted returns, so you are rewarded for the risk you are taking on. One of the tools that Morningstar Investment Management uses are ETFs. The team begins by identifying markets or sectors where they believe they will best be rewarded given the risk taken on – a country, segment or thematic for example. They then evaluate whether an ETF is an appropriate product to access the desired exposure.
ETFs are typically used to gain low-cost access to opportunities that don’t need to be built from the ground up, as opposed to positions requiring active management. For instance, if there is an opportunity in Country A but the team has reservations about the broader market, they may opt for an active manager or construct a portfolio and own the segments they prefer. However, if they view Country A’s assets as undervalued across the board, an ETF becomes the preferred vehicle.
When selecting an ETF, the team evaluates several criteria including liquidity, the quality of the parent provider, the nature of the tracked index and the level of tracking error. Cost is another crucial factor. As Wacher notes, if the index is suitable and the ETF is owned by a quality provider the ultimate decision is to opt for the lowest-cost option available
Interestingly, the team rarely remove ETFs from a portfolio on account of them being ‘bad’ investments. Rather, they simply exit the position when they believe the opportunity has run its course and is less attractive relative to others. This is a portfolio construction decision when the asset is no longer serving its original purpose.
Active vs passive
When I broached the active vs passive debate, Wacher reiterated a rather simple notion: all investing is active investing. There are no passive decisions. The decision to use an ETF or any other investment product is inherently an active decision, regardless of the product’s investment strategy.
For example, the Australian market has a large concentration in financial services and the mining. This will arguably never go away. So, when investors buy into a broad-based Aussie market fund, they’re essentially accepting this exposure. The key consideration for a passive index is whether you are comfortable with this notion. Active managers may be utilised in situations where you wish to tailor your exposure.
Wacher notes that when his team have conviction that the broader market is providing reasonable risk adjusted returns in aggregate, they’re comfortable owning the index ‘passively’ through an ETF. However, if they identify structural issues such as excessive concentration risk or overvalued segments, a broad market ETF would not be suitable.
In saying that, active ETFs are a different ballgame to their passive counterparts. Wacher stresses the importance of due diligence, not only of the product’s structure, but the investment process, track record over time and how much conviction you have in the manager’s skill. It’s a more complicated investment process.
What can individual investors takeaway?
I think it’s important to note that individual investors and professionals have very different goals and motivations. It’s very difficult for retail investors to try and emulate the methods of professional investors and it might not be suitable for their outcomes either.
The primary purpose of investing for individuals is to achieve their financial goals. Professionals on the other hand play a balancing act between client expectations, reputation, regulatory demands and the pressure to outperform benchmarks. Their success isn’t solely judged by returns or meeting their goals as they are also navigating an entire ecosystem of accountability and optics.
Professionals are also under pressure to perform well on a short-term basis, even when this this creates a misalignment with their strategy. However, as an individual investor, over-optimising your short-term returns can be detrimental to your long-term goals.
Wacher suggests that individuals should be looking for assets that are going to provide them better risk adjusted returns and how they determine that should be underpinned by a consistent process. Buying ‘cheap’ assets from a valuation-driven perspective means limited downside and a larger upside potential. In contrast, buying an expensive asset means there is greater room for a correction. Investors are faced with the double whammy of taking on more risk with less upside potential.
Although buying into market weakness makes sense, this is easier said than done and can sometimes even be the wrong thing to do. Adhering to a structured process maximises the probability of making good decisions.
This article by Mark LaMonica discusses three advantages individual investors have over professional investors.
