Factors are to assets what nutrients are to foods. They’re what really matter. My goal when picking ETFs is to find the most-efficient ways to obtain desired factor exposures, in the same way a dietician picks meals to achieve a certain balance of nutrients, asserts Samuel Lee, editor of Morningstar ETF Investor.
In equities, there are five major factors: market, value, momentum, quality, and size. These factors have historically earned excess returns.
The market factor is simply defined as the return of the total stock market. Market and size generate returns as compensation for their risks.
Value, momentum, and quality, on the other hand, earn much of their returns by exploiting investor misbehavior. Stock pickers have been exploiting these styles for decades.
When picking funds, I believe you should look for ones that offer efficient exposure to value, momentum, or quality—ideally—all three. At the very least, your fund should minimize exposure to expensive, poor-returning junk stocks, which historically have chewed through capital.
Schwab US Dividend Equity ETF (SCHD) is my favorite US equity fund at the moment, which might seem strange given that it’s lagged the broad market since inception. However, it has three things going for it.
First, its loadings to value and quality factors are sizable, both since its 2011 inception and its 1999 back-tested index inception. That its live and back-tested returns show big and fairly stable value and quality loadings is reassuring.
Over its full history, the index exhibited a value loading of 0.6, a quality loading of 0.3, and no momentum loading. However, the fund favors big, defensive stocks, which reduces its expected return. I expect SCHD will largely keep up with the market, but with much lower drawdowns and volatility.
Second, it’s dirt-cheap in all respects, with a 0.07% expense ratio. The strategy’s turnover averaged 15% since launch. Moreover, the fund is not bloated to the point where its trades push prices around.
Finally, its index, the Dow Jones US Dividend 100, is sensibly constructed. The index screens for US stocks that have paid a dividend in each year for the past ten years.
This screen weeds out smaller, less durable, and more-speculative stocks. It then ranks the stocks by annual indicated dividend yield and kicks out the bottom half.
The remaining stocks are ranked by cash flow/total debt, return on equity, indicated dividend yield, and five-year dividend growth rate. The four rankings are equal-weighted, and the 100 stocks with the highest composite ranks are selected for the index.
Note that the ranking criteria penalize firms that 1) don’t earn adequate cash flow for each unit of debt they assume, 2) aren’t earning big profits for each dollar of invested capital, 3) haven’t grown their dividends, and 4) are expensive. By using value and quality criteria, the index focuses on cheap quality stocks.
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