Transition to the Capital Class with ETFs

Why save & invest?

Saving and investing are important. I have said this before, and I will say it again. There are two classes in society, labour and capital. Unless you are a creditor or owner of a company, you are in the labour class. Means your wealth depends solely on the result of your time invested at work.

Saving and investing in bonds (creditor) and equity (shareholder), puts you in the capital class. This transition between labour class to capital class is probably more important to us, now than ever, since the gap between both classes are widening at a quick pace, (read: Thomas Piketty) and its expected to worsen.

Basics of Buying ETFs

Its painfully simple. Exchange traded funds should be in your saving portfolio, because it’s easy to manage, provides instant diversification, and is difficult to screw up.

What are ETFs?

ETF is a big shopping bag of financial stuffs. The stuff in question can be stocks/bonds/derivatives/other ETFs. Anything with a cash flow and is actively traded in the financial markets can be put in this shopping bag. ETFs usually follow some pre-defined rules in terms of what to put in that bag. It could be stocks only from Russia (RSX), or only gold mining firms (GDX), or only bonds (MINT) etc. The funky letters in the parenthesis tells you the identifying ticker name for these ETFs, in case you are interested in doing some homework before investing. Google the tickers + etf. ETFdb is an ok website to use.

Investment motive

The first thing I would do is to examine my motives for investing. Are you investing because you want to finance a home in 10 years, or build a retirement nest egg? Maybe even just to try it out and find out why everyone is talking about it. Or perhaps you want to have the thrill of making money speculatively, in pyjamas on a Wednesday afternoon, scratching your balls in your chair? Whatever your motive could be, I shall show you in this article how ETFs can help you achieve your goals and not burn half your money, unlike your divorce.

Financing big purchases

First, I would set a target date, for when the expected withdrawal needs to happen. Then I would go make myself a cup of tea, because we are in this for the long game. Might as well take a chill pill. Usually, depending on the target date in mind, its good to start off aggressive and slowly tone it down as we get closer to the target date.

Retirement income

Well, you need a target date again, which will be your target retirement date. As you draw closer to the target date, keep to less volatile holdings and go into capital preservation mode. Its OK to lose half your money when you are 27, not so cool to lose half your money when you’re 72.

You know that jumpy financial advisor in that ugly glazed double-breasted gray suit, calling you every other week to recommend you some top-of-the-line investment product when you are in your golden years. Ignore him. He does not have your well-being at heart, he only cares about the commission he will earn from you. Don’t make any exotic, opaque, risky investments in your silver and golden years. If necessary, take the money out from a trading account, and in to a savings or fixed deposit account.

Trying it out

ETFs are the best for beginners. It’s really hard to lose all your money with ETFs. If you follow the rules below, you’d be fine.

Speculation

ETFs are not for you. Stop reading and go to the casino.

Risk appetite

Asking for your risk appetite is a polite way for those pesky financial advisors to ask you, “how much money can you lose before you shit your pants?”. The problem is, those guys asking you the questions don’t manage your money, and those guys managing your money have no clue who you are. The slimy guys at your banks probably direct your money to one of the low cost ETFs, and pocket the difference in commission anyway. Some banks charge a lot for fees, to do something so simple! Investing through your bank increases the risks too, since usually there are two counterparties instead of one. Investing is not rocket science, you can do it yourself. If you want to pay someone to do it, get an actively managed ETF then.

If you hate taking risks, that’s fine. Me too. Nothing wrong. All the better. Start constructing a portfolio with a conservative philosophy. If you are a risk taker, that’s fine too. It’s entirely up to you if you choose not to rubber up, when things get hot and heavy with the person you just met at the swingers’ club. Same for how you build a portfolio. At the end of the day, build a portfolio that doesn’t keep you up at night.

Remember, we are in for the long game, ain’t nobody gonna be checking the portfolio every 5 minutes. The whole point of investing is to put the money to work, while you work too. Its counter-productive if you have to manage your portfolio and a job. That’s why we define a time-frame, philosophy, strategy and stick to it.

Rules

There are some rules that are good to follow, since we’re talking about your hard-earned money.

Expense ratios and sales charges
Keep these as low as you can. Expense ratio is the cost to YOU for owning the ETF. There is strong correlation between low gross expense charges and good long term performance. Most big ETFs from Vanguard & Blackrock have an expense ratio below 0.3%. That means you get charged $30 for every $10,000 invested. Pretty reasonable. Anything more than 0.99% is too much, IMO.

Some good looking sales bro will call you ever so often and tout that his firm has unlocked the secret to long lasting excess alpha returns, through smart beta, and adhering to some modified, multifactorial index, yada yada yada. The first question you have to ask him is how did he get your phone number. The second is can you take me off your phone list. And lastly, what’s the expense ratio? These are 3 questions which he will try his best to avoid answering.

Volume

Buy ETFs that are traded. Volume should be 6 digits. Anything less, you’re asking for liquidity troubles. Imagine when the shit hits the fan and you can’t sell your stuff or when you are making sick bucks and you can’t sell your stuff.

A good indicator is to glance at the trading volume column. Be sure to check it during trading hours. Another less reliable method is to check the assets under management (AUM). Anything with more than $1 billion is usually traded frequently.

Diversify, diversify, diversify

This is so important, it has to be said thrice. Your risk appetite will define the way you diversify. You ought to diversify over the following: asset type, geography, size, equity type

Asset type

There are ETF for bonds, equities, commodities, derivatives, other ETFs.

If you are conservative, put 60–70% of your money in bond ETFs, and the rest in anything that catches your eye; as long as you follow the rules. If you are aggressive, put 60–70% of your money in equities ETFs, and the rest preferably in some bonds ETF; rules apply too. Any allocation in between conservative and aggressive are acceptable too. If you’re interested, go google Asset Allocation

Bonds

Buying bonds makes you a lender. The borrower is up to you to choose from, it could be a government, a municipality or corporates. Its healthy to have a good mix between the different entities you lend to. You can only lose what you put in.

Bonds are safer than equities simply because there is less uncertainty in cash flows. The bonds dictate how much has to be paid out, and the borrowers usually repay it. Especially for governments, since governments usually prefer to print money to repay the bonds than to default and be blocked off the capital markets (Argentine-style!). Do take note that interest rates and exchange rates will affect the valuation of your bonds and cash flow. However, if you cast your net wide enough, and have a long enough investment horizon, there is nothing much to worry about.

I recommend governmental bonds and corporate grade bonds. Municipal bonds are tricky. Town councils like to default. Municipal governments can’t print money too. I avoid them.

There are different classes of government bonds. Usually they are split between developed economies (AGG, BND) and developing economies (EMB). BND for example, holds 17,301 different bonds in 1 basket. That is more than enough diversification. EMB top 10 holdings includes lending money to Russia, Argentina, Hungary, Poland, Peru, Uruguay. Since holding emerging economies bonds are more dicey than developed markets, they pay more to you for interest. Another cool thing about owning bonds is that you can go to their citizens and say, your country owes me money. Absolutely true!

Bonds Duration

Bonds are separated through the duration. As usual, when in doubt, diversify through the distinctions. Google “Bond duration” if interested.

Equities

Means you are a part owner of the company. You can earn money in 2 ways, the value of your stock goes up, or they send money to you in the mail (dividends). Again, you can only lose what you put in. Taxes apply.

Geography

You want to spread out your purchases across continents and nations. This insulates you from country-specific events. A good rule of thumb is not to have more than 40% of your portfolio based in one continent. North America is an exception.

Remember to diversify based on your needs. For example, if your primary residence is in the US, your job pays in USD, and your job is based in USA, then you have more than enough exposure to the United States of America. It would be very pointless in the view of diversification, to invest your savings in Singapore. I act on this. My portfolio has no positions in my employing company, nor in the country where my livelihood is based on.

If you are aggressive, go for emerging markets (VWO, EEM, IEMG) and frontier markets (FRN) ETF. These usually experience more volatility. Meaning that the value of your portfolio jumps around a lot, and there is a stronger chance for higher returns.

If conservative, go for the developed markets like North America (VTI, SCHB) and Developed Europe (VGK).

The mentioned VTI and SCHB have 3723 and 2054 holdings respectively. Meaning to say that by buying VTI, you are purchasing 3723 companies in 1 go. This is recommended because you have instant diversification. Assuming equal weights, if 30 companies go bankrupt, you would have lost less than 1% of your money invested in VTI. Its much better than buying individual stocks. Take note that VTI and SCHB both have very low expense ratios too. You pay $3 for every $10,000 invested, and you gain from such diversification.

Size

Equities come in more or less three sizes. Large cap, mid cap, small cap. Cap is capitalization, not the thing that cool kids buy to hide their freckled, stunted foreheads. Conservative investors should stick to large cap. Large companies usually have everything in order, have strong market share, good cash flow, and make money in general. There are less surprises with these boys. The more aggressive you are, the more you should include mid and small cap in your portfolio. Note that in a recession, smaller cap companies suffer a lot. Smaller cap companies also experience great jumps and drops in prices.

Equity type

Other than by size, equities are also split by type: Value, Core, Growth. It’s good to diversify across the 3 types as well, and I feel it’s OK to have a preference if one wishes.

Value are stocks that are comparably cheap, considering their earnings. This can be due to their industry, which has little growth prospects, or perhaps the company is domiciled in a country with short-term turmoil, hence a lower price due to the uncertainty.

Core stocks are the backbones of the economy, whose stocks are a best representation of the domestic economy. These are usually well known companies and have a strong brand value. IVV which represents the core of the US economy, includes Apple, Microsoft, Exxon, J&J, GE, Berkshire Hathaway, Facebook, Amazon etc. It’s usually good to have some global core in your portfolio.

Growth are stocks that are usually comparatively expensive, considering their earnings. This is due to their growth prospect, and the promise of better returns in the future. Typical industries that have growth classification is Tech and Healthcare. In my opinion, the most bubbly valuations can be found here, as it’s hard to quantify future earnings accurately. Personally, I don’t hold too many growth ETFs if I can help it.

I understand that managing by geography, size and type can be too troublesome for the retail investors. There are tools like Morningstar X-ray out there, where you can key in your holdings and this pops out.

My ETF holdings some time ago (Produced with Morningstar)

As you can see, my holdings are mostly in large caps, because I am pretty conservative when it comes to investing. I try to stay away from small cap because those guys are too volatile for me. I have strong preference for value stocks too, which I will explain later why. For now just try to keep the stock style matrix well spread out or top heavy and you will be OK.

Sectors

Different sectors behave differently, and you will have to diversify likewise accordingly.

My ETF holdings some time ago, split by sector (Produced by Morningstar)

If you are more conservative, go for utilities, telcos, consumer staples and consumer discretionary. Materials and Industrials somewhat applies too.

If you are more aggressive, then hold healthcare, energy and IT stocks. Try not to have more than 20% of your portfolio in one sector, as sector valuations commonly move together.

Fund houses

Vanguard, Blackrock, Guggenheim, Credit Suisse etc. These are fund houses. You should try to diversify your holdings across fund houses because funds from the same house can have a selection bias. The selection bias may lead to a concentration in your holdings. We want diversification, not concentration.

Leveraged ETFs

Avoid them. The roll costs are usually too painful. Owning leveraged ETFs is like owning a pet crocodile. It’s all fun and dandy at the start, but if you keep them for too long, it will return to bite you in the ass. Time horizon for keeping leveraged ETFs should be max. a few months.

Inverse ETFs

Avoid them. Roll costs again. Betting against the market long term, correlates with negative returns.

Investment Strategies

Here, we shall discuss some of the investment strategies prevalent in today’s markets.

Buy and hold

Personally, I like to buy and hold. Less transaction charges, which correlates strongly with better long term performance. Set aside some money from your income every month, and put them in pre-defined ETFs. Then just hold them all the way till you need the money or you are convinced your holdings are too overvalued. (For valuation, google either: PE, Shiller PE/CAPE, PB)

I believe the market is cyclical. Like the oft quoted phrase, the stock markets short term is a voting machine, and long term a weighing machine. What I do is when I am drinking coffee in the morning and reading the news, I keep an eye out for turmoil. Usually everyone is selling & dumping when turmoil hits, so you just wait and watch the discount grow while the fear mounts. After some time, I invest in that country or sector. Then I forget about it. Since my investment horizon is a few decades, I have time to spare till that sector or country picks up again.

Case: At time of writing,

1. Russia is placed under sanctions and experiencing weak oil prices.

2. Brazil has political turmoil through a corruption scandal of Rousseff

3. Malaysia political class is facing corruption allegations, suffering oil prices

4. Energy sector getting destroyed through low oil prices

5. Financial sector battered through low interest rates

These are stuff you see on the news all the time. For point 1,2 & 3, you can purchase Russian (RSX), Brazilian (EWZ) or Malaysian (EWM) stocks or their bonds (ELD, EMSH), or both. Usually they are at a discount when crisis hits.

For point 3 & 4, you can purchase sector specific ETFs. Energy (VDE, XLE) and financial (VFH, FNCL, XLF)sectors are relatively cheap compared to before.

You can make proxy bets too. Ask yourself. If oil is cheap, which countries or sectors would benefit the most? Countries like India (INDA, EPI) and Philippines (EPHE) import a lot of oil as a percentage of GDP. Airlines (JETS, ITA) and transportation (IYT) companies spend the majority of costs on fuel. Cheap oil bodes well for all of them, so you can expect their business outlooks to improve and that they will provide good returns.

My strategy is basically bargain hunting. I wait outside the supermarket till something goes on discount, then I saunter in and pick it up. Buy low, sell high, remember? Unfortunately, this strategy is not for everyone. You need to have patience to ride out the market turmoil and cycles. You also have to keep your hands away from the trading platform, which is harder than expected. No matter what, remember to keep your investments diversified.

I shall include the other strategies here for discussion sake. I do not necessarily think these are good ideas.

Smart Beta

Smart beta is the new game in town. Personally I think it’s stupid. Even sad to a point. The idea is so dumb, they put the word Smart in front of it. Its like naming your son Smart, hoping that it’s a self-fulfilling prophecy.

Smart beta is the desperate way asset managers try to remain relevant today. The sorry sad fact is, most asset managers suck sweaty balls. When they outperform, they can’t repeat the fluke. You are better off just indexing. Asset managers realized that, and try to reduce a winning strategy to beat the index, by making an index with simple rules, then following it blindly.

The rules are anomalies identified from academic literature. They back-test (also known as lying to themselves) it, then fiddle around to find a formula to deliver the best result they were looking at. The problem is, once an anomaly is discovered in the market, it cannot continue. People will arbitrage the profits away. Well, at least most of these funds are kind of diversified.

Momentum

These ETFs seek out stocks or sectors that are gaining momentum. They are usually an ETF of ETFs, which results in higher expense ratios. Momentum ETF usually have different geographical focuses. Expect the global ones to incur more expense charges. The high fees are why I avoid them.

The most held momentum ETF is First Trust Dorsey Wright Focus 5 ETF (FV), which as of the time of writing includes:

First Trust Utilities (FXU)

First Trust Consumer discretion (FXD)

First Trust Internet (FDN)

First Trust Consumer Staples (FXG)

First Trust Energy (FXN)

This ETF holds 5 different ETFs of the 5 sectors that have the most momentum in trading. Sly mofos double-charging their expense ratios too. One thing to take note is that because the ETF changes its holdings drastically, it could create unexpected concentration risk in your holdings.

Long Short

Long short can have long and short positions in different assets. Long means you own the stock. Short means you sell a stock you do not currently own, in the hopes that the price drops and so you can conduct the cancelling trade and profit. There may be an underlying objective, where the ETF claims it will be 130/30 for example. This means its 130% long and 30% short. I avoid long shorts because their expense ratio is high, averaging near 1%.

Volatility Hedged

These ETFs invest in equities and volatilities derivatives. In English, it means that they buy insurance against wild swings in prices. The good thing is the downside is supposedly hedged. The bad thing is that you have to pay for this protection, meaning that the hedge hinders performance. I have not tried their services, and hence can’t recommend them.

Merger arbitrage

This one is cool. I am not sure though if this strategy provides long term returns. When a company buys another company, the buyer usually has to pay more for the target. Merger arbitrage funds (MNA) will check out the M&A scene and hold positions in the target companies, to earn this premium. Problem is, an ETF like this typically holds only a few stock. Since mergers and acquisitions typically happen in only a few industries where scale pays off, your holdings in a fund like this would be concentrated too. Thirdly, you are not protected against a market sell-off. Worse still, in the event that there is a sell off, the merger would probably not take place and you would not have earned the premium.

Momentum, Long-short, Volatility Hedged, Merger arbitrage ETFs are usually actively managed. Means more fees to pay.

Conclusion

ETFs are really simple to get started, and to put your investments in your hands. Through ETFs, its easy to gain diversification. Decide if you are a risk-taker or risk-averse, define an investment philosophy and hone a strategy, then cast a wide net across geographical, asset types, asset sizes, sectors and fund houses, forget about your investments, until the day you need money to cure the cancer you got from midnight binge on dank memes. Good luck.

All views expressed are personal opinions and not of that of the employer. Nothing written here should be construed as advice. Information presented is believed to be factual and up-to-date, but I do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.

One clap, two clap, three clap, forty?

By clapping more or less, you can signal to us which stories really stand out.