Unconventional wisdom: My ETF choice for Aussie equity exposure

Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

Unconventional wisdom: My ETF choice for Aussie equity exposure

“The humility required for good judgment is not self-doubt—the sense that you are untalented, unintelligent, or unworthy. It is intellectual humility. It is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgment must therefore be riddled with mistakes.”

- Philip Tetlock

Humility rarely comes to mind when you think about the personality traits of investors. Successful investors are portrayed as brash and confident. And professional investors often take on this swagger and present theories and suppositions in a manner more fitting of a truth. As often happens individual investors mimic professionals.

A degree of confidence is beneficial. After all investing is a risk-taking endeavour. But humility plays an underappreciated role in success. Humble investors are prone to research investments thoroughly and are sceptical of prevailing narratives. Humble investors are picky and say no far more than yes to investment opportunities.

In the spirit of humility, I am going to apply some scepticism to my own portfolio. This is not some wanton act of self-flagellation. As investors we benefit from considering why we may be wrong. This is Buffett’s former side-kick Charlie Munger’s inversion technique. It is the red team / blue team exercises that militaries use to simulate the actions of their adversaries.

I am going to explore the case for and against an ETF that I’ve been buying for the past few years which is now my largest Australian equity holding – the VanEck Australian Equal Weight ETF (ASX: MVW).

In part one I will outline what I’m trying to accomplish and why I think MVW is the right ETF for me. In part two next week I will consider why I may be wrong.

What I am trying to accomplish

What is often absent from investing commentary is the most important thing of all – the investor and what he or she is trying to accomplish. Part of this is for practical reasons. Whoever creates the commentary doesn’t know anything about the consumers of the commentary. But part of this is by design because too many details get in the way of a sales pitch.

What I am trying to accomplish is recorded in my investment strategy. I’m trying to build a growing stream of passive income. Every five years I add to the passive income that I spend to incrementally make my life more meaningful. And, yes, I know…money and meaning are not the same thing. But people keep charging me for things I like to do.

I am buying MVW in an account that I will start spending when I turn 50 which should roughly coincide with my next existential crisis provided the current one comes to an end. As everybody knows a crisis isn’t cheap – especially ones you manifest. The bottom line is I need these investments to work out.

Most of my portfolio is invested in US shares but since I’ve moved to Australia 11 years ago I’ve been increasing my allocation to local shares and that is the purpose of this account.

To build a growing stream of passive income means balancing yield and growth and that is the type of ETF I am looking for.

To choose any investment is to forsake all others. It isn’t productive to compare each investment you buy to every other investment. That is a recipe for either analysis paralysis or for constantly churning your portfolio. Instead have a set of criteria based on your goal. Make sure the criteria is stringent to eliminate most investment opportunities.

However, sometimes comparison is worthwhile. In the case of an equal weighted ETF like MVW there is an obvious substitute – a market cap weighted ETF. There are several I can choose from but since they are basically the same I will pick the BetaShares Australia 200 ETF (ASX: A200).

What is an equal weighted ETF?

In contrast with a market capitalisation weighting where the largest companies make up more of the index MVW and other equal weighted ETFs allocate an equal amount to each holding.

In the case of MVW and A200 there is a difference in the number of holdings. A200 unsurprisingly has 200 holdings. MVW has 72. On the surface this sounds like a dramatic difference. But the relative weightings in a market capitalisation index matter.

The ASX 200 is very concentrated. The largest 72 companies make up over 87% of the index. Excluding the 128 smallest companies from A200 does not profoundly change the exposure of MVW. What makes a bigger difference is changing the allocation of the top 10 shares in the ASX 200 which make up 49% of the index.

The academic argument for equal weighted indexes

For the academic argument for an equal weighted index we turn to one of the greatest names in investing – Professor Hendrik Bessembinder. Bessembinder has done extensive research on where returns come from.

Specifically, he has found that a small number of shares drive returns. Bessembinder’s 2018 study covered 26,000 US listed companies between 1926 and 2016. Only 90 companies account for half of all shareholder wealth. That’s one-third of 1 percent of the total number of listed companies.

The top 4 percent or 1,000 companies account for all shareholder wealth. That means 96 percent of all US listed shares had a return equal to or below the US Government Treasury Bill rate.

The implication of this and other academic studies is that returns are skewed. There are a small number of shares that do extremely well and disproportionately contribute to overall returns. Further analysis shows that the top performers generally start as small companies.

This intuitively makes sense. Large companies are more mature and generally grow slower. Small companies have a wider range of outcomes and can either hit it big or fail. But even if there is a greater chance of a small company going bust investors buying a basket of shares are protected given the asymmetry of return outcomes – there is no limit to how much a share can go up but it can only go down 100%.

In an equal weighted index an investor gets more exposure to smaller companies. In theory over the long-term an equal weighted index will do better.

Do I buy this theory? Not completely. The Bessembinder research covered 90 years and that is a big sample size. However, the market may have fundamentally changed since then given the rise of passive investing in market capitalisation weighted indexes.

When money keeps pouring into passive market capitalisation weighted indexes a disproportionate amount goes to larger companies. And despite lots of academic research showing small companies outperform – most famously the Fama and French three factor model – large cap shares have outperformed in the US for the last decade and in Australia historically.

The impact of small companies also gets blunted by rebalancing in an equal weighted index. You are not simply riding that small company all the way up. You are selling when a company relatively outperforms. You retain exposure to the company but this reduces the performance impact on an ETF from a high-flyer.

The prospects for the top companies in the ASX 200

I’ve covered the academic theory on why you may want to select an equal weighted index. But ultimately what matters is the actual companies that make up a disproportionate amount of a market capitalisation index and how they do in the future.

One of the reasons I picked MVW is because I do not like the business models or prospects of the banks and miners that dominate the ASX 200. The domination of the ten holdings is apparent in the following chart.

Miners are cyclical and reliant on commodity prices which generally means they don’t have moats. They are also highly capital intensive. This means that their dividends vary significantly year to year. That does not align with my investment goals. I also think the tailwind of Chinese commodity demand is eroding.

Banks are opaque, complicated and prone to principal agent problems. I just don’t like banks as I’ve been burned in the past. I also don’t see many prospects for growth. With the exception of Macquarie, Australian banks have failed at overseas expansion. And there is little prospect for market share growth in Australia.

The following chart shows the top ten holdings in the ASX 200 and our analyst projections of future dividend growth for the next five years and the compounded annual growth rate of the dividends.

It is a bit of a mixed bag. I generally look for at least 5% dividend growth which historically would grow my real – or inflation adjusted – passive income. CSL, Wesfarmers and Macquarie meet this standard and I already own CSL as an individual holding. CBA is close.

The other six names on the list would barely cover normal levels of inflation or fall well behind in the case of BHP. If our analyst projections are even somewhat accurate this list in aggregate would fall well short of my goal.

This adds to my scepticism about prospects for meaningful growth in earnings and dividends for the market capitalisation weighted ASX 200.

What has happened historically?

The only thing that matters as an investor is the future. Yet we can still learn from the past. And historically MVW has delivered against my goals. The return picture is in favour of A200 over the last 5 years as you can see below.

I am interested in returns. But the returns are similar, and the dividend growth picture has been strong for MVW.

In this case I will compare MVW to Vanguard Australian Shares (ASX: VAS) which tracks the ASX 300 and has a longer track record to A200. Given the top-heavy nature of the Australian market the ASX 200 and ASX 300 are similar.

Since 2015 the distribution compound annual growth rate (“CAGR”) for MVW has been 10.62%. Over the same time period VAS has had a distribution CAGR of just 1.15%.

Final thoughts

I think this is a compelling case that MVW is the right ETF for me. The question is if I can build an equally compelling case that my thesis on MVW won’t play out. That is the exercise I will go through next week.

Comments? Email me at [email protected]

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What i’ve been eating

Does it even matter what the food looks like when you are eating on the street in Bangkok? Anyone who has been to Southeast Asia can picture the experience. It is humid. Slightly chaotic. Tuk-tuks and motor bikes hypnotically avoid collisions as they dart about. Tourists who look like they haven’t showered in weeks stroll by in local beer t-shirts.

The order was pad see uw and laab. And the restaurant was the one I’ve been to half a dozen times that I only know by sight. The one across the street from the bar with the live music. Next to the tattoo parlour. Somewhere near Khao San Road.