This would be the perfect ETF
This week's episode of Investing Compass looks at the characteristics of the perfect ETF
In this week's episode, we go through the characteristics of a perfect ETF.
You're able to view the full article here.
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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your personal situation, circumstances or needs.
Mark LaMonica: Okay, so we're going to talk about perfection today, Shani. But some people, if they get everything on their wish list, think that their life will be perfect. Now, you shared with Will and I your Amazon wish list before we started recording this.
Jayamanne: Not because I wanted you to buy me anything. I just said I looked at it and I questioned the state of my mental health.
LaMonica: Yeah, I would definitely buy you something off of there because one of the things that's on there is four soup spoons. And like there's nothing special about the soup spoons.
Jayamanne: It's like $16 for these four spoons.
LaMonica: Exactly. So I think if Will and I chip in, we can at least get you two of the spoons and maybe you can get the other two yourself.
Jayamanne: Yes.
LaMonica: Does that sound fair? You also have a couple books on there.
Jayamanne: I have some books, yes.
LaMonica: Which is more appropriate. Do you want to share those books?
Jayamanne: They're just cookbooks. Yeah, nothing investing related.
LaMonica: Okay, well, there we go.
Jayamanne: I want to ask you though, what's on your wish list?
LaMonica: I want a deep fryer.
Jayamanne: You want a deep fryer?
LaMonica: Did I ever tell you the deep fryer story?
Jayamanne: No.
LaMonica: I got a deep fryer before I got married. And my wife said we could only use it once before the wedding, just so I would like fit in the frame of the wedding pictures. And so I used it once. And then we moved apartments and my wife broke her ankle. We didn't have any money, so I moved us by myself, which was not great. And somehow I lost the detachable. It's one of those safety cords with magnets that pulls out so that I don't trip over the cord and cover myself in oil. Thing was gone. And so I had a deep fryer used it once. And this was like 18 years ago. And I'm still upset about it that I don't have a deep fryer.
Jayamanne: Do you think it was intentionally lost?
LaMonica: I think there's a strong possibility. She didn't want a fat husband, yet here she is getting just what she doesn't want. But the opposite of the way that I look is perfection. And we are going to talk about perfection today. So this is obviously a very high standard. Do you think anything is perfect, Shani?
Jayamanne: I think that the Milo Kit Kat bar is pretty good.
LaMonica: Which you messaged me. You said you had one yesterday and I've never had one.
Jayamanne: No, I'll get you one.
LaMonica: Although I have had a Kit Kat.
Jayamanne: And you've had the Milo scoop shake.
LaMonica: That frozen thing that you said that your parents used to get you when you were little.
Jayamanne: So it just mix those two together, basically.
LaMonica: I might just buy the actual bar. But we're going to go through an article today that I wrote on the perfect ETF. Now, obviously nothing, with the exception of this Kit Kat Milo bar, is actually perfect. But I had a discussion with my boss, who you know, Chris. And we're talking about ETFs in general. And I was up on my soapbox complaining about some of the new ETFs that had come out. And he told me that anyone can be a critic. But I should describe to him the perfect ETF.
Jayamanne: Have you seen like the Simpsons meme where it's like old man chats at cloud?
LaMonica: Yes, because you say that every time I complain about anything, even if it's horrible.
Jayamanne: Yeah, well, so he basically called you a complainer.
LaMonica: Basically, yes.
Jayamanne: So what was the solution to this?
LaMonica: The solution was I wrote this article on the perfect ETF.
Jayamanne: So talk to me about the article.
LaMonica: I will. What I really described was the way that I think is best to invest. So this is obviously very subjective and it's just my opinion. So everyone can take this with a grain of salt. The first thing to keep in mind is that an ETF, of course, is just an investment product. And an investment product is simply a means to an end. What matters is what you are trying to accomplish. And that's where I'll start in designing the perfect ETF. So what kind of ETF can help Australian investors achieve their goals?
Jayamanne: And we all save and invest for different reasons. But at a high level, we're all trying to do the same thing. We're sacrificing consumption today in the hopes of growing our savings to have more to spend in the future. What matters is earning a return in excess of inflation, taxes and fees. And each of those are real costs that leave less money to spend in the future.
LaMonica: Yeah, exactly, Shani. So my perfect ETF would invest in shares because they have the highest long term returns above inflation. My perfect ETF would minimize taxes by keeping turnover low. So turnover, of course, is when shares in this case are sold in the ETF. And if there's a capital gain, it gets passed on to the investors who own the ETF. My perfect ETF would charge a reasonable fee. So these are all non-negotiables.
Jayamanne: But I'm guessing that your perfect ETF would be actively managed with all that criteria because the whole premise of this is that the perfect ETF doesn't exist. And a lot of these big passive indexes already have ETFs.
LaMonica: That is true. And I do want to be clear. I'm not advocating for investors to pick an active ETF. That would be hypocritical of me since I would never buy an active ETF. But maybe because there's no ETFs like the one I'm about to describe. So maybe that's the reason I don't buy one.
Jayamanne: So let's talk through this actively managed ETF. What would make it different to all the other actively managed ETF?
LaMonica: OK, the person picking the shares of my ETF would focus on an investment strategy that works over the long term, and that is buying great companies at a reasonable price. Now, maybe a lot of people are listening to that thinking, oh, I've heard of ETFs like that. Well, that's fine for people to say it. But I would have a manager that actually did it because despite saying that, most professional managers don't.
Jayamanne: So if they're managing this ETF actively, how is the manager picking what goes into the ETF?
LaMonica: OK, well, I'd start with a moat, something we talk about a lot. So a great company can grow the business at a rate of return that exceeds the cost of capital. This is hard to do because competition is at the heart of capitalism. And while consumers get better goods and services, companies and the owners of those companies suffer. So in order to compete, they continually have to invest in research and development, marketing or engage in price cutting. That means less money to expand the business. It means less money to return to shareholders.
Jayamanne: A company with a sustainable competitive advantage or a moat helps to reduce the impact of competition. Sustaining the moat is the key. Each year the company will gain a small advantage over competitors. But over time this advantage will compound and the person managing the perfect ETF will have to be patient.
LaMonica: Exactly. Criteria number two, Shani.So, my second piece is it would be valuation focused. Over the long term, the performance of a company will drive the share price, but in the short term, share prices may fluctuate significantly. I want the person managing my ETF to use those opportunities when the market drops to pick up these great companies at decent prices. So to do this, I'm comfortable with a little bit of cash being built up when prices are high, and what I really don't want them to do is pay too much for even the best company, because that's not a formula for long term success.
Jayamanne: And buying a great company at reasonable prices work, this is demonstrated by the performance of the Morningstar's Wide Moat Focus Index, which is made up of U.S. shares with wide moat shares trading at low prices. In the last 10 years, the Wide Moat Focus Index has returned a little over 1% a year more than the S&P 500.
LaMonica: Yeah, which is good news, right? The perfect ETF would only hold companies in strong financial condition. So I want the manager of my ETF to look for this as a criteria. Identifying companies with moats helps, but balance sheets are also important. Economy will go through inevitable ups and downs and all companies face periodic challenges. By concentrating on strong balance sheets, my ETF will hold companies that can withstand those difficult periods.
Jayamanne: And one thing to concentrate on is that financial strength means that they will do more than just survive. They will thrive. A company with a strong balance sheet can take advantage of industry-wide slowdowns to invest in gaining market share when competitors are pulling back.
LaMonica: The perfect ETF, as I said before, would invest for the long term. And I do want my ETF to be focused. I can, of course, go buy an index fund. My perfect ETF will only include the manager's best ideas and hold between 20 and 40 shares. And then, as I've said multiple times, because almost no professional investors do this, focus on the long term, not just say that you do.
Jayamanne: Now, an investor that is buying this ETF would have to accept something. If you take a long-term approach, you must understand that there may be quarters or even years when the ETF underperforms some arbitrary benchmark. And you have to be okay with that. But I think this way also. I know that building wealth is a long-term endeavor. And as I said in our episode on my investing philosophy, I focus on performance in excess of fees, taxes, and inflation. And I want strong performance. But I also know that a fund manager that is constantly trading, rotating their portfolio, and searching for short-term catalysts is going to have a difficult time outperforming. And I know those actions will lead to higher taxes. Periods of underperformance is a price that I have to pay for this long-term approach. And I'm comfortable with that because I'm patient and I know that real wealth is built over the long term.
LaMonica: I feel like you're getting on board the perfect ETF.
Jayamanne: I am. I do make fun of you, but I think this is in the best interest of investors, which is what you do.
LaMonica: Well, there you go. Shani on the bandwagon, but will still make fun of me. The perfect ETF would be transparent, Shani.
Jayamanne: This is going to be a ground my gears by Mark LaMonica segment, isn't it?
LaMonica: I guess so. But I know that I've said this like 50 times, but it is ridiculous that Australia is one of the few countries in the world that doesn't require full disclosure of holdings. So it's never made sense to me. If you're a long-term investor, you shouldn't care if people know what's in your portfolio. And I think potentially there's so much resistance because a lot of these managers are not long-term investors and they don't want people to constantly be reminded about how much their portfolio is changing. But I, of course, would want the manager to be completely transparent because it's my money that I'm investing after all. So the least they can do is show me what's in the portfolio. And I don't just want because I'm interested in investing. So I would also like some commentary. I don't just want transparency into what's in the portfolio, but I'd like to know what the manager is thinking, what's the rationale for when they're making buy and sell decisions. And I'd like them to write that out for me and provide it. And I personally like the intellectual challenge of investing. So I'm interested in what people think and we never get that. We never have any ideas. Just a slick marketing material that comes out. You don't actually get that transparency.
Jayamanne: All of that was very valid, Mark.
LaMonica: So what you're implying is most of these, as you call them, grind my gear sections are just like me raving away.
Jayamanne: Not at all.
LaMonica: Okay. I mean, I'll take that. Well, that's my perfect ETF. So not too complicated, but fairly unique in terms of what you can actually get out there.
Jayamanne: So I think that my observation with this ETF is that it's more about how to invest instead of what to invest in. Do you think that's about right?
LaMonica: Yeah, absolutely. I mean, I think we say this all the time, right? That it's the process investing matters, not investments. And so really a lot of this is process driven. And I think we both agree with that.
Jayamanne: Yeah.And the biggest issue that most investors have is their own behavior. And the consequences of that behavior. So the question of course is, can you find a manager that will adhere to all of those requirements? Mark, of your perfect ETF.
LaMonica: I mean, probably not, or it would be out there. I mean, there's a lot of ETFs out there. And this one does not exist. So I don't know. I'll probably just have to start my own, right? And you can be my first investor, Shani. All right. Please deliver your investment in cash.
Jayamanne: You know, I'll put it on my Amazon wish list and see what happens.
LaMonica: There you go. And if this ETF takes off, maybe I can afford a deep fryer. But anyway, thank you guys very much for listening. We really appreciate it. My email address is in the show notes. Let me know what you think about the perfect ETF and things that you think I'm missing or offer to buy Shani four spoons, four soup spoons. Thanks a lot for listening.
