Why I bought an underperforming ETF for my retirement portfolio

“The most important organ in investing is not the brain, it's the stomach” – Peter Lynch

I recently bought my first equity ETF outside of super. In this article, I’ll go into some of the questions I asked myself and why I ended up making the investment I did.

What am I trying to achieve?

Every investment should be bought with your end goal and personal situation in mind. Here’s a quick rundown of mine: I recently turned thirty and my retirement pot is tracking behind where it should be given the long-term ‘number’ I want to hit.

For this reason, I have decided to invest $200 more from each paycheck towards retirement. The main timeline I have in mind for this investment goal is 35 years, but I also wanted a nearer term goal to keep me motivated. I set a five-year goal of having $25,000 more in my portfolio.

Starting with an initial balance of $500 and adding $400 per month over the next five years requires a 6.7% per year return to hit that goal. Stopping contributions at that point, getting the same average return, and assuming 3% inflation would give me $72,000 in today’s dollars by 65.

I view this goal as both realistic and meaningful. It is also one that, given the time horizon and required return, is suited to equities over other mainstream asset classes. Before deciding which equities to invest in, though, I did some soul-searching.

Know thyself

Reaching long-term investment goals requires you to remain invested for the long term. Remaining invested for the long term requires finding investments that you are comfortable holding. And finding those investments means understanding yourself.

As I revealed in an article about a shameful year of “investing”, my main weakness in the past has been overtrading. I was often overwhelmed with so many “must-buy” investment ideas that I rarely held anything long enough to benefit.

Addressing this in my portfolio took a lot of effort: I implemented far stricter criteria on which shares I allow myself to buy. Each position needs to satisfy several different measures of business quality and suitability. None can be sold for at least three years once bought.

My problem with holding index tracking ETFs

At this stage, you might be wondering why I didn’t just buy what you could call the ultimate “forever asset”: an ETF that tracks an index like the S&P 500 or ASX200. Set and forget. My problem is that I probably wouldn’t be able to ‘set and forget’ it.

Why? Because I have always been somewhat receptive to warnings that 1) equity indexes have become very concentrated and 2) valuations look high in many of the industries and shares they are concentrated in.

This may not actually prove to be a bad thing – after all, it has definitely gone well for investors in these index tracking ETFs recently, and is a 5% position in Apple really the end of the world? All in all, though, I’m not especially comfortable with it. And I need to be comfortable with any investment that I plan to leave uninterrupted for many years.

The only index funds I own are in my super account, which is invested in my provider’s default indexed option. Even that was dictated more by me not wanting a big chunk of my super in private credit than it was by any desire to be a Boglehead.

What I was looking for in my next investment

The last thing I wanted, then, was to invest thousands of dollars into an index tracking ETF for my retirement, only to become skittish if valuations and/or concentration continue to move further in the way they have been.

Nor did I feel the need to add to the fifteen or so individual shares that I already own. I just wanted an investment that is suited to my goals, that I’d be comfortable leaving uninterrupted, and that I can keep buying regularly without thinking too much.

I decided to explore the ETF route for suitable options, and the idea of a value factor ETF came up quite early on. After all, the main issue I’ve had with buying and holding an index tracking ETF is that valuations have seemed historically high for many years now. Perhaps I would be more comfortable holding a basket of the market’s cheapest and less appreciated companies.

Weighing up value tilted ETFs

Value approaches seek to own the market’s cheapest stocks. They have held up just fine for most of the stock market’s history, albeit not so much in relative terms recently. More importantly, they have been able to deliver the kind of return I need to reach my goal.

I searched ‘value ETF’ into Morningstar and found three initial candidates:

iShares MSCI World ex Australia Value (IVLU)
Vanguard Global Value Active ETF (VVLU)
Dimensional Global Active Value ETF (DGVA)

While the idea of a diversified and value-oriented vehicle appealed to me, I also wanted my choice to align with the approach I take with the rest of my retirement investments. With that in mind, here are some of the major criteria I have in place for individual share purchases:

Company has a competitive advantage that I understand
Company has a strong financial position
Earnings growth of 7% a year or more looks feasible
Valuation at purchase is a potential tailwind, not a headwind

Not all of those really apply to choosing an ETF, but one thing is clear: I don’t just want to own cheap stocks. I want the companies I own to be of above average quality. After reviewing these options against the investing criteria for my portfolio, a clear winner emerged.

Looking under the bonnet

Investing in an ETF (or a managed fund for that matter) involves handing over control of how your money will be invested. As a result, it is important to have an idea of how those funds are likely to be allocated going forward.

The iShares option is passive in that it simply replicates the holdings of MSCI’s World ex Australia Value Index. This index weights stocks depending on how cheap they are on a price-book, price to earnings and EV to operating cash flow.

The Vanguard and Dimensional products do not seek to replicate this index. Instead, they use their own algorithms to allocate funds.

VVLU’s system favours cheaper stocks based on price-to-book, price-to-earnings and price-to-operating cash flow – very similar to the value index.

By contrast, Dimensional favours stocks that score highest on three factors that have historically boosted equity performance, as per the studies of long-term equity returns conducted by US academics Fama and French.

Here are the three main cogs of Dimensional’s systematic approach to equity investing:

DGVA’s allocation therefore tilts not just to cheaper stocks on a price to earnings or cash flow basis, but towards smaller companies from the investment universe and those able to generate more profitable returns on investment.

This results in what I saw as a very different ‘value’ proposition to the Vanguard and iShares options.

Quality at a fairer price?

Using P/E ratings as a barometer, DGVA’s holdings screen as more expensive than the other two value ETFs (albeit much cheaper than the global index). Using our analysts’ company moat ratings as a guide, though, this appears to come with a notable uptick in quality.

As of December 31 almost two-thirds of the individual holdings had been assigned a Narrow or Wide Moat rating by our analysts. This compares to under 28% of the Vanguard option and around 39% of the value index tracking IVLU.

Figure 2: ETF P/E ratios, sales growth, dividend yield and moat ratings. Source: Morningstar

This suggested to me that DGVA might provide me with the lower valuations I was looking for, without sacrificing as much on the quality of company I had exposure to. In other words, DGVA seemed a better match for the investing approach I take more generally.

Looking deeper into DGVA

The global index’s overweight in the tech and communication services sectors, which for mega-caps are essentially one and the same, gives way to a big skew to financials and a more even spread beyond that.

Figure 3: DGVA sector weightings versus global index. Source: Morningstar

Like with most value titled ETFs, this means much bigger weightings to energy and basic materials than the global index. Fun fact: the global index’s weighting to just two tech stocks, Apple and Nvidia, is almost twice the weighting to energy and basic materials combined.

At the individual stock level, there is also far less concentration. This should come as no surprise as DGVA (and any other factor style ETF) is trying to construct a basket of stocks with certain qualities as opposed to a portfolio weighted by the company’s market value alone.

Figure 4: DGVA top holdings versus global index. Source: Morningstar Direct

Performance and costs

DGVA has underperformed its MSCI World ex Australia index benchmark over the last one-, three-, five- and ten-year periods. Given its tilt to value and preference for the smaller side of its large-cap universe, that isn’t surprising. Mega-cap growth has been king recently.

I have no such benchmark apart from my goals, which require an average annual return of around 7%. With that in mind, this strategy’s average 11.2% annual return over the past fifteen years and 6.95% average return since inception – a number squashed by its launch just before the 2000-2003 bear market – gives me cause for optimism.

The fees seemed fine, too. Annual total costs of 0.46% come in lower than most managed funds and are only 20 basis points (0.2%) above what the cheapest passive ETF options generally charge. Given that this seems a far better fit for me, I think it’s a price worth paying.

It’s important to note that I am not saying this ETF will beat the market over my holding period. I chose this investment because 1) I think it can generate the kind of returns I need to achieve my goal and 2) I am more likely to leave it untouched than I am with an index tracking ETF.

A note on extra retirement savings

At the beginning of this article, I missed something important regarding my personal circumstances: I am British and there is a considerably higher than zero chance that I will return to the UK from Australia one day.

Given my distrust that Australia won’t make tax rules for expats’ super balances even more punitive than they are today, I am investing these extra retirement savings outside of super.

For those of you living in Australia without the burden of being a foreigner, you might find methods like salary sacrificing into super more attractive. Of course, you should seek advice on this based on your personal situation.