My point is, Quality, Momentum or even NASDAQ 100 are chosen in a non-arbitrary way, which makes them kind of passive. There is a set of rules which determines which company gets included and at which weight. And they seem to constantly beat the market. Then why does the market put such a high price on stock of companies that are known to have trouble and nobody expects them to make a sudden rally?
According to the efficient market theory, when we see a risk premium from investing in quality stocks, we should asks ourselves, what is the extra risk that the investor is taking? To me, it’s weird, because it seems like the quality stocks only have upsides. If investing in quality yields better returns with no increased risk, the prices of these stocks should go up to make this premium disappear. Why does this not happen?
Thank you for noticing this, i had totally missed it. Although it makes my point a bit weaker, I still think that it is remarkable that:
Buffett (arguably one of the greatest investors over the last 60 years) says in his letters since the 70s that the number one criteria to look for is return on capital
40 years later, when we say “Wait a second, what would actually have happened if we had followed his advice”, we end up with a very fine result, even if backtested.
I’ll grant you that. I will rename the topic from “passive” to “index fund”. The approach i am trying to follow here is to ask:
The first step (totally passive) is to say that I do not know anything.
But then, is there a single decision that could dramatically improve results? Thinking from first principle, what drives wealth over the long term? I’d argue that a consistent high return on capital comes pretty close to that.
You only need a database of 10-K filings (or local equivalents) to be able to compute a return on capital, growth rate and financial leverage. The factsheet says that the index is rebalanced every six months based on these criteria.
I like Ben Felix but sometimes he should not rely so heavily on modern portfolio theory. MPT works in some cases, and not at all in others. For instance, in this study, Baker and Haugen showed that low-risk stocks (as measured by volatility) consistently over-perform high risk stocks in every developed market.
Someone will try to find a new factor to explain the anomaly and make the French-Fama model consistent, but at some point it is better to ask if you cannot start again on a better basis.
the fact that the human brain works in a logarithmic way and is incapable to grasp exponential growth
But mainly, i think there is a structural issue with how the industry and analysts evaluate stocks. Let me explain.
You might know that the number one valuation method to evaluate a business is the discounted cash flow analysis. Analysts try to forecast the cash flow for the next few years, after which they say that they don’t know what’s going to happen so they assign a GDP growth rate in perpetuity after 5 or 10 years. That is to say, they assume that after 5 or 10 years, the business is going to grow at the same rate than the economy, i.e not a lot. That means that each of the forecasted year will have its discounted cash flow, and after that they will add what we call the Terminal Value, i.e the value of all the cash flows after the period of projection.
The vast majority of analysts will use 5-year or 10-year DCF models to value a company and pay painstaking attention to the assumptions to drive their interim period cash flows. If you do yourself the exercise, you will notice something interesting. Here is the contribution of the terminal value to the appraised value of the firm given different interim growth rates in a 10-year DCF model:
Projection Period Growth Rate
Terminal Value Contribution
5%
73%
10%
78%
15%
82%
20%
85%
25%
87%
30%
89%
In other words, what happens before the 10 years only weights for 11% to 27% of the company. What is 11%-27%? A margin of error. You can get the next 10 years of projections wrong- as long as you know what the company will look like 20 years from now.
This has a lot of implications:
Again, people use 5-year or 10-year DCF models where they model in high growth rates and high rates of return. At the end of the “projection period”, they will plug in a perpetual 2% growth rate to the then “boring” company. What if a company can compound capital at a higher rate than its competitors for longer than that? A junior analyst will get laughed out of the room for creating a 20 or 30-year DCF, so again, unfortunate situation for the junior analyst but an opportunity for investors.
If you follow financial news, you will notice that experts and Wall Street all focus on next quarter EPS expectation. This is all noise and is irrelevant. First, next quarter EPS weight close to nothing in the value of the business. Second, remember that instead of focusing on EPS, you should ask if the profitability of the business has not been impaired.
Now that you know that most of the value of a business lies in what happens after 10 years, next time you see a -30% drawdown like we had in march, if you believe that the business has the balance sheet to survive, you should pounce on the occasion.
This is another topic, but this comes down to the qualitative analysis of the competitive environment of the business and its competitive advantage (i.e “moat”). Maybe at some point i will do another thread on the subject.
Thank you for the post Julianek. This is very helpful as I am considering whether to invest my 2nd pillar currently being transferred to Value Pension vested benefit account in MSCI World Quality or MSCI world
Did you find anything in your research on how they did the backtest - did they go back and apply the quality algorithm fully to 1994 financial statements and then model which stocks it would have bought ? And update the portfolio for every year between 1994 and when the index was created
Yes, you’ve raised this argument once. But is it seriously so bad? I mean, individual investors can be short-sighted, they are mortal. But institutions exist for 100+ years. A fund should look 30 years into the future, because they should still exist and be in the game at that point. You’re saying that most of these companies don’t?
It just seems like such a simple thing to overlook. To think that you could invest into an ETF and get 2-3x returns in 20y horizon is just incredible. If you were a passive investor (in the understanding of betting on one horse and sticking to him), would you seriously go for MSCI Quality in favor of VT? Is this something you would advise to consider for me and other holders of VT? Do you have some links to other FIRE sources where they encourage this approach?
And finally, what’s your take on MSCI Momentum, mentioned by Glina? I like that it includes Tesla & Amazon, but at the same time I don’t think it’s a smart index if it only looks at the price graph, without looking at the fundamentals.
He also says that at least for his estate planning, he wants it in a pure passive fund:
“Well I can tell you I haven’t changed my will and it directs that my widow would have 90% of the funds in index funds,” Buffett said. “I think it’s better advice than people are generally getting from people that are paid a lot to give advice.”
Every factor, every country, every sector will once shine bright in the sun. There is no point in chasing past winners. Reversion to mean will eventually occur.
We can see that this seems to hold true for Value vs Growth. Value has been superior for at least 50 years, but recently the gap is very small (see chart).
If the same will happen to Quality & Momentum, time will tell. Right now we only have 25 years of data. (MSCI has price data since 1975, but no point to compare without dividend). But I have to say the advantage is impressive. And it’s funny how Q & M go almost neck and neck.
Mhm… I seem to be quite late to the party here, but…
I happened to settle on the MSCI quality index about 3 and a half months ago as main investments
Though I might not have shared it on the forum back then
But… see the bottom of this post for the caveat.
Beware, it does not.
This is quality factor ETF. It’s a trap that I almost also fell into myself, cause you do have to read the fine print. I’ve even seen an ETF having switched from the Quality index to the Sector Neutral Quality index. I think it was an iShares one, might be this very one (though I’m too lazy to check).
Again, this also does not track the MSCI Quality, but is a sector neutral factor index ETF.
The funny thing is though: Retail ETFs actually tracking that very index seem impossible to find.
You can look it up on JustETF, ETFdb or Yahoo. I haven’t been able to find one.
(I haven’t yet looked into the specifics of the institutional investor ETFs offered by Finpension).
The Amundi ETF, though named “factor” ETF similarly to the iShares and Xtrackers above does track the (non-“sector neutral”) MSCI Europe Quality index, whereas IWQU and XDEQ track the “sector neutral” variants of the indices.
What does sector neutral mean? See MSCI World Sector Neutral Quality Index. Or simply: they keep the sector (IT, Health Care, Financials etc…) weighting the same as in “plain” MSCI world.
Personally I see no point whatsoever in doing so and staying “sector neutral” to the MSCI World. Especially since I’ll be diverging from MSCI World’s weighting of stocks anyway. I’m not convinced either that every sectory is just a “good” as any other. If there’s more “Quality” stocks in one sector (for example the overweighted IT and health), why shouldn’t I overweight that sector myself and invest more in it?
I think if you look at log scale charts, and judge the distance between two curves, that’s the same as rolling returns. But here you go. I don’t see here anything 100x more useful.
Does this have a negative bearing on the performance? If not, would this really disqualify the ETF? Why did you decide Quality factor would be the best, anyway? How about the QUAL ETF? It’s only USA, but does it also have this sector neutral nonsense? (edit: I checked, it does)
By the way, guys, can you explain this to me. It’s from Investopedia’s article on factor investing:
Empirical research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets
So… how can it be that stocks with lower volatility get higher returns? Why would low volatility be a risk factor, we usually associate high volatility with risk. I see this as some sort of casino effect? Investors opt for volatile stock in hope of realising short time returns? Doesn’t seem to make sense to me, any better ideas?
Sorry, I did expand a bit on that by editing my previous post. But to answer: Yes, the sector neutral indices seem to lack behind considerably for most (mid- to longer term) timeframes that you might compare historically.
Honestly, I probably couldn’t explain is as well as Julianek in the opening post. And Terry Smith of Fundsmith. I very much believe you can’t always be right. But even more than picking successful outperformers, you might be able to at least weed out some of the crap in all-market indices.
And then, of course, there’s been a rather long historical overperformance of the Quality index.
As for the sector neutrality, while Cortana’s outright rejection of anything that’s not overall-market seems somewhat fatalist to me it’s still somewhat comprehensible to me Why you should stick to given sector weightings of MSCI World is totally beyond me. From an investor’s perspective, that is (it might have some academic merit in analysing factor premiums).
By the way, the CS Quality ETFs available through Finpension do make no mention of sector neutrality. That they’re having IT overweighted at 36% at the moment, indicates they do indeed follow the “true” quality index.
Funds with a 30+ years lifespan are actually a minority and it would be interesting to study the investment philosophy of those that last this long. The few that come to mind (Sequoia, Berkshire, Markel, Baupost Group, Chuck Akre) all understand the importance of compounding at a high rate over the long term. Regarding DCF, all I am saying is that i have never seen an actual DCF analysis in any article/analyst presentation that made sense. Add to that that all the analyst research services focus on valuation guidances based on evaluation of next quarter EPS and I have a little opinion of most institutions (especially the sell side research, which will manage to justify any price by tweaking just enough its DCF models…)
Maybe it is simpler to grasp if you invert the problem:
If you wanted to make sure that your investments do NOT grow at a satisfying rate over the next 30 years, how would you go about it? I bet you would make sure to invest in companies that do not go anywhere and provide very little returns to reinvest. After all, if the business does not compound, why should your investment do? (OK, you could say that you would reinvest the dividends. But if it is a bad business, receiving dividends is uncertain, and in any case the dividend yield would be too low to be satisfying).
So if you know that the road to long-term failure is to invest in bad businesses that do not compound at a satisfying and sustainable return on capital, why would you want to include them in your portfolio in the first place? You want to make sure they never land in your portfolio. What remains is quality stocks.
(Note that the focus here is on the long-term. Some people make money on the short term investing in bad business because of market re-ratings, but they need to constantly recycle their ideas and this would not be suitable for an index approach.)
Regarding FIRE, I did not find any related resource, as this topic is still maturing in my head. But I bet it would have an impact on many aspects, especially the Withdrawal Rates.
I do not hold any mature opinion about momentum as I did not spend enough time to think about it. However at a first level:
There might indeed be some overlap between the two approach, because a compounding business with a stable high return on reinvested capital will surely have a strong upward momentum during its lifetime.
Amazon is a particular animal: it posted losses for a very long time because Bezos has chosen to treat all its growth investments in R&D and in software as expenses, i.e losses. Nothing appears as an asset on the balance sheet. However as soon as Amazon stops its R&D expenses you realize that the company is printing money. Whereas other companies treat investments as capex (which appears on the balance sheet as assets), Amazon just treats them as expenses (and thus pure loss on the PnL statement). It tricked many people for a long time. But it is not the same with TSLA. Even if you add back R&D, Tesla’s earnings still have the profile of a car company (i.e grossly inadequate returns on employed capital). All of the valuation resides in the expectation of an army of robotaxi without competition in the very near future.
Thanks for noticing this, I was as well having difficulties finding an ETF tracking exactly this index. And indeed having a sector neutrality makes no sense to me. There are sectors that are simply more profitable than others, and you would not want having more oil frackers just because they are under-represented…
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it’s still somewhat comprehensible to me Why you should stick to given sector weightings of MSCI World is totally beyond me. From an investor’s perspective, that is (it might have some academic merit in analysing factor premiums).
