For all the new readers, here at IT, i aim to collect guest articles from some of the interesting characters in the finance space to contribute towards the free articles i post for all newsletter readers. My aim is to grab a diverse range of perspectives and experiences to share with you all.
Today we are bringing you insights from Josh at Nizzynomics. This marks edition number 7 of the guest articles series. I typically aim for one guest per week, depending on sourcing and other variables.
Previous Guest Articles:
Edition 1: Jaxson B
Edition 2: David Belle
Edition 3: Curtis Davies
Edition 4: Sade Taiwo
Edition 5: Jay Smith
Edition 6: Kia Commodore
Josh from NizzyNomics
Today’s guest is Josh, a finance blogger who has spent time in the trenches of the banking industry. Josh currently his blog ‘nizzynomics’ where he posts weekly.
Josh grew up in London, and took the traditional route into education where he spent time at a state college, and eventually studied at LSE. In a professional capacity, Josh has had first hand experience as an equity trader for a number of years.
You can find out more about Nizzynomics here:
Today Josh had decided to write about ETFs, and walk us through the rational for the construction of his own ETF holdings.
“My ETF Shopping Spree “
If you work in the investment industry in a material capacity, chances are you will have some pretty strict restrictions on private investing and trading activity. Many people are only allowed to invest in un-concentrated discretionary products where decision making is driven by an un-impressionable external fund manager. This obviously poses some frustration but the conflict of interest warrants the restriction. Some people love car shopping, others love jewelry shopping. In this newsletter I will take a broad look at how I approach my favorite type of shopping, ETF shopping.
What is an ETF ?
If you know what an ETF is please skip this paragraph, I just want to make sure we’re all on the same page given it’s the crux of today’s topic. Exchange Traded Funds are pooled investments that seek to replicate a specified index (i.e. S&P500), commodity (i.e. gold) or basket of securities (i.e. high yield bonds). Shares in the ETF trade on the stock market and can be bought or sold in the same way as single stocks.
The fund has a collective value which is depicted by the net asset value of the fund (fund running costs are stripped out). It is impossible to actually buy an index so theoretically an ETF can be worth more – remember it is a fund after all. For instance, the NAV of a fund could be $20bn and the underlying value of the index it seeks to replicate could be only $10bn.
The ETF could be physical whereby it holds the actual instruments that make up an index or synthetic whereby a series of swaps and derivatives are used to create exposure without actually trading the underlying. I won’t go too deep into the mechanics of how ETFs work but hopefully this gives you enough of the gist. Let’s proceed.
Why do people invest in ETFs?
• Investing Restrictions
• Thematic Exposure
• Relatively Cheap
• Liquidity and Market Access
Types of ETF – Themes & Factors
There are many types of ETFs that cut across numerous asset classes. My primary concern (largely due to being 26 y/o) is to skew my entire portfolio towards equities. As such, on my shopping spree, my mode of selection is geared towards themes and factors. Themes are straightforward to understand, you observe something in real life and seek to invest in such a way that aligns your pockets with said theme.
For instance, the phenomenon of global population growth leading to waste management & clean energy themed ETF investments. Factor based ETFs are a bit more fiddly at the core due to the associated quantitative research methods. But still, it is easy to understand conceptually. I like to compare Factor- Nizzynomics – Guest IT Newsletter based ETfs with the Human Population which can be grouped in numerous ways depending on physical characteristics
Factors -> Single Stock -> ETF Cells -> Single Human -> Population of Humans
Investment factors are akin to the cells that make up a person’s body. Thereafter, a population of people can be grouped in numerous ways depending on characteristics that make up their body. For instance, everyone with big ears could make up the ‘Big Ear Group’ and everyone with brown eyes could make up the ‘Brown Eyes Group’. This grouping process is similar to how factor or theme based ETFs are constructed. For instance, $IVWL is an IShares ETF product which comprises of stocks that rank above threshold in a value factor screening process – stocks which are trading significantly below fundamental valuations. Most screening processes are quantitative in nature and most firms have proprietary methods in doing so.
Constructing the Shopping List
When putting together a shopping list, I layout the themes and factors I wish to build exposure to. Given the low touch nature of mid-long term ETF investing, the fundamental analysis process is markedly different to idiosyncratic single stock research you see on the Investment Talks platform or that which you do during manual portfolio construction. Most funds hold hundreds of securities, and to be honest it isn’t necessary for me to MOT the financial statements of each one. Capital allocation is the bigger driver of decision making. I only embark on ETF shopping after I have contributed to workplan pension schemes, contributed to a stocks & shares ISA, considered paying down student loan and thereby leftover with unallocated cash. From my perspective, thematic investing through ETFs is all about betting on what the future will look like and which subset of companies will be responsible for getting us there. Views on this are generally informed through an accumulation of research and my own worldview. Thereafter, it becomes a case of aligning parts of my portfolio [unallocated cash] to investment vehicles which offer skewed exposure along those lines.
From a technical perspective, aligning with the flow of capital is somewhat amateur but also intentional. Investing doesn’t always need to be complicated or sexy. Sometimes I buy certain ETFs with the view that momentum [numerous momentum factor computations exist so let’s just take it at face value for the purposes of illustration please] will drive returns at some point in the future if it isn’t already. One glaring reason for that is the sheer amount of liquidity in the financial system and the fact that the fund managers biggest headache is often how to allocate cash balances.
The simpler the strategy, the better as I don’t have time to manage my investments actively. I choose my desired exposures, draw up my shopping list, set out an execution strategy and hold over multiple years until the original thesis comes to fruition or is proved wrong. Timing is not something I’m looking to perfect in this exercise and after all investing 101 tells you it’s near impossible to consistently correctly time the markets to perfection. Over time, things smooth out.
The Shopping Process
I don’t go ETF shopping very often [it is a passive exercise once deployed] maybe once a year but 2020 has been a strange year so I’ve had 2 shopping trips so far, one in March and one in August. In March I got lucky, I had been sitting on a cash pile (liquidated my main funds in January) as I was due to move my whole life over to Hong Kong which obviously didn’t come to fruition due to covid-19. Alas, I was able to redeploy into ETFs when the market went to s***. Again, the thought process was simple: the magnitude of the sell-off was driven by redemption induced selling (raising cash), fund liquidations, stop losses, pure fear and a bunch of other stuff best not to delve into in case anyone has PTSD.
Nevertheless, as discussed with Fanbytes CEO Tim Armoo & David from Macrodesiac on an Instagram live session, either capitalism was about to blow up in our faces or we had just been presented with the biggest buying opportunity our generation has ever seen. In the case of the former, money and investing doesn’t matter if the world is in anarchy, primitive survival is the priority. As for the latter case, I was happy to own a basket of ETFs at the highs just a few weeks prior and Hong Kong was now on hold so it only made sense to redeploy that cash into the market at such attractive valuations. You will notice the ETFs that make up my index fund are ESG linked because as well as trying to be a good person the ESG flow of capital is changing the investment landscape and thus drives spreads in comparable return profiles.
Fast forward to August and I am quite satisfied with my index exposure which I dedicate this year’s ISA to, I am no longer moving country and so no need to liquidate, if we go higher great, if we go lower that’s ok too, I have automatic monthly additions. However, I had a 3 year derivative product expire recently of which I needed to reallocate the cash proceeds. I wrote about the decision making process of what to do with lump sums of cash here and after some deployments towards student loan, I decided to hunt yield through ETF shopping. See below the list:
Associated Costs & Risks (not an exhaustive list)
TER and OCF – Total Expense Ratio refers to the cost of holding the ETF over time and generally it is so cheap these days that anything over 50bps would look a tad pricey, still useful to compare across ETF providers. Ongoing Charges Figure offers some insight into the cost efficiency of the fund in general. If this is too high compared to similar ETF providers, alarm bells should be ringing around the operational efficiency of that fund.
Re-balancing – the desired frequency of rebalancing highly depends on the nature of the theme or factor I’m investing in. For instance, I would expect $VYM holdings to be generally stable over a period of months due to the recurring revenue and free cash flow generation of those companies. I wouldn’t be fussed if the ETF rebalanced annually. Conversely, I would expect factor rankings to change quite frequently so I would need my ETF to rebalance often enough to stay in line with its objective benchmark. If not, I must be comfortable with this risk factor.
Intersectionality – one thing to be conscious of is that just because I invest in a particular theme or factor it doesn’t mean I won’t take on secondary exposure in something else. It’s important to bear this in mind as you can easily end up constructing a shopping list of ETFs that generates unintended characteristics. An ETF is also essentially a portfolio in of itself so if you really wanted you could perform portfolio statistics and optimisation given the details around holdings are transparent but in reality this takes time and effort which I just cannot commit to so I don’t. Instead, I ensure my shopping list is only comprised discrete risks I am happy to take.
ETF Provider – we shop around for groceries right, looking for deals and bargains. ETFs are no different. Different providers offer the same products (caveat: some are exclusive) so compare term sheets if necessary to make sure you’re getting the best deal. As alluded to, passive investment products are highly competitive and fairly generic so it may boil down to nitty gritty things like where your current year ISA is housed.
Timing/Hedging Risks – investing in ETFs doesn’t guarantee positive returns in t1 nor any other t and we still take on market and long directional risk (unless you trade around and/or Nizzynomics – Guest IT Newsletter use inverse ETFs to go short). Take this into account when thinking about your execution strategy. If I didn’t have a balance of student debt I’d use 50% on shopping and 50% dry powder in cash in case we get a decent pull back.
FX Exposure – many of the ETfs we invest in are denominated in USD and upon execution an FX conversion is performed. In practice, this leaves us with FX exposure if USD is not our home currency. For instance, consider the following scenarios where USD goes up or down. Look what happens to the cash position if the hypothetical investor didn’t hedge - he/she makes or loses money depending how the FX rate moves.
If you make good returns on the ETF itself the FX exposure is negligible but it’s good to be aware, especially if investing passively over a long period of time when FX rates can move materially or particularly into ETFs that are emerging market currency exposed and unhedged. Furthermore, you might have a macro view, you may think the dollar is about to die. Nevertheless, I’d say hit up someone like Macrodesiac if you want to incorporate macro decision making into your process.
2000 words later and I think I’ll leave it there. All the best with your investing journeys and I’ll catch you on the other side.
I think you will agree that was an interesting stroll into the mind of another investor’s rational behind their ETF purchases.
As you may now, i am also an advocate of passive investing. Over time, i allocate capital towards both my general portfolio and my passive ETF portfolio.
Josh has provided us today with a granular insight into some of the considerations one may make when deciding how they allocate their capital.
I hope you enjoyed today’s guest
As always, until next time