Fundamental, Dividend or Quality?

Yesterday we took a quick look at the state of value investing, prompted by an article in Barron's. Another Barron's article looked a little deeper, looking at value ETFs primarily but also a couple of so called fundamental ETFs. Fundamental ETFs weigh out things like revenue, cash flow, debt and other metrics that seem to overlap with value. Typically the process underlying a fundamental ETF will have a few more moving parts than value funds which look at various types of ratios like price to sales or price to earnings. 

One of the ETFs listed was the Schwab Fundamental US Fundamental Large Company ETF (FNDX) which we've never looked at here. One of the comments, always read the comments, said that Schwab US Dividend Equity ETF (SCHD) was better. The reader said that the ten year return was identical but that SCHD paid out more income than FNDX. The reader was right for ten years. For five years, FNDX compounded at 15.51% versus 13.60% for SCHD but yes, SCHD paid more in dividends for the five year period as you might expect. Depending on your tax situation though, more dividends may not be better.

This table captures ten years.

For the same period, the S&P 500 compounded at 12.94% with a standard deviation of 15.24%. All four of the funds in the table seem like they are sort of related, value-ish. 

Check that. The older quality factor funds' performance doesn't really differentiate all that much from market cap weighting. Invesco Quality (QUS) was about 240 basis points better than market cap weighting in 2022, but you can see in the bar chart the others were all dramatically better. Despite the crisis alpha in 2022, there was none to be found in the 2020 Pandemic Crash from FNDX, SCHD or SPYV but somehow the Invesco Quality ETF was better by 5-6%. In the mini crash at the end of 2018, FNDX and SPHQ did worse than the S&P 500, SPYV was about the same as market cap weighting and SCHD was the best performer for that event.

In trying to sort out why there was pretty much no crisis alpha in 2018 and 2020 while there clearly was in 2022, my hunch is that 2018 and 2020 were shorter panics driven by exogenous shocks and an important part of 2022's story was the big lift in interest rates which changes all sorts of valuation methods and shines a spotlight on certain fundamental attributes. Please leave a comment if you have a different theory.

While the there is differentiation in performance, less so with quality, there doesn't appear to be reliable crisis alpha with these. That is important for setting expectations. Looking at the above bar chart, value whiffed completely in 2020 and dividends missed completely in 2023. The partial year of 2014, only quality, the green bar, was close to market cap weighted.  

Looking at the ten year compounding numbers, I wouldn't dismiss any of these, they are all valid, and will capture the effect for the most part. I wouldn't buy any of them though hoping for a repeat of 2022 however. Maybe they will all do as well in the next bear market or maybe not. Dividend funds generally got pounded far worse in the Financial Crisis than market cap weighting because dividend indexes were heavier in financials. 

The correlations of all the funds we're talking about is 0.91 or higher. There is no way to know if fundamental or dividends will offer any protection in the next event. More reliable protection in serious market events would come from holding assets with negative correlations or no correlation. 

The 90/10 blend outperformed SCHD and FNDX with less volatility. It held up better than VOO in 2022 but did not offer a ton of crisis alpha that year. It did help some in the 2018 mini crash and helped a lot in the 2020 Pandemic Crash. The appeal from the 90/10 blend, in addition to a smoother ride and some crisis alpha, is that if the market takes a real hit and a client has to take money out near the low (it happens), BTAL can be sold while it is up without permanently impairing capital. The need to protect against a large decline with BTAL is less, after a large decline has already happened. 

Obviously, you probably have your own ideas on how to handle all of these variables. 

I'll close out with some blends involving Invesco S&P 500 Momentum ETF (SPMO). Some interesting things happen with this.

Blending SPMO with FNDX and SCHD as shown above, outperformed the S&P 500 for ten years with less volatility. Both also did deliver crisis alpha in 2022 which is good but I just wouldn't rely on that in the future. 

And adding BTAL into the mix is perhaps more interesting still.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.