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High Returns From Low Risk: Taking the Funds Route

In the previous chapter of their book, "High Returns From Low Risk: A Remarkable Stock Market Paradox," authors Pim Van Vliet and Jan de Koning explained how to use a stock screener. Their purpose was to help their readers find stocks that were not only low risk, but also had income and upward momentum.

However, not everyone wants to pick stocks and manage a portfolio. For those investors, the answer may be a mutual fund or exchange-traded fund. That involves making an important decision, but Van Vliet and de Koning reassured us there are no "really bad" low-risk stock portfolios, just "good" and "better." Note that they applied this to just low-risk portfolios.


Broadly speaking, you have two choices: a passive fund based on an index or an active fund with a manager who chooses stocks based on their own criteria. As the authors note, each approach has its advantages (and disadvantages).

Passive funds, also known as "tracker" funds, track one of the many indexes, such as the S&P 500 or the German DAX 30. There are hundreds of such indexes, or indices. The managers of trackers do not make choices about stocks, they simply rebalance regularly to ensure they have the same stocks, in the same proportions and in the same weightings as their benchmark indexes.

Since these managers do not need to pick stocks, passive funds usually have lower fees than active funds. In addition, trackers are fully transparent because anyone can learn the components of the benchmark index. There is an important drawback to transparency, which is that everyone knows what trades the trackers will have to make to mirror the benchmark index; opportunistic traders who can move quickly will jump in ahead of the upcoming trades, thus pushing up costs to the trackers.

Most low-risk indexes offer a basket of about 100 to 300 low-risk stocks. As ETFs and mutual funds, they are listed on stock exchanges and can be bought and sold easily. In addition, they often trade in relatively low denominations, so new investors with limited means can get started right away.

Van Vliet and de Koning added that you can use screeners to identify low-risk funds and ETFs. As they pointed out, most brokers have them and many online sites offer them as well. I did searches for "ETF screener" and "mutual fund screener" (quotation marks not needed) and got many results.

As an example, they listed the ETF Database, which I visited and was able to set up a screen in just a matter of minutes (if in doubt about settings, you can use those I used in setting up the All-In-One screen for stocks).

How should we choose an ETF or passive fund out of the many offered by the screeners? The authors profiled two of the most popular trackers (at least they were in 2016):

  • S&P Low Volatility Index (SPLV), which tracks the one-year volatility of all stocks in the S&P 500 index, ranks them from low to high and buys the 100 with the lowest volatility. The fund is rebalanced every quarter to keep up with changes to the S&P 500; the average holding period is two years.
  • The iShares Edge MSCI Min Vol USA Index (USMV) follows the MSCI USA Index of 600 stocks. It uses a more complex approach, which is to consider not only the volatility of each stock but also how it contributes to the volatility of the total portfolio. It averages 170 stocks, is rebalanced twice a year and the average holding period is five years.



Both are multibillion-dollar funds, and they focus on just volatility. Neither of them includes income or momentum characteristics. That's important because Van Vliet's research showed that a portfolio based on what they call the "rule of three"--low risk, income and momentum--would outperform a plain low-risk portfolio by an average of 3% per year.

To get all three, investors need active-investing funds, most of which will have a proprietary strategy. To find such a manager, they can check with their investment advisor or use a service such as Morningstar. The latter provides detailed information about the risk and return characteristics of mutual funds and ETFs (as well as other securities).

Finally, the authors warned that there is no such thing as buy-it-and-forget-it funds or ETFs. Investors should routinely monitor their funds to ensure they are staying on track. Van Vliet and de Koning noted you can easily follow news about your investments by setting up coverage at a service such as Google Alerts (it's free). I do this myself, and every Sunday morning get a dump of recent news about the securities I own or follow. Mostly, I just check the headlines for anything that might be a red flag; in other words, it's quick and easy.

Conclusion

For those who can't or don't want to pick stocks and manage a portfolio of stocks, there are mutual funds and ETFs. In this chapter, Van Vliet and de Koning have focused on the differences between passive, or tracker, funds and active funds.

Passive funds, usually based on indexes of some kind, are cheaper but constrained to the characteristics of the indexes. Active funds, on the other hand, pick individual stocks, making them more expensive, but also more flexible. To get a fund that incorporates income and momentum, an investor likely will need to go to actively managed funds.

Finally, the authors explained that there are screeners for both mutual funds and ETFs. These greatly simplify the process of finding stocks that meet our criteria.

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This article first appeared on GuruFocus.