Like the Benefits of ETFs? Let’s Talk About Models

The ETF sector has been heralded as a better way to invest than the mutual fund industry and has subsequently garnered a significant number of assets over the last few years. U.S.-listed ETFs reached ~$13.1 trillion in assets under management (AUM) exiting this past October, according to data published by JPMorgan.

If you’ve watched the space, you know it’s evolved from S&P 500 sector-based strategies to targeted and tactical exposures to thematic ones. When we think about these baskets, which offer diversified exposure (or should) to their intended strategy, for all the positives of the ETF wrapper, there can be some shortcomings.

ETFs offer multiple benefits, including that they trade like stocks and offer diversified exposures like what we enjoy with the First Trust Nasdaq Cybersecurity ETF (CIBR) . However, there are also some criticisms when it comes to ETFs:

1. Methodologies can be vague or inconsistent.

2. Holdings sometimes contradict the theme. Examples include “clean energy” ETFs holding fossil fuel suppliers or the basket behind the Ark Space Exploration & Innovation ETF (ARKX), which includes Deere & Co. (DE) as a top-10 holding. Granted, Deere does have a satellite-fueled GPS mapping offering, but does that mean it should be a top-10 holding when the bulk of its profits are generated from ag equipment?

3. Large liquid companies are sometimes included to meet certain trading volume targets even if they don’t necessarily match the stated investing strategy.

4. Some ETFs tend to be more marketing than substance. We’ll refrain from naming the more obvious offenders, but odds are you'll come across some of them.

Thinking on those points poses the following question: What if there were a way to capture a smaller, and purposely curated basket of stocks that brought a high purity level for the intended strategy without relying on any one company?

Models… Did You Say Models?

Such a framework has been around for a while, especially following the development of fractional sharing, which allows one to invest in stocks based on a dollar amount, so you may end up with a fraction of a share, a whole share, or more than one share. It was the hallmark of Folio Investing, Motif Investing, and several others, and as of today, those efforts have either been swallowed up or replicated at the likes of Schwab (SCHW) , Interactive Brokers (IBKR), and many others.

In financial industry vernacular, what we’re talking about are “models,” but in reality, they are a smaller basket of stocks compared to most ETFs. This means they can be more concentrated than some ETFs that have 50,60, 70, 80 holdings. However, it also means crafting the right investment strategy, and the down selection process is crucial. And like many ETFs and the S&P 500, they tend to be reconstituted on a quarterly basis.

At Tematica Research, which is where I wear my other hat, we have not only created thematic indices that support a few ETF products that trade in Europe, but also crafted a set of thematic and targeted exposure models. These are high-purity baskets of six to eight stocks, each with its own distinct investment strategy. Some of them mirror the thematics that we've incorporated in TheStreet Pro Portfolio, and that we discuss in our ripped-from-the-headlines signals alerts. Others are more targeted strategies that can range from ones focused on dividends and market hedging to EPS growth.

Tell Me More About This EPS Growth Model

While it may not be the most original name, EPS Diplomats is a model of large-cap companies that offer the fastest rate of EPS growth over a multi-year period. That basket is screened regardless of industry sector or sub-sector, which means the down-selected list of companies can span a wide array of sectors.

Why the focus on earnings growth? Because earnings growth is often seen as a signal of a company's competitive strength, operational efficiencies, and future growth potential. Shares of companies that provide historically consistent earnings growth faster than the stock market receive premium valuations compared to those awarded to the S&P 500.

And as we’ve often discussed with you, multiple expansion paired with earnings growth tends to drive outperformance relative to the market, better known as alpha.

The basket of eight stocks is reconstituted on a quarterly basis to reflect updated EPS expectations for the current year and the following one.

Sounds Great, but Why Are You Telling Us This?

Simple.

On Monday, November 17, we will add a fresh EPS Diplomats model into our investment strategy, a move that will bring a basket of eight new stocks into the Pro Portfolio. When we discuss this basket or write about it in the Monthly Roundup, it will be treated as one investment even though each of the eight stocks will show up in the Pro Portfolio table.

Near the end of each quarter, we will re-run the methodology, which focuses on multi-year EPS growth, to factor in the latest consensus EPS figures and reconstitute the model’s basket. On the last day of the quarter, we will close out the existing basket and move into the new basket. If a company in the old basket makes the cut and remains in the new one, we will not make any trades in those shares.

For example, we will initiate this new basket when the stock market opens on Monday, November 17, close it out on Wednesday, December 31, and initiate the newly reconstituted basket on Friday, January 2. That new basket will be closed out on Tuesday, March 31, and replaced with a fresh basket on Wednesday, April 1. And so on…

Because we are treating the basket of eight stocks as one investment, when we reconstitute the basket, each of the holdings will start off the new quarter at 0.25% of the Pro Portfolio’s assets. Another way to look at it is that the entire basket will begin each quarter at 2.0% of the Pro Portfolio.

3 Questions Answered

Will we be adding or exiting any of the basket’s components during the quarter?

The only time we may adjust the model’s composition is if a company is acquired. Otherwise, the model is set until the next reconstitution. That also means there are no price targets or ratings for each of the positions that make up the basket.

What if a company already in the Pro Portfolio is screened into the EPS Diplomats model?

While that would be a supporting point for ownership in the Pro Portfolio, we would not want to violate our 4.5% position cap or complicate matters if we opted for whatever reason to exit the stock in the Pro Portfolio. As such, we would not include an existing Pro Portfolio position in EPS Diplomats but instead replace it with the next down-selected company.

Will we be using other models?

While we won’t rule it out, this is something brand new to the Pro Portfolio, so let’s hold our horses. At its core, the Pro Portfolio has focused on well-positioned companies and their stocks — to be clear, we don’t see that going away. Rather, much like our select use of ETFs in the Pro Portfolio, we see this as a nice way to broaden its exposure in a diversified manner. Let’s also consider that the strategy behind EPS Diplomats is unique and one that ties back to our focus on faster EPS growth compared to the S&P 500.

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At the time of publication, TheStreet Pro Portfolio was long CIBR.