It’s clear that the financial sector has been a terrible performer all year. In my general approach to investing I do agree with much research that over the long term value and especially small value stocks outperforms the overall market. Yet there are times when one has to look up from the instrument panel and look out the window.
Large value indices tend to be heavy with financial stocks. This is also the case with dividend weighted indices. This is not surprising because high dividend stocks tend to be large cap value. As a consequence large value stock ETFs in late 2008 underperformed the market trimming back of them would have been a prudent move. Large value indices such as VTV, PRF and IWD would fall into this category.
Doing so again this year makes sense for the same reason. The outlook for financial stocks remains terrible. The banks are weighed down with bad loans and real estate they are valuing at prices far higher than their market value, they face lawsuits, the flat yield curve hurts them and new capital requirements make it impossible to generate the high level of trading profits some were able to achieve in the past. Thus it is no surprise that earnings forecast for JP Morgan (NYSE:JPM) have been slashed. Goldman Sachs (NYSE:GS) earnings estimates were reduced even further just in the last few days.
In my view this is just the beginning. Despite the unified action to protect the banks the storm clouds have far from cleared for European banks and the European economic and financial system, the big issues remain unresolved.
Even if a Greek default is avoided it will include some large marking down and rescheduling of the debt held on the books of French banks and that’s just the beginning Italy and Spain will be next. And if the French and German banks are bailed out in a TARP type bailout (we already have a name for it: TALF), one can look at the performance of US financials after TARP gives a good forecast for the future. It’s hard for me to conceive that the impact won’t be another hit on US financial institutions.
US banks will not be immune from the fallout it could easily be a replay in slightly smaller terms to the mortgage meltdown. Who knows how much exposure to Greece and the rest of the PIGS US financial companies have both directly and through derivatives. Not to mention exposure to corporations, hedge funds and others that are “small enough to fail”.
A look at the major large cap ETFs shows the damage so far this year and how closely it is tied to financials.
Here is one year total return and volatility:
- VUG growth (4.3% financials)
- VTV value (21.8% financials)
- DLN large dividend no financials which is basically large value no financials
- XLF the financials ETF
click on images to enlarge
So a first step to consider is eliminating holdings in large value ETFs. Something I've been watching since the summer. The following article, however, from probably my favorite finance author Naseem Taleeb got me thinking about a further readjustment to portfolios.
But the puzzle represents an even bigger elephant. Why does any investment manager buy the stocks of banks that pay out very large portions of their earnings to their employees?
The promise of replicating past returns cannot be the reason, given the inadequacy of those returns. In fact, filtering out stocks in accordance with payouts would have lowered the draw-downs on investment in the financial sector by well over half over the past 20 years, with no loss in returns.
Why do portfolio and pension-fund managers hope to receive impunity from their investors? …?
It is hard to understand why the market mechanism does not eliminate such questions. A well-functioning market would produce outcomes that favor banks with the right exposures, the right compensation schemes, the right risk-sharing, and therefore the right corporate governance.
One may wonder: If investment managers and their clients don’t receive high returns on bank stocks, as they would if they were profiting from bankers’ externalization of risk onto taxpayers, why do they hold them at all? The answer is the so-called “beta”: banks represent a large share of the S&P 500, and managers need to be invested in them.
In light of what I think could be another strong leg down in the financial sector it makes sense to look at a further adjustment. This would entail selling of total stock market indices. In order to maintain a cap weighted core representing the total stock market one could replace it with a large growth ETF such as VUG and an equal amount of DTN the dividend weighted ETF that excludes financials.
It also makes sense to retain a small value holding. My clients have access to DFA funds which are available to a limited group of financial advisors. ETFs covering this part of the market include VBR and PRFZ.
Replacing VTI will be a split between VUG and DTN gives exposure to large cap stocks with financials eliminated. The fact that DTN is dividend weighted is not particularly relevant to me it’s the only large value ETF that doesn’t hold financials.
The existence of DTN is a bit of a lesson in recency. The Wisdomtree group of ETFs came to market with great fanfare with Jeremy Siegel proclaiming (yes a renowned Prof actually said this) that dividend weighting was a way to produce better returns at lower risk. I was a bit of a skeptic already of Professor Siegel who despite his renowned in the general public is not exactly up there with the top minds in academic finance or economic.
His propensity to overblown conclusions was present in his early 1990s version of "Stocks for The Long Run" which recommended 100% stock portfolio for those with very long time horizons. I have the fourth edition which has no spedific model allocations.
Professor Siegel and Wisdomtree had the misfortune to launch their dividend weighted funds in 2007. The next year their flagship ETF DLN heavily weighted with financials, dropped 35.84% a tad better than the S&P 500 and the total stock market index. So out of the ashes came DTN the large cap dividend.
At least there’s a real record of what can happen to high dividend portfolios. Some dividend investors may insist that they ”knew" to dump their high yield financials before their price declines would offset years of dividends in terms of total return. I’m not so sure, and I’m not so sure they will know when to prune other potential disasters from their portfolio I certainly am not at all sure I would. Hence I allocate by asset class with ETFs.
It will likely make sense to readjust the allocation back to VTI at some future date. in the future. But given my outlook for financials I don’t think that will be very soon. For the foreseeable future the outlook is extraordinarily bad for financials. I would call this a tactical move to adjust a long terms strategy of overall allocation to US stocks.
Here is three years of data for a 50/50 DTN VUG it shows the difference in performance under the period of sharp sell-off of VTI. The data include some MPT statistics and show higher returns lower volatility and higher sharpe ratio for the non financials portfolio. But note the high correlation of .99, The two will move together, this strategy may increase returns but it won't avoid the risks of a down US stock market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.