Regular Portfolios Update: Replacing CAPE And XEF.TO With QVAL And IVAL

Last update on Jan. 24, 2015.

UPDATE 1: Unfortunately, I found out that both QVAL and IVAL are ineligible for registered accounts such as TFSA, RRSP and RESPs. As a result, I've decided to switch the regular portfolios back to incorporate CAPE and XEF.TO. I sincerely apologize for this mistake.

UPDATE 2: Sources have told me that QVAL and IVAL should be eligible for registered accounts in a few weeks. I'll keep everyone posted.

 

Financial companies introduce new ETFs every year. Sometimes, new ETFs offer enough improvement over existing ETFs that it becomes worthwhile to include them in our portfolios. Two such ETFs released last year are ValueShares U.S. Quantitative Value ETF (Ticker: QVAL), and ValueShares International Quantitative Value ETF (Ticker: IVAL).

I first heard about the new ETFs through other value investors. As the name suggests, the ETFs employ a 'quantitative value' strategy to choose which stocks to include in its portfolio. In essence, a quantitative value strategy employs a computer to do what human value investors do manually: sort through financial statements and other regulatory filings in order to find undervalued stocks.

I must admit that I was skeptical at first. I know of many other ETFs that follow a quantitative value strategy, but do it poorly. The devil is in the details. For example, some of these ETFs will choose stocks based on the Price to Earnings (P/E) Ratios. I’ve outlined some of my reasons against relying on P/E Ratios in this article.

However, I had heard some good things about the new ETFs and decided to dig deeper. I read a book called Quantitative Value, in which Alpha Architect members explained their strategy in detail. I liked what I read.

 

Pros And Cons Of QVAL And IVAL

Let me summarize the broad steps, outlined in the book, to select stocks. Each step I’ve described below consists of a few smaller steps.

  1. Avoid potential frauds
  2. Avoid those that may potentially go bankrupt
  3. Rank stocks by cheapness
  4. Rank stocks by management’s track record
  5. Rank stocks by profitability and stability
  6. Combine the rankings and pick the highest ranked stocks

To justify the methodology used in each step, the authors performed extensive statistical analysis to compare different alternatives. If you would like more granular detail on each step, I encourage you to read Quantitative Value yourself. It’s quite a good read, though you would need some knowledge about investing to understand it.

When the authors ran their algorithm on historical data stretching back almost 40 years, they found that stocks chosen by their algorithm would have outperformed the market by roughly 7% per year, without taking on meaningful additional risk.

However, those results don’t mean the algorithm will continue to outperform the overall stock market by 7% per year going forward. Some strategies look good when viewed through the historical lense, but may stop working as the behaviour of investors change. To their credit, the authors acknowledge this possibility as well.

Although it is possible the algorithm will stop working, I believe it will continue to do well for two reasons: First, each step of the algorithm uses value investing principles, which makes intuitive sense to me. When a strategy makes intuitive sense, there’s less reason to suspect that the strategy was born out of historical coincidences. Second, the algorithm consists of many steps. Even if one or two steps of the strategy stop working, the algorithm will continue to generate positive results as long as the other steps keep working.

Although I think using the Quantitative Value strategy will generate positive results overall, it still has some drawbacks.

1.The ETFs that employ the strategy come with higher expenses. QVAL and IVAL both charge roughly 0.8% per year, which are roughly 0.5% per year higher than the ETFs we’ve been using at MoneyGeek. Of course, if the ETF’s algorithm performs as well as it has on historical data, the extra cost should be well worth it. But if it doesn’t, the higher expenses will drag down performance.

2. QVAL and IVAL contain 40 to 50 stocks each, as opposed to hundreds contained in the ETFs we’ve been using at MoneyGeek. Some people might feel that by switching to QVAL and IVAL, they will be taking on more risk by becoming less diversified.

However, this drawback is likely purely psychological. According to the authors’ research, the portfolio produced by the algorithm wasn’t meaningfully riskier because (A) their algorithm filters out highly risky stocks, and (B) because diversification doesn’t provide much benefit for portfolios containing more than 20 stocks.

3. Value investing isn’t just a science, but an art as well. Using a computer to do the research would mean reducing it to a science, because computers can only examine numbers. Therefore, using the algorithm would mean potentially missing out on big opportunities, as it is possible that a company’s past results don’t portend its future. As Warren Buffett says, his “best buys have been when the numbers almost tell you not to.”

Despite the drawbacks, I believe the strategy will continue to outperform the overall stock market in the future. That’s why I’m changing the regular portfolios to accommodate the ETFs. Specifically, QVAL will replace CAPE, and IVAL will replace XEF.TO.

 

Practical Considerations

Lastly, just a word on the logistics of buying and selling ETFs. For most of us, we should be able to buy and sell the ETFs at any time using a ‘market order’ from your brokerage account. Just as a quick recap, a market order instructs your broker to buy or sell the ETF at whatever price it’s offered by others right now.

However, there’s a very small possibility that if you make a large market order, the exchange provider won’t be able to handle the volume and it will result in you paying a higher price for the ETFs than you should. Therefore, if you plan on buying or selling over $200,000 worth of either CAPE, QVAL or IVAL, I would recommend using limit orders. If you don’t know how to make limit orders, please watch our video.

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