My name is Anders Bøgebeck. My mission is to help you become a better investor and trader. Why is this important? We are not only helping ourselves by becoming financially free. Along the way we help society by either allocating capital the right places or creating better products and services. That's why I want to help you achieve the life you desire!
Have you ever wondered which fund you should put your retirement savings or investment account into? I will walk you through a systematic approach to finding the most suitable fund with the highest return / risk ratio. These are the steps:
1. Thought process on how to find the right fund
There are basically two major investment strategies. Buying value companies or buying growth companies. The value approach operates with the ratios forward price/earnings, price/book and price/sales. The philosophy is to find well-established companies at cheap prices. This is kind of a mean-reversion investment strategy: you hope the price returns to "normal levels". The other investment strategy is to find companies with high growth. You want to look at earnings per share trending growth, growing sales and market leaders. This is more like "follow the trend" mentality.
Let's have a look at how those two investment strategies would compare to each other. To do that, we will compare the tickers VTV and VUG. These are the Vanguard large-cap growth ETF and Vanguard Value ETF. By looking solely at their 10-year annual performance VTV had a 10.74 % return and VUG a 15.55% return https://finance.yahoo.com/quote/VUG/performance?p=VUG. Clearly growth has beat value in the last 10 years. The broader stock market, which is often referred to the SPY had comparably a 13.04% return in the last 10 years (you can look everything in this post up on Yahoo Finance). This means, that a basket of the 500 most financially well companies in the US performed better than value companies. It seems like the VUG beat the SPY. I think of growth vs. value companies in this way: Imagine you are at a horse race. Do you want to bet money on the fastest horse in the race at a fair price? Or bet on an average horse at a cheap price. Warren Buffet states it in this way: "It is far better to buy a wonderful company at fair price than a fair company at a wonderful price".
So should we just go for VUG fund then? Not that fast. Let's have a look at the holdings of the VUG. When looking at picture 1, we see that it has a overweight of technology stocks.
It makes sense: there has been huge growth in this sector for the past 10 years and it most likely won't stop. In order for one industry to grow fast, capital must move between industries. This means, that some industries will underperform for others to outperform. That's because ressources are scarce and all companies are competing for these every day to satisfy consumers. The same scenario plays out in the stock market: funds move from dying industries to growing industries. That's how ressources are efficiently diverted to industries which will profit from future demand of consumers.
So the holdings of VUG mainly consists of the FAANG stocks https://www.investopedia.com/terms/f/faang-stocks.asp. These have been the market leaders for growth in the past 10 years. Actually there is a fund, which are more focused on these market leaders; the QQQ. You might think, that the more focused the fund becomes the less diversied you are in your portfolio. But we must look at returns in the light of risk. You must focus on two important numbers: the Sharpe ratio and the Treynor ratio. The Sharpe ratio measures the returns of a security in the light of its volatility or standard deviation. The Treynor ratio measures the returns of a security in the light of systemic risk. The higher these numbers are the better because you are getting more return relative to the risk your are taking. Think of the Sharpe ratio like this: You do not want to take 100% risk but only get 25% in return. However, it's better to take 100% risk and get 200% in return. Think of the Treynor ratio like this: When some ugly global news come out, your fund should take a lighter hit than the rest of the broader market. Picture 2 shows how you can compare risk between funds.
At the date of writing this post, the QQQ had a Sharpe ratio of 0.96 compared to the VUG of 0.83. And a Treynor ratio of 17.28 compared to the VUG of 14.03. Okay, so the QQQ was a better bet than the VUG for the past 10 years. The QQQ is even more focused on growing technology companies than the VUG. Can we do even better? It seems like we can. The XLK fund is even more focused on growing technology companies than the QQQ. But is it still justified to be so focused on growing technology companies? Risk-to-return wise it is, because XLK has even better Sharpe and Treynor ratios than the QQQ. It's also clear to see from a technical analysis standpoint. When the SPY crashed from corona-virus shock in 2020 the XLK was still up about 18% from its low in early 2019. This means that a portfolio only invested in XLK took a much lighter hit than the broader market. What about during the financial crisis? Some may think, that these growing technology companies only will perform during major bull markets. But open up any price chart of XLK and SPY and you will see that they took approximately the same hit. XLK also had a better return in the bull market after the dot-com bubble compared to the SPY.
Why not go all-in on AAPL (Apple) or MSFT (Microsoft) then? You don't want to do that, because some ugly news about either of these companies will cause a lot of pain in your portfolio. You have to diversify.
Actually, I was able to find some high-performing ETF's, which had the four main good criterias:
Hopefully, you will find something even better!
2. Summary of funds listed from worst to best
Here is the chain of funds mentioned in this post from worst to best.
VTV --> SPY --> VUG --> QQQ --> XLK --> PXSGX --> FSCSX
When considering a security or fund to invest in, you must look at returns relative to risk. To do that, use the Sharpe ratio and Treynor ratio when comparing performance. Ideally, be long the market leaders in growing industries and hedge aginst broader market risk with put options or buy inverse ETF's (like SPXU) to optimize the Sharpe and Treynor ratio of your portfolio.
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