In the ETF industry’s relatively short history, investors have witnessed a slew of one-of-a-kind products hit the Streets; from plain vanilla funds to ETFs that utilize unique screening methodologies, investors can now choose from more than 1,400 different options. Carlos Dies, President of investment-research firm MarketGrader, recently took the time to discuss the compelling strategy behind the new Barron’s 400 ETF (BFOR), which aims to provide investors exposure to “America’s most promising stocks” [see The Complete History of SPY].
ETF Database (ETFdb): What was the inspiration behind creating the Barron’s 400 Index?
Carlos Diez (CD): MarketGrader actually created its first index, MG40, in 2003, several years before we created the Barron’s 400. At the time our research service was brand new and nobody knew us or our methodology, so we thought that the best way to show our clients whether MG worked was by putting our research to the test in a model portfolio. MG40 did very well (it helped that the stock market did very well in 2003) and we gained our first institutional client in the asset management space.
As we began to develop other MarketGrader indexes we thought there would be investor interest for a broad index that could compete against some of the traditional broad market benchmarks. Around that same time we had developed a research and content sharing agreement with Barron’s, since they saw in our grading methodology some of the attributes they watched closely when picking the companies they write about. It quickly became clear that we could collaborate in developing a broad index that selected what they called the “most promising companies in America” [see Free Report: How To Pick The Right ETF Every Time].
ETFdb: What is the methodology behind the B400 and how does it actually work?
CD: MarketGrader rates almost 6,000 North American stocks; virtually everything listed in the U.S. and Canada (except pink sheet stocks). We do this daily, even though few things change in the underlying grades and rating of every company; nevertheless, we do it daily to ensure all the latest stock prices are included in the valuation portion of our analysis.
Here’s where it’s important to differentiate between our individual grading process and the index rebalance schedule. The grades are, as explained above, calculated daily while the index, in this case B400, is rebalanced twice a year. So here’s how the grading works:
MarketGrader calculates for each stock 24 individual fundamental indicators across four categories:
- Cash Flow
Each category has six indicators and each one of those is assigned a letter grade between A+ and F. A numerical grade is also assigned to each indicator depending on the letter grade. All 24 indicators are then aggregated into a final numerical grade that ranges between zero (0) and one hundred (100). Thus, if a company had an A+ in each of the 24 indicators it would get a perfect score of 100. Our rating is assigned depending on this score. Anything above 60 is rated ‘Buy,’ while 50-59 represents a ‘Hold’ rating and anything 49 and below is rated ‘Sell.’ To give you an idea of how rigorous our grading system is, as of this morning our coverage universe was broken down into 16% Buys, 16% Holds and 68% Sells. This isn’t far from the historical mean.
Now to the index: on the third week of March and September, MarketGrader picks the top 400 grades based on the process described above in order to build the index. However, it applies a few other rules to ensure the index is well balanced and that its underlying components are liquid enough. First of all, only companies with a float-adjusted market cap of at least $250 million are eligible. It also ensures that all selected stocks have a minimum 3-month dollar based avg. daily volume of $2 million. Finally, it makes sure that no more than 20% of all selections (or 80 stocks) belong in the same economic sector. The resulting 400 stocks are equally weighted and this becomes the Barron’s 400 Index [see 10 Questions About ETFs You've Been Too Afraid To Ask].
ETFdb: Why does it make sense to use the ETF wrapper for investors looking to pursue this sort of strategy?
CD: The ETF wrapper makes sense for several reasons. First of all, the creation/redemption mechanism facilitates the rebalance process in a very tax-efficient way. It also ensures that fund shareholders aren’t penalized in terms of taxes when others redeem; it also allows the fund to stay fully invested without having to hold large cash positions. From a marketing and transparency standpoint the ETF structure is ideal because obviously anyone with a brokerage account can buy the ETF once it goes live. The fund advisor doesn’t have to jump through all kinds of hoops to make sure it gets approved on all sorts of platforms.
ETFdb: There are some out there who believe ETFs have gone too far from their initial intention of offering broad-based exposure to buy-and-hold investors. What’s your take on the innovation in the ETF industry over the last several years?
CD: I would say that in some cases that’s accurate but not in others. I think the original intention of the ETF structure was to give institutions a highly efficient and inexpensive vehicle to gain exposure to a given market. With time individual investors caught on to its benefits, which only helped to expand the structure’s popularity. As more sponsors developed new ETFs, they opened new markets and new asset classes to investors in a way few dreamed of only 20 years ago. And they did so very inexpensively for the investor. All of this has been extremely positive [see Alpha Seeker Portfolio 2.0].
However, as in any growth market, it’s normal that you get investors trying to participate in the trend, who then start devising products to launch just for the sake of launching them. You then get a case of the tail wagging the dog, where sponsors decide to launch an ETF as step one of their plan and then they try to identify an index, asset class, geography, niche or strategy to track. But the market is self-correcting and so eventually products make it or not based on their own merit.
Bottom Line: For those looking to invest in the most fundamentally sound companies with the most attractively priced shares, the new Barron’s 400 ETF (BFOR) is certainly a compelling option. Considering that the Barron’s 400 list has consistently outperformed leading stock indexes, the ETF wrapper has now allowed investors to easily and cost-effectively tap into what may be “America’s most promising stocks.”
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Disclosure: No positions at time of writing.