You probably already know that because of market-capitalization weighting, a broad index such as the S&P 500
can be concentrated in a handful of stocks. Index funds are popular for good reasons — they tend to have low expenses and it is difficult for active managers to outperform them over the long term.
For example, look at the SPDR S&P 500 ETF Trust
which tracks the S&P 500 by holding all of its stocks by the same weighting as the index. Five stocks — Apple Inc.
and Tesla Inc.
make up 21.5% of the portfolio.
But there are other considerations when it comes to diversification — namely, factors. During an interview, Scott Weber of Vaughan Nelson Investment Management in Houston explained how groups of stock and commodities can move together, adding to a lack of diversification in a typical portfolio or index fund.
Weber co-manages the $293 million Natixis Vaughan Nelson Select Fund
which carries a five-star rating (the highest) from investment-researcher Morningstar, and has outperformed its benchmark, the S&P 500.
Vaughan Nelson is a Houston-based affiliate of Natixis Investment Managers, with about $13 billion in assets under management, including $5 billion managed under the same strategy as the fund, including the Natixis Vaughan Nelson Select ETF
The ETF was established in Sept, 2020, so does not yet have a Morningstar rating.
Factoring-in the factors
Weber explained how he and colleagues incorporate 35 factors into their portfolio selection process. For example, a fund might hold shares of real-estate investment trusts (REITs), financial companies and energy producers. These companies are in different sectors, as defined by Standard & Poor’s. Yet their performance may be correlated.
Weber pointed out that REITs, for example, were broken out of the financial sector to become their own sector in 2016. “Did that make REIT’s more sensitive to interest rates? The answer is no,” he said. “The S&P sector buckets are somewhat better than arbitrary, but they are not perfect.”
Of course 2022 is something of an exception, with so many assets dropping in price at the same time. But over the long term, factor analysis can identify correlations and lead money managers to limit their investments in companies, sectors or industries whose prices tend to move together. This style has helped the Natixis Vaughan Nelson Select Fund outperform against its benchmark, Weber said.
Getting back to the five largest components of the S&P 500, they are all tech-oriented, even though only two, Apple and Microsoft, are in the information technology sector, while Alphabet is in the communications sector and Tesla is in the consumer discretionary sector. “Regardless of the sectors,” they tend to move together, Weber said.
Exposure to commodity prices, timing of revenue streams through economic cycles (which also incorporates currency exposure), inflation and many other items are additional factors that Weber and his colleagues incorporate into their broad allocation strategy and individual stock selections.
For example, you might ordinarily expect inflation, real estate and gold to move together, Weber said. But as we are seeing this year, with high inflation and rising interest rates, there is downward pressure on real-estate prices, while gold prices
have declined 10% this year.
Digging further, the factors also encompass sensitivity of investments to U.S. and other countries’ government bonds of various maturities, credit spreads between corporate and government bonds in developed countries, exchange rates, and measures of liquidity, price volatility and momentum.
The largest holding of the Select fund is NextEra Energy Inc.
which owns FPL, Florida’s largest electric utility. FPL is phasing-out coal plants and replacing power-generating capacity with natural gas as well as wind and solar facilities.
Weber said: “There’s not a company on the planet that is better at getting alternate (meaning solar and wind) generation deployed. But because they own FPL, some of my investors say it is one of the largest carbon emitters on the planet.”
He added that “as a consequence of their skill in operating, they re generating amazing returns for investors.” NextEra’s share shave returned 446% over the past 10 years. One practice that has helped to elevate the company’s return on equity, and presumably its stock price, has been “dropping assets down” into NextEra Energy Partners LP
which NEE manages, Weber said. He added that the assets put into the partnership tend to be “great at cash-flow generation, but not on achieving growth.”
When asked for more examples of stocks in the fund that may provide excellent long-term returns, Weber mentioned Monolithic Power Systems Inc.
as a way to take advantage of the broad decline in semiconductor stocks this year. (The iShares Semiconductor ETF
has declined 21% this year, while industry stalwarts Nvidia Corp.
and Advanced Micro Devices Inc.
are down 59% and 60%, respectively.)
He said Monolithic Power has been consistently making investments that improve its return on invested capital (ROIC). A company’s ROIC is its profit divided by the sum of the carrying value of stock it has issued over the years and its current debt. It doesn’t reflect the stock price and is considered a good measure of a management team’s success at making investment decisions and managing projects. Monolithic Power’s ROICC for 2021 was 21.8%, according to FactSet, rising from 13.2% five years earlier.
“We want to see a business generating a return on capital in excess of its cost of capital. In addition, they need to invest their capital at incrementally improving returns,” Weber said.
Another example Weber gave of a stock held by the fund is Dollar General Corp.
which he called a much better operator than rival Dollar Tree Inc.
which owns Family Dollar. He cited DG’s roll-out of frozen-food and fresh food offerings, as well as its growth runway: “They still have 8,000 or 9,000 stores to build-out” in the U.S., he said.
In order to provide a full current list of stocks held under Weber’s strategy, here are the 27 stocks held by the the Natixis Vaughan Select ETF as of Sept. 30. The largest 10 positions made up 49% of the portfolio:
% of portfolio
NextEra Energy Inc.
Dollar General Corp.
Wheaton Precious Metals Corp.
Intercontinental Exchange Inc.
McCormick & Co.
Aon PLC Class A
Jack Henry & Associates Inc.
Motorola Solutions Inc.
Vertex Pharmaceuticals Inc.
Union Pacific Corp.
Alphabet Inc. Class A
Johnson & Johnson
Cogent Communications Holdings Inc.
Kosmos Energy Ltd.
Berkshire Hathaway Inc. Class B
Monolithic Power Systems Inc.
Luminar Technologies Inc. Class A
Source: Natixis Funds
You can click on the tickers for more about each company. Click here for a detailed guide to the wealth of information available free on the MarketWatch.com quote page.
The Natixis Vaughan Select Fund was established on June 29, 2012. Here’s a 10-year chart showing the total return of the fund’s Class A shares against that of the S&P 500, with dividends reinvested. Sales charges are excluded from the chart and the performance numbers. In the current environment for mutual-fund distribution, sales charges are often waived for purchases of new shares through investment advisers.
Here’s a comparison of returns for 2022 and average annual returns for various periods of the fund’s Class A shares to that of the S&P 500 and its Morningstar fund category through Oct. 18:
Total return – 2022 through Oct. 18
Average return – 3 Years
Average return – 5 Years
Average return – 10 years
Vaughan Nelson Select Find – Class A
Morningstar Large Blend category
Sources: Morningstar, FactSet