Aztlan Global Stock Selection DM SMID: A+ On Diversifying Risk

For all new ETF launches, I demand one thing from you – do something different! With this as my measuring stick, the Aztlan Global Stock Selection DM SMID ETF (NYSEARCA:AZTD) scores at the top of its class.

• How does this fund attempt to invest?
• What are the pros and cons of such a fund?
• Who might this fund be suitable for?

Quit Giving Us More of the Same!

As I scroll through the ETF launches of 2022, I become discouraged. I see a glut of value and growth ETFs…as if we didn’t already have those. As well, there are loads of thematic ETFs where the provider attempts to find a niche of stocks they can bundle and charge management fees on without really giving investors anything new. I scan a plethora of income and dividend funds, which pretty much all sound the same.

As I analyze the list of 431 new ETF launches last year, there are a few that stand out to me. AZTD catches my eye and I give it a closer look.

My One Sentence Summary

If I had to sum up what AZTD does in a sentence, it would be this: a fund that attempts to diversify risk equally across regions, sectors and companies while focusing on great stocks.

Diversifying Across Regions

Three regions are represented: North America, Western Europe, and Asia. Of the 27 stocks held in AZTD, 9 are from each region. Each region will represent 33.34% of the total holding weight. Below is a breakdown of the potential countries that will be invested in from each region.

North America

Western Europe

• Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom

Asia

• Australia, Japan, and New Zealand, but excluding Hong Kong, and Singapore

Diversifying Across Sectors

Nine sectors are represented in this strategy. They exclude Energy, Pharmaceuticals, and Real Estate.

• Materials, Industrials, Consumer Discretionary, Consumer, Staples, Health, Financials, Information Technology, Communication Services, and Utilities.

Again, diversification is the objective as one out of nine stocks are from each sector. I think you can see their methodology here.

• Three regions equally represented
• Nine sectors equally represented within each of those regions
• Equal-weight positions with each company

Now, if this is as far as they went with this ETF, I would commend them on their objective to diversify. But it’s their ranking of each stock in each region and sector where I feel this fund goes from B- to A+ and makes it worthy of contemplation.

Ranking Stocks Based on 6 Styles

The reason I am so interested in this next section is that I work as a consultant creating factor models for various firms and ETFs. My experience in this field has taught me that using a combination of factors and styles is far more powerful than any one approach.

This next chart is in no way meant to suggest any kind of performance metric on AZTD. It does highlight, however, the diversification benefits in the S&P 500 if you select 100 stocks and hold each position equal-weight across the various sectors with a multi-style ranking system. The ranking system displayed in this chart is compliments of Portfolio123 and ranks stocks according to growth, low volatility, sentiment, momentum, quality and value. The benchmark is the S&P 500 Equal Weight ETF (RSP).

This is a simple example of the power of a multi-factor ranking system with good diversification, even with a huge swath of the S&P 500 index. The effects would even be more pronounced if I compared it against a cap-weighted index such as the SPY.

Let’s briefly break down the 6 components to their ranking system.

Value Factor

This is basically the inverse of the price-to-earnings ratio. It is called earnings yield. They consider both the 12-month trailing earnings yield as well as the future expected earnings yield. Deeper value is ranked higher.

Cash Flow Factor

Cash flow ratios are important to analyze. You can have booked profits using an accrual-based accounting system but your company can still go broke if you don’t have cash flow to stay alive.

This cash flow factor group looks at numerous aspects such as trailing dividend history, future dividend estimates and free cash flow yield. I believe free cash flow yield to be one of THE most important factors when analyzing stocks. Not the only one…but it is at the top of my list.

Capital Structure Factor

They analyze return on equity over the past 5 years and estimates of future ROE.

What this should do is find companies which are efficiently using their equity to generate profits. It should exclude companies which have a highly leveraged capital structure where profits are being made due to dialed up leverage risk.

Growth Factor

This looks at trailing 3-year earnings growth as well as future estimates

EPS Revisions

Since 2007, buying stocks with upwards earnings revisions has been a top strategy at the American Association of Individual Investors. The AAII performance history shows that the ‘earnings revision strategy’ holds two of the three top spots for all-time winners.

My own research reveals that this is a powerful strategy but it requires frequent reconstitution of the portfolio to retain excess returns. Alpha decays quickly. AZTD rebalances monthly, which is frequent enough to take advantage of this.

Price Momentum

This looks for relative price outperformance over 3 months and 12 months.

Price momentum has been tested in international markets since 1900 according to this paper. It is a powerful style, although one that I find is very temperamental if used in isolation.

Momentum can crash, which is why I appreciate that this fund mixes it with other styles and factor themes.

Overall Thoughts of Risks

When I look at this fund as a whole, what are my thoughts? I give it an A+ for the multi-factor ranking system. I give it an A+ for diversification across regions and sectors. I give it an A+ for equal-weighting each position.

What are some concerns that some investors may have?

Some may not like to pay the 0.75% expense ratio. Most ETFs do not provide additional returns above a basic S&P 500 fund so investors feel that the lowest expense ratio will save them money. But that’s because most ETFs in these historical studies were not designed well. Massive ETFs that cover broad segments of the market which are cap-weighted will tend to look similar. They are taking advantage of the same risk premiums (mostly size) even though they come by hundreds of different names. If you are buying an average ETF which has tens of billions of AUM, chances are they will be another run-of-the-mill fund with run-of-the-mill returns and risk. But as I said at the outset, I demand that funds do something different. AZTD does that. They will likely never amass billions in AUM and therefore need to charge more in expenses. They are adding a load of value and I believe that investors need to change their mindset and discern vanilla broad market index funds versus something like what AZTD is doing.

Other investors may not like the higher turnover. Lower turnover leads to lower fees. While that is true, it also handicaps the fund as to what kind of alpha it can harvest. If you rebalance once a year, you can forget about alpha from earnings revisions. If a fund is doing anything dynamic, you want it to be nimble so as to change direction when necessary. What is the point on screening for stocks if you refuse to look at them again for another 12 months? What if your value stock has horrible fundamentals and turns into overpriced junk? Should you wait 12 months to replace it just to keep trading costs down?

You may be uncomfortable with diversifying across sectors and countries. Perhaps you prefer to focus on just a couple of sectors which you are familiar with in domestic markets. I can’t fault you for that. My dad is 100% into gold stocks as that is what he knows best. It is not my thing but I don’t want to change his mind either.

Final Thoughts

For what this fund does, I give it high marks. It diversifies risk across sectors and regions and firms in an intelligent way while picking the best-ranked stocks across many styles. If I was to recommend a portfolio of ETFs for most investors it would likely include AZTD for diversification and a great ranking system for individual stocks, Fairlead Tactical Sector ETF (TACK) for a sector momentum and a trend strategy that manages bear market risk as well as a true small-cap value ETF such as Roundhill Acquirers Deep Value ETF (DEEP).

Well done Aztlan!