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2016 Investment Strategy With ETFs: Part 2

As we saw in Part 1 of this series , ETFs have been very popular. Understanding the trends in this area is helpful in being able to select ETFs in the right way and for the right purposes. This second part of the series will continue the discussion to understand ETFs in greater detail so that investors can make better choices. One of the important predicted changes is that institutional investors are likely to become more diverse. This will be seen on a global scale. Active ETFs Active ETFs are one area that many industry pundits believe will be the way of the future. As outlined by PWC (2013) : “After a slow start, active ETFs are picking up steam and are likely to become major drivers of a wider range of uses and greater share of wallet across a more diverse client base.” It is believed that this will create challenges in a range of areas, such as in the need for innovative approaches to the regulations associated with portfolio transparency. This has held back active ETFs until now. Additionally, it is not believed that everyone will benefit from active ETFs, and there is unlikely to be a broad-based move away from so-called “style box investing”. ETFs’ Pros and Cons It is thought that ETFs are going to continue to experience some issues as they grow and develop. Some of the problems that have been outlined include performance tracking problems, trade settlement and liquidity. Regulatory challenges, operational risks and poor technical understanding are also likely to hold back demand in some areas. Nonetheless, overall it is anticipated that ETFs are going to have a critical role in the asset management industry in the medium term. It is considered by PWC to be unlikely that ETFs will experience a slowing up of growth or even a reduction in growth in the short to medium term, as they are still very popular. Other changes in this area are likely to include increased customisation. Looking at the changes to ETFs from a different perspective, The Wall Street Journal (2013) asked experts in this area what they think . Like PWC, the Journal documents the increased likelihood of actively managed funds. While to-date these have not done particularly well in attracting investment, it seems this is likely to change in the future. Other projections for this industry include an increase in competition in this area. Some worry that ETFs may be too popular, and that there is too much chopping them around. It is thought that as a result of this, there is potential for some consolidation in this market. There were worries among some of the experts that there could be an increased likelihood of failure of new ETFs produced. The problem is perceived to be that while some of the products have big names behind them and will be able to achieve critical mass, others definitely do not, and these may struggle to attract investment. Some believe that these funds will start looking quite a bit more like managed funds in the future. Investment Strategy It seems that ETFs are here to stay, and their popularity continues to increase. This means that an ETF strategy is a useful component in any investment approach. The strategy used needs to consider the increased number of ETFs worldwide. It is suggested that there are several approaches to make money from expertise with ETFs. One of the suggestions is creating opportunistic products that are based around marketplace events. A second is looking at them as the base for packaged solutions, for annuities or allocation funds. A third is to go down the actively managed route, taking outcome-focused strategies that use ETFs. A final option is looking back and creating products that are sold in an ETF format instead. In doing this, the asset manager needs to understand the ETF system and the opportunities faced. This means also being able to see how distribution platforms and databases can be used. It also involves looking at the ways that investors can be educated, so that people understand what ETFs are and the value that they bring to the table. Differentiating is considered to be particularly important in attracting attention.

Asset Class, Sector, And Country Returns For 2015

Every chart tells a story. Which story depends on what you choose to see. The asset class tables tell stories of best returns, worst returns, or a middle ground that avoids both. Maybe it’s the tale of mean reversion and infinite cycling of markets. Or randomness. Unpredictability. Irrationality. I’ve explained it before here , here , and here . This time, I’ll hold off till the end because most people will see what they want to see and ignore the rest. As usual, I’ll point out a few things I see in the tables, along with some other year-end data that was left out. Let’s get started. It was a lackluster year. For the most part, assets went nowhere in 2015. Emerging markets are the sole exception finishing the year with a double-digit loss. Emerging markets lost money four of the last five years, including losses three years in a row. A track record like that is a solid reason to dump an asset…or buy one. Depending on how you see things, emerging markets could be the best or worst investment going forward. Emerging markets lost money four of the last five years, including losses three years in a row. A track record like that is a solid reason to dump an asset…or buy one. Depending on how you see things, emerging markets could be the best or worst investment going forward. REITs are the best performer five of the last six years, the best annual returns over the last 15 years, and finished positive seven years in a row. Dividends drove a lot of that performance. REIT dividend yields are half of what they were in 2001. High-yield bonds were in the red for the first time in seven years. High-yield bonds were actually positive through June, though not by much. Then, the Fed raised rates for the first time in a decade. I’m sure many high-yield bond funds did worse. I’m certain many investors were caught by surprise. They wanted to boost their bond yield by 1-2% without realizing they were taking on more risk for the return. A diversified portfolio lost money for the first time since 2008, underperforming cash. The range of returns, from best to worst, was the smallest it’s been over the last 15 years. It’s hard to complain about a 1% loss when the best performer in the portfolio earned 2.8%. I guarantee many will complain anyway because it didn’t live up to the last few years. The S&P 500 is now positive for seven straight years, along with 12 of the last 15 years. That has only happened twice before – an eight-year stretch from ’82 to ’89 and a nine-year run from ’91 to ’99. Back in 2008, how many people predicted a positive S&P 500 for seven years straight? My guess – nobody. The S&P 500 sectors were split evenly last year with five winners and five losers. Those five winners haven’t seen a losing a year since 2008. Collectively, the sectors have performed great since the crisis. Every sector was positive in four out of the last seven years. It could have been five, if it wasn’t for the energy sector’s 2014 loss. Of course, energy was considered cheap at the end of 2014 (even I thought so). Then, it got cheaper in 2015. As a group, the developed markets aka MSCI EAFE basically broke even. For developed countries, Denmark actually had the best returns of 2015, at 24%, while Canada was the worst. Finland, Denmark, Belgium, and Switzerland each extended their gains to four years in a row while Ireland hit its fifth. If you were ranking developed countries based on highest CAPE ratio, the U.S. would be #4. Only Denmark (#1), Ireland (#2), and Japan (#3) are higher. As for consecutive losses, six developed countries – Germany, U.K., Spain, Australia, Sweden, and Norway – now have two losing years in a row (none have three). Of those six, Norway and Spain have the lowest CAPE ratio. As I said at the top, emerging markets have seen the worst of it the past few years. The table only tells half the story. Only two emerging market countries – Russia and Hungary – were positive for 2015, out of 23 in the MSCI EM index. And consecutive gains don’t exist. Hungary had the best year at 36%. Greece was the worst with a 61% loss, following a 40% loss in 2014. Buying a Greece ETF to start 2015 was an expensive lesson. Markets that fall far can still fall a lot further. Greece wasn’t alone. Four other countries – South Korea, Mexico, Malaysia, and Poland – have two losing years in a row. And four – Brazil, Chile, Colombia, and Czech Republic – sit with a three-year losing streak. With all that carnage, it’s no surprise that emerging markets have the lowest CAPE ratio and highest expected returns than any other asset class to start 2016. Remember If you shoot for the best performers every year, you risk ending up with the worst. While the worst performers, the hardest to buy into, can sometimes produce the best results…for those with patience and a high tolerance for pain. However, if you try to avoid the worst, you’ll likely miss out on the best, while ending up somewhere in the middle. And if you expect greatness every year, you’ll be disappointed often. Just look at 2015.

‘We Front-Loaded An Enormous Stock Market Rally’

Richard W. Fisher served as the President of the Federal Reserve Bank of Dallas for more than a decade (2005-2015). His appearance on CNBC this week offered remarkable insight into why voting members on the Federal Reserve Open Market Committee (FOMC) embraced zero percent rate policy as well as quantitative easing (QE) for so many years. One of the most controversial statements? Fisher candidly admitted, “What the Fed did, and I was part of it, was front-loaded an enormous market rally in order to create a wealth effect.” He did not say that the Fed sought to achieve maximum employment. He did not bring up inflation targeting or stable prices either. Rather, one of the world’s most influential people in any room acknowledged that the Fed wanted to push stocks higher to make participants feel wealthier. How was this wealth effect supposed to benefit workers? Or promote stable rates of inflation? Presumably, when people feel wealthy, they spend more. When they spend more, corporations see more revenue from the goods and services that they provide. When companies achieve better top-line and bottom-line results, executives express greater confidence by adding new employees. When an increasing number of workers find jobs, unemployment falls to lower and lower levels until, eventually, maximum employment spurs wage growth and desirable levels of inflation. That was the plan. However, there have been several problems with the Fed’s wealth effect ambitions. For one thing, keeping borrowing costs so low for so long primarily benefited those who were already in decent shape. Wealthier folks have super-sized stakes in the stock market and were able to increase the value of their portfolios substantially; less wealthy folks have seen erosion in real (inflation-adjusted) household income – money that most live month-to-month on. Those in the highest marginal tax brackets were able to add to their real estate holdings. In contrast, very few families in the middle or lower-middle class had the resources to acquire short sales or foreclosures. Another problem with the Fed’s wealth effect agenda? Corporations leveraged themselves to the hilt. Borrowing money on the “ultra-cheap” allowed them to buy back copious amounts of stock shares. That helped shareholders of those stocks, but it did not bring back labor participation rates to pre-recession levels. The all-important 25-54 year-old demographic is still hemorrhaging workers. Corporations never really went on the anticipated hiring binge. Instead, they went on a seven-year stock buying spree with the Fed’s easy money. Total debt levels have doubled since 2007. And while the average interest rate paid on corporate debt has declined, interest expense has risen dramatically. Do we even want to ruminate about what will happen if the Fed pushes borrowing costs up appreciably in 2016 and 2017? As it stands, corporations already need to allocate significantly more net income toward servicing the interest on existing loans. So Richard Fisher acknowledged what many people believed all along. Specifically, the Fed’s primary goal since the banking crisis in 2008 has been to push stock and real estate markets to new heights. In doing so, they hoped that the wealth effect would indirectly achieve its dual mandate of stable prices and maximum employment. Of course, when you front-load an enormous stock market rally, won’t stock prices reach exorbitant valuation levels? Is there a painful period of reckoning on the back side? Did anyone at the Fed consider what history teaches us about overvalued stock markets and overvalued real estate markets? Mr. Fisher may not have given the questions much thought during his tenure his tenure on the FOMC. However, he revealed his current thinking to CNBC: These markets are heavily priced. They are trading at 19.5x earnings without having the top-line growth you would like to have. We are late in the cycle. These [markets] are richly priced. They are not cheap. I could see a significant downside. I could also see a flat market for quite some time, digesting that enormous return the Fed engineered for six years. Obviously, the former President of the Dallas Fed cannot predict market direction. Nobody can. And one might argue that a monetary policy wonk does not a valuation guru make. On the other hand, Fisher’s valuation concerns may have merit. For S&P 500 operating earnings of $106.4 (12/31/15) to reach current year-end estimates of $125.6, they would need to grow 18%. At $125.6 and the S&P 500 at 1950, the Forward P/E becomes 15.5. Yet analysts have been ratcheting down expectations from 10% earnings growth to 7.5%. (And in 2015, growth flat-lined entirely). If one generously accepts the wisdom of analysts at 7.5% operating earnings growth, and the S&P 500 at 1950, the Forward P/E on a year-end estimate of $114.4 becomes 17. The 35-year average Forward P/E is 13.2. That’s right. Even after January’s stock carnage that has seen the S&P 500 crater 100 points from 2043 to 1943, the stock market is still pricey. Reverting to the average Forward P/E would require operating earnings to reach $114.4 at year-end AND the S&P 500 to sink to roughly 1515. That would be in line with a typical bear market descent of 28.9% from the peak (2130). Valuation concerns notwithstanding, there’s little doubt that the Fed did indeed front-load an enormous market rally. Here’s how easy it is to tell. Take a peek at how the Vanguard Total Market ETF (NYSEARCA: VTI ) fared as it relates to the Fed’s acquisition of bond assets with electronic dollar credits (a.k.a. “QE”). Specifically, in mid-December of 2012, the U.S. Federal Reserve upped its QE3 program to $85 billion per month in the acquisition of U.S. treasuries and mortgage-backed securities. The program began winding down in 2014 during the “Great Taper,” though the final day of the last asset purchase actually occurred in mid-December of 2014. The 2-year performance for VTI? Approximately 52%. Now visualize what transpired when the Fed officially removed its QE3 stimulus. Through 1/7/16, there has been a whole lot of risk and volatility. There hasn’t been a whole lot of reward. Surprising? Not particularly. In fact, “risk-off” treasury bonds via the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) have outperformed “risk-on”stocks since the end of the Fed’s QE. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.