By John Lunt, President, Lunt Capital Management, Inc.
Financial advisors are continually reviewing the strategic positioning and tactical tilts within client asset allocations. The beginning of a new year offers the opportunity to answer five key questions that will likely have a significant impact on client portfolios.
ETFs have dramatically changed the way allocations can be built and how these allocations can be tactically positioned. ETFs may be utilized as core allocations, or they may be used as tools to create tactical tilts based on broader macro views.
The ETFs mentioned below are not recommendations, but are simply examples of available ETF tools that may be used to implement a particular viewpoint.
There is no guarantee these or any ETFs will be effective in addressing particular market conditions.
However, the examples listed below highlight the wide range of core and specialty ETFs available from a multitude of providers.
This article does not attempt to answer the questions posed, but rather, to highlight the ability to implement a variety of viewpoints using ETFs.
Question 1: Should I position for higher or lower interest rates?
Yields have surged higher in the aftermath of the U.S. Presidential Election. There are rumblings of fiscal stimulus and projections of multiple rate hikes in 2017 from the Federal Reserve. If rates continue higher, financial advisors may look to shorten duration in fixed income allocations using ETFs like the iShares 1-3 Year Treasury Bond ETF (SHY), the Vanguard Short-Term Bond ETF (BSV), the iShares 1-3 Year Credit Bond ETF (CSJ), or even an active ETF like SPDR DoubleLine Short Duration Total Return Tactical ETF (STOT). Concerns about higher rates will likely impact other asset classes. This could point investors towards rate sensitive allocations in equities, such as the PowerShares S&P 500 ex-Rate Sensitive Low Volatility ETF (XRLV). Some strategists suggest the jump in rates is overdone, and deflationary forces will re-emerge. To implement this view, advisors could look to extend duration by adding the iShares 20+ Year Treasury Bond ETF (TLT) or the iShares Core U.S. Aggregate Bond ETF (AGG).
Question 2: Should I position for a stronger or weaker U.S. dollar?
Currency impact on equities and fixed income is often significant but underappreciated. While some currency experts see post-election U.S. Dollar strength continuing, others such as Ulf Lindahl at A.G. Bisset believe the U.S. Dollar is poised for a period of weakness. Either view can now be effectively implemented with ETFs. For example, an international equity allocation could use either the iShares Core MSCI EAFE ETF (IEFA) or the iShares Currency Hedged MSCI EAFE ETF (HEFA). This currency decision exists in more granular allocations, such as the SPDR S&P International Dividend ETF (DWX) or the SPDR S&P International Dividend Currency Hedged (HDWX). ETFs exist that allow the currency decision at the country level, like the Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP) or the unhedged iShares MSCI Japan ETF (EWJ). ETFs are available for direct currency exposure that may act as a supplement to international fixed income allocations. A stronger dollar view would suggest an allocation to the WisdomTree Bloomberg U.S. Dollar Bullish ETF (USDU). A weaker dollar view could be implemented using the Guggenheim CurrencyShares Euro Trust ETF (FXE) or the Guggenheim CurrencyShares Japanese Yen Trust ETF (FXY).
Question 3: Should my U.S. equity allocation be aggressive or defensive?
Large cap U.S. equities have been a leading asset class in recent years. While defensive, yield-oriented sectors and strategies flourished in the first half of 2016, the latter half of the year has seen a rebound in more aggressive, cyclically-oriented sectors. The post-election moves have been dramatic, signaling sector repricing and new underlying assumptions. Some market participants see deregulation, tax reform, and infrastructure spending from a Trump administration and a Republican Congress as a rationale for taking a more aggressive stance within their U.S. equity allocation. Adding specific sector exposure could aid this view, such as the Industrial Select Sector SPDR ETF (XLI), the Financials Select Sector SPDR (XLF), and the Consumer Discretionary Select Sector SPDR (XLY). Broader exposure that articulates this view may include the First Trust Large Cap Value AlphaDEX ETF (FTA) and the Elkhorn S&P 500 Capital Expenditures ETF (CAPX). For some, the market may have over-estimated the impact of a Trump administration, leaving markets poised to disappoint investors. Defensive sector ETFs are available to articulate this view including the Consumer Staples Select Sector SPDR (XLP) or the Utilities Select Sector SPDR (XLU). Broader allocations which attempt to lower volatility or focus on quality include the PowerShares S&P 500 Low Volatility ETF (SPLV) or the VanEck Vectors Morningstar Wide Moat ETF (MOAT).
Question 4: Should I favor international developed markets or emerging markets?
U.S. large cap allocations have flourished in recent years, leading to a tendency among some to neglect the international equity allocation within portfolios. The decision to hedge this allocation or to leave it unhedged has the potential to significantly impact risk and returns. Within international equity, there is a constant debate between developed and emerging market equity. Allocating more to either of the broad asset classes can be efficient and cost effective when using the Vanguard FTSE Developed Markets ETF (VEA) or the Vanguard FTSE Emerging Markets ETF (VWO). Both allocations are weighted by market capitalization, and specific countries may have weights that will not significantly impact performance. Single country ETFs allow advisors to be more deliberate in country and currency exposure. For example, Germany (8%) and Australia (6%) are single-digit country allocations within VEA. An advisor could add the iShares MSCI Germany ETF (EWG) or the iShares MSCI Australia ETF (EWA) to emphasize either of these markets. India is 12% and Mexico is 4% of VWO. An allocation to the iShares MSCI India ETF (INDA) as a compliment to a core international equity position would result in a deliberate overweight to a growing market that some suggest may be less impacted by potential global “trade wars.” Advisors who believe the Trump-inspired sell-off in Mexico is overdone could add the iShares MSCI Mexico Capped ETF (EWW). Some argue a growing U.S. economy may help its immediate neighbors, including Mexico and the iShares MSCI Canada ETF (EWC).
Question 5: Should my commodities allocation focus on strategy or on market beta?
The performance across most commodity markets has been dismal in recent years. However, with a whiff of inflation, fiscal stimulus, and tough talk from OPEC, commodity markets may provide opportunity. Years of commodity underperformance has led some advisors to allocate commodity sleeves to managed futures funds or ETFs, such as the WisdomTree Managed Futures Strategy ETF (WDTI). Managed futures typically incorporate other asset classes and focus on “strategy” rather than pure market “beta.” Negative views on the asset class would likely result in a focus on managed futures strategies. A more optimistic view of commodities has several unique options, including the PowerShares Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC). Advisors looking to add active ETFs or fundamental commodity ETFs may look at the First Trust Global Tactical Commodity Strategy ETF (FTGC) or the Elkhorn Fundamental Commodity Strategy ETF (RCOM).
This is only a small sample of questions that could be asked as part of a review of a model asset allocation. It is certainly not intended to provide a comprehensive view of the questions or potential ETFs that could be used to express an array of viewpoints. It is a bold statement that ETFs have completely changed a financial professional’s ability to implement a cost effective, transparent, and robust asset allocation. However, this statement is accurate as the breadth and depth of ETF tools has empowered financial advisors to efficiently express views that will likely have a significant impact 2017 portfolios and on client outcomes over the long-term.