The U.S. exchange-traded fund (ETF) industry continued to grow in 2020, reaching $5 trillion, according to a new research report published by Cerulli Associates.
And it’s expected to grow even more over the next decade as issuers increasingly offer “a greater variety of differentiated exposures beyond the commoditized core,” according to Cerulli’s latest report, U.S. Exchange-Traded Fund Markets 2020: Broadening Product Use.
According to Cerulli, the ETF industry is undergoing a momentous shift. “The majority (79%) of U.S. ETF issuers report that they are currently developing or planning to develop transparent active ETFs, despite only 3% of ETF assets being currently held in such products,” the report noted.
On a category level, Cerulli noted that “product development focus remains on U.S. fixed-income and U.S. equity products, despite such categories being most likely to be rated as product-saturated by advisers.”
Instead, Cerulli noted that issuers may seek to launch thematic and environmental, social, and governance (ESG) products. “These products allow for greater differentiation and appeal to younger investors and advisers,” Daniil Shapiro, a Cerulli associate director, said in a release.
What’s more, Cerulli noted that advisers are also more willing to use fixed-income ETFs (both passive and active), which are perceived to have proven themselves through COVID-19-related volatility.
According to Cerulli, issuers increasingly perceive that the passive ETF landscape is product-saturated and fee-compressed and transparent active ETFs will become the product of the future. That’s especially so since investors will be able to use (transparent active ETFs) to achieve more of their financial objectives, according to Cerulli.
To be fair, not all advisers are sold on transparent/semi-transparent active ETFs. “I don’t think they are adding anything on a risk-adjusted basis,” said Charles Sachs, the chief investment officer of Kaufman Rossin Wealth. “But if someone wants that for a smaller portion of their equities for the thrill of it, then great.”
Marty Fridson, the chief investment officer at Lehmann, Livian, Fridson Advisors, says transparency in ETFs is beneficial, from the standpoint of understanding the underlying investments and how they’re selected. “But transparency by itself is no guarantee of sustainability of the ETF and may even work against it,” he said. “A case in point is United States Oil (USO) - Get United States Oil Fund LP Report, which was highly transparent about how it rolled over its position in the front-month oil future. That transparency enabled hedge funds to front-run its trades and create massive problems for the ETF.”
Fridson also noted that semi-transparency is not a problem when the asset class is well understood and liquid. “It presents more of a risk in less liquid assets such as bonds, commodities, and derivatives, and where leverage is employed,” he said.
Regardless of whether that trend plays out or not, here’s a look at the ETFs chief investment officers are adding to and/or trimming from their client’s portfolio as we start the new year.
Cheap Sectors with Upside Potential
Two ETFs that Vahan Janjigian, the chief investment officer of Greenwich Wealth Management, has been adding to client portfolios are Energy Select Sector SPDR ETF (XLE) - Get Energy Select Sector SPDR Fund Report and S&P Select Financial SPDR (XLF) - Get Financial Select Sector SPDR Fund Report.
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“I believe the energy and financial sectors are very cheap and I have been encouraged by their recent strength,” said Janjigian. “I was particularly surprised to see how well energy stocks have done since the election, especially since [President-elect Joe]Biden was viewed by most investors as being bad for carbon-based energy
Janjigian also believes higher interest rates are inevitable, but not necessarily imminent. “Financials should benefit from higher rates and I think long-term investors would do well by adding financials now,” he said.
Besides adding positions, Janjigian has “done a little trimming” in the tech-heavy Invesco QQQ Trust (QQQ) - Get Invesco QQQ Trust Report and even the SPDR S&P 500 ETF Trust (SPY) - Get SPDR S&P 500 ETF Trust Report, which is heavily weighted toward technology. “I think tech stocks have become much too expensive,” he said. “Because I recognize they could always go higher, I'm not getting out entirely - just cutting back.”
Janjigian is trimming QQQ but others are adding to their position in it.
QQQ same risk as to the S&P 500 but higher return characteristics
When stress-tested against the S&P 500, Invesco QQQ Trust offers surprising similarities in terms of risk, but substantially higher return characteristics, said Robert Wyrick, Jr., the chief investment officer of Post Oak Private Wealth Advisors.
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“This has been a top holding in most of our portfolios for quite some time and while there will likely be periods of rotation towards more value-oriented holdings, I do not see this as a sustainable long-term trend,” said Wyrick. “Many of the top holdings in QQQ such as Apple (AAPL) - Get Apple Inc. Report, Microsoft (MSFT) - Get Microsoft Corporation Report and Amazon (AMZN) - Get Amazon.com, Inc. Report are expected to grow revenue by about 25% in 2021 and there simply aren't many other areas of the market that offer this level of growth.”
Many investors, said Wyrick, seeking "post-COVID" trades which is certainly understandable, but a post-COVID world doesn't mean companies will suddenly stop using Microsoft or Salesforce.com (CRM) - Get salesforce.com, inc. Report or other enterprise solutions that are driving efficiencies and earnings growth. “Nor do we see consumer trends such as online shopping, computer hardware, making digital payments, or the desire for faster broadband, as examples, slowing down,” he said.
What’s more, Wyrick said Invesco QQQ Trust’s allocation to healthcare and consumer staples while also having no allocation to real estate adds to the appeal of this holding as well.
Time for Small Caps
The SPDR S&P 600 ETF (SLY) - Get SPDR S&P 600 Small Cap ETF Report is a great way to get exposure to small caps, specifically the S&P Small Cap 600 Index, said Erin Gibbs, the chief investment officer at Gibbs Wealth Management.
It’s not as famous as the Russell 2000 but it’s well-diversified. Heading into 2021, as investors become less risk-averse small caps provide higher expected profit growth with better value compared to large, she said.
Small-cap stocks have performed well over the past two years, rising 10.4% through November 2020 and 25.5% in 2019. And that trend may continue in 2021. But as good as that performance has been, U.S. small- and mid-cap companies have, since 2018, underperformed their more popular large-cap companies, mostly fueled by mega-caps dominating all markets. Large-cap stocks rose 14.5% through November 2020 and rose 31.5% in 2019, according to Callan Institute’s Periodic Table of Investment Returns.
“The long period of underperformance pushed them out of favor,” said Gibbs. “But the fourth quarter has been a reversal period and from the beginning of November, small and mid-caps have been outpacing the large-caps,” she said.
Wall Street consensus expects S&P Small Cap 600 index 2021 profit growth of 66%, compared to 24% for the S&P 500 large caps. “Twice the rate of profit growth is meaningful but even more attractive when you take into account the cheaper valuations,” she said. “The S&P 600 Index has a forward P/E of 22.3X versus 23.5X for the S&P 500.”
According to Gibbs, the higher growth expectations are partially due to the small caps being hit harder in 2020 but Wall Street and economists agree that small businesses have greater potential if we rebound at 4-5% GDP next year.
Others share this forecast for small-cap stocks.
U.S. small caps have underperformed their large-cap counterparts for quite some time, said Steve Osterink, the chief investment officer of Advisory Alpha. “We've seen a nice rebound in small-cap over the recent past but there could be more room for growth in this asset relative to large caps. If the economy continues to rebound, this could happen somewhat quickly.”
Shorter Duration High Yield
Shorter duration high yield has been increasingly attractive in the fixed income space, said Osterink. “High-quality bonds are paying next to nothing, so we are looking elsewhere for yield,” he said. “Also, the Fed seems to be supporting most segments of the fixed income markets which is seemingly reducing the potential risk.”
Diversify Outside the U.S.
Christopher Pavese, the president and chief investment officer of Broyhill Asset Management, recommends diversifying outside of the U.S., noting that emerging currencies and emerging equities offer the most attractive risk/reward today.
The Vanguard Emerging Markets Select Stock Fund (VMMSX) - Get Vanguard Emerging Mkts Sel Stk Inv Report and Pzena Emerging Markets Value fund (PZIEX) - Get Pzena Emerging Markets Value Instl Report (PZVEX) - Get Pzena Emerging Markets Value Inv Report are two liquid vehicles that provide investors exposure to emerging market/value, he said.
At the moment, Broyhill’s largest emerging market investments are in Latin America. “We own airports, Coca Cola bottlers, and convenience stores in South/Central America,” he said. “Each of these investments was driven by fundamental, bottom-up, stock selection, but investors looking to replicate the regional/currency exposure here might look at ETFs in the region which should also benefit from a declining dollar and U.S. fiscal stimulus.”
Increase Allocation to ‘Classic Value’
Investors might also consider increasing their allocation to “classic value” more broadly, says Pavese. Why so? Shorter duration, asset-heavy, value stocks are likely to be major beneficiaries of record stimulus, he says, noting that there are more than a few long-only options here to select from.
“For investors more cautious about today’s sky-high valuations, we think a long/short value/growth fund makes a lot of sense here,” he says. “Generally speaking, the best investors in this space are being paid 2% and 20% but there are a growing number of liquid alternatives available.”
An approach like that of Gotham Funds makes a lot of sense here and offers multiple ways to win, says Pavese. The Gotham Large Value Fund (GVALX) is one such option.
Wes Gray, CEO of Alpha Architect, favors international value and momentum. For developed markets, consider Hartford Multifactor Dev Mkts (exUS) (RODM) - Get Hartford Multifactor Developed Markets (ex-US) ETF Report and for emerging markets consider Cambria Emerging Shareholder Yield (EYLD) - Get Cambria Emerging Shareholder Yield ETF Report.
Thematic Investing Takes Flight
Dan Weiskopf, a portfolio manager at Toroso Investments and the lead ETF Strategist for the ETF Think Tank, thinks the appetite by investors for thematic investing will continue in 2021 and possibly even accelerate.
“Active strategies, especially those ETFs that are actively managed, dominated both the flows and the returns in 2020,” he said. “However, investors have been spoiled by the rewards by risk-taking in certain funds and flows need to broaden out rather than just chase performance.”
Having said that, Weiskopf thinks investors today (young and more experienced) now want to own what they know and believe in. A “growth factor” is not enough of a reason, he said.
“I think client conversational alpha will become increasingly more important in 2021,” said Weiskopf.
As an example, take the ProShares Pet Care ETF (PAWZ) - Get ProShares Pet Care ETF Report, which was up about 62% in 2020 as of this writing. “If the price of the ETF goes down 20% in 2021, I just don’t think investors will sell their pet any more than they will sell the ETF,” he said. “In fact, at a lower price, I think the theme will get more flows.”
Healthcare is also an area that Weiskopf thinks is seeing a great deal of disruption and “we know people are not getting younger.”
Trends in healthcare are deep-seated, he said. “To that point, I think the second generation of ETFs have gained real traction in 2020 in part because the first generations sector ETFs are too broad and not capturing the disruption,” said Weiskopf.
One of his favorites in this area is ROBO Global Healthcare Technology & Innovation (HTEC) - Get ROBO Global Healthcare Technology and Innovation ETF Report, which focuses on global healthcare technology companies that generate a portion of their revenue from medical and healthcare technology.
Another fund to consider is the actively managed Amplify Transformational Data Sharing ETF (BLOK) - Get Amplify Transformational Data Sharing ETF Report, for which Toroso Investments serves as the subadviser. BLOK employs a strategy that is “aligned with disruption from the blockchain and crypto space, a trend that Weiskopf feels confident is still in its early stages of development.
Another ETF for which Toroso Investments also serves as the subadviser is SoFi Gig Economy (GIGE) - Get SoFi Gig Economy ETF Report. That fund, he says, is at the core of the change that is taking place in the Gig economy. “Something like 45 million people in America by 2030 will be changing jobs and many will have a side gig to help them balance out their economic circumstances,” said Weiskopf. “The work-from-home theme carries over to this trend as well.”
Worried About Tail Risk
If you happen to worry about tail risk, Gray recommends looking at Arin Large Cap Theta Institutional (AVOLX) - Get Arin Large Cap Theta Institutional Report which he says is “run by a savvy group who specializes in managing tails and the price isn't crazy.” The fund seeks to accomplish its objectives through non-traditional investment strategies that offer exposure beyond traditional stocks, bonds, and cash.
And Weiskopf, for his part, thinks as long as central banks continue to support liquidity in the markets investors in 2021 could be rewarded. “But that does not mean returns should be double-digit in 2021,” he said. “In fact, to a large degree, I think the markets are vulnerable to a significant pullback and alternative strategies.”
Weiskopf also remains troubled by return expectations for people in the bond market, but as long as the central banks keep markets flush bond money can stay stable or even provide some income for investors.
“However, how investors may be able to take advantage of these circumstances is in the M&A activity,” he said.
For that, he likes the IQ Merger Arbitrage (MNA) - Get IQ Merger Arbitrage ETF Report. “Think through the environment today,” said Weiskopf. “Private equity has a surplus capital to spend and many public companies are incentives to do deals. They can either tap the capital markets using leverage or use their stock to justify their high multiples and grow through synergies.”
Bond Replacement Funds
Given a lack of fixed-income investment opportunities, Lee Munson, the chief investment officers of Portfolio Wealth Advisors, is currently replacing some of his bond exposure in his 60/40 portfolios with iShares Mortgage Real Estate Capped (REM) - Get iShares Mortgage Real Estate ETF Report.
“These are not physical assets. They are portfolios of loans, leveraged up,” he said. “Right now, I would rather have leverage risk the credit risk. Why? The Fed is clear they will allow my REITs to borrow cheap money until 2023 or longer. That also reduced volatility.”
So, he said, we have a mortgage REIT market that literally got blown up, and overall is trading below book value. “The group is paying double what junk bonds are paying, eight times a 10-year Treasury, and actual assets backing the loans anyway,” he said. REM has a 12-month yield of 9.44% as of Dec. 28, 2020. And its price to book value was 0.79 as of Dec. 24, 2020.
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