One Strategist’s ETF Playbook For 2018

December 14, 2017

John Davi is known in the fund industry for his research, and now at the helm of New York-based Astoria Portfolio Advisors, he is managing some $115 million in ETF portfolios. For five years, he has been putting out an annual ETF Playbook, and he shares here what he likes and doesn’t like when it comes to ETFs for 2018. As we look toward 2018, what are the key investment themes you’re focused on?

John Davi: We’ve been bullish for some time, and think there’s a high probability this late-cycle, pro-cyclical rally will continue, at least for the first one to two quarters.

But I'm watching for one of three things to change my outlook. First, to see if liquidity starts to deteriorate. Second, if this synchronized earnings recovery collapses, and finally to see if inflation materially rises.

In the second half of the year, we’ll likely see higher dispersion because we'll have a few rate hikes. By definition, Fed rate hikes and their quantitative tightening program will result in a decline in liquidity. The rate of change is what drives markets, and if on-the-margin liquidity declines, there are significant implications for investors’ portfolios.

Throughout our portfolios, the dominant theme is that we want to be long yield-curve-flattening beneficiaries. Historically, what's worked when the yield curve’s flattened is things like U.S. energy, European equities, emerging markets, oil and commodities. That's our overarching theme for next year. It’s not a big departure from what’s worked in 2017. Does staying the course work, for the most part?

Davi: What investors often forget is that cycles can last for a long time. Even though we're late cycle, the late part of the cycle can last for several years.

Our indicators suggest we'll continue on the same path for the first few quarters, but depending on what happens with Fed rate hikes, quantitative tightening, other countries' banks slowing down QE purchases, things can materially change.

Liquidity's been one of the key drivers of risk assets for several years now. If we see a reduction in liquidity, especially on the margin, that can have some significant portfolio implications. That's why, while we're constructive, we’re saying that next year you want to own uncorrelated assets like alternatives, gold and even own some long-dated Treasuries for crash protection. From a factor perspective, what factors do you like for 2018?

Davi: Timing factors is like trying to pick the market top or bottom.

My suggestion is to pick the factors you like and to stick with them. We like global value, global small-cap and global momentum. U.S. growth has certainly outperformed in prior years, so in our view, it represents a funding risk. You get a significant margin of safety with value stocks.

All the assets we own on the equity side—energy, financials, emerging markets, Japan, Europe—by definition are more value-centric. We’re also advocating looking at factors internationally, not just focus on the U.S. Investors are obsessed with U.S. smart beta ETFs, but they need to understand that factors are a global phenomenon. How do you translate all these themes into ETFs? What are some of your picks?

Davi: To play the yield-curve-flattening beneficiaries, we like the Energy Select Sector SPDR Fund (XLE), the PowerShares KBW Bank Portfolio (KBWB), the iShares Core MSCI Total International Stock ETF (IXUS), the WisdomTree Japan Hedged Equity Fund (DXJ) and the iShares Core MSCI Emerging Markets ETF (IEMG). These are late-cycle, cyclical parts of the market that historically have done well when the curve’s flattened or the economy’s entered the latter part of the economic cycle.

Another theme we have is, while liquidity is abundant and earnings are inflecting higher globally, it makes sense to go down the risk curve and own international small-caps. We like the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS).


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