This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Rusty Vanneman, CFA, CMT, chief investment officer of Omaha, Nebraska-based CLS Investments.
The second quarter was great for the U.S. stock market, but not all equity asset classes participated to the same extent. The dispersion was impressive, and going forward, some of these segments offer opportunities for investors.
Growth stocks, for instance, such as those in the technology and consumer discretionary sectors, handily outperformed value, such as financial stocks. Value stocks continued a streak of underperformance essentially dating back to before the financial crisis.
The recent quarter also proved trying for international equities. In fact, it was one of the worst three-month stretches versus the U.S. stock market in some time. Rolling three-month performance over the past few decades shows the recent degree of underperformance measured a whopping two standard deviations—something that has only happened 2% of the time. In other words, one should expect a quarter of such poor relative performance to happen only once every 12.5 years.
Value stocks and emerging market (EM) stocks are now on sale. The chart below compares the valuations of value stocks in the U.S. to the broad market going back to 2001. (The red line is the long-term average. The yellow lines are one standard deviation away from the average.) Value stocks usually trade at a discount to the market—a 21% discount is the average since 2001—but they are now trading at a 26% discount—the biggest sale on value stocks since 2001.
A look at emerging market stocks shows that the discount isn’t as dramatic, but it does show that EM appears to be attractively priced. To note, EM did gain nearly 40% in 2017, so some of the valuation gap has decreased after it was on its biggest sale in nearly 15 years going into last year. Still, the chart below suggests to me that buying EM appears to make more sense for long-term investors than selling it.
Did the losses in EM last quarter make sense? Time will tell, of course, but it does seem at this point that trade rhetoric has created a bit of a panic, which in turn, may have created a buying opportunity. Research Affiliates, a research firm in Newport Beach, California, recently published this article suggesting the panic may have been overdone.
What To Do About These Asset Classes With ETFs
Given the data above, and like mixing peanut butter with chocolate, how about we mix value stocks with emerging market stocks? It just so happens there are two great ETFs that basically add these exposures together: the Invesco FTSE RAFI Emerging Markets ETF (PXH) and the Schwab Fundamental Emerging Markets Large Company Index ETF (FNDE).
Coincidently, both of these ETFs use indices from Research Affiliates and their RAFI Fundamental Index, which describes itself as “a non-price-weighted index strategy that aims to deliver excess return versus the cap-weighted benchmark by using fundamental measures of company size to systematically rebalance against the market's constantly shifting expectations.”
Both ETFs are very similar in terms of exposures as well as expected returns and risks, but they do have a few notable differences. While both are emerging market exposures that focus on the deepest values within EM, their differences mainly stem from their investment universes used in their underlying benchmarks, though other aspects of portfolio construction also contribute to slight differences in potential returns and risks. As a result, here are the notable differences:
- FNDE has South Korea as part of its universe. Thus, its largest position is Samsung, which is not in PXH.
- PXH has a lot more in China. It also has a lot more in financial stocks.
Despite these small differences, in my opinion, both ETFs are extremely attractive for long-term portfolios. Owning one, or both, should help returns in the years ahead.
CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds. Contact CLS’ Chief Investment Officer, Rusty Vanneman, at 402-896-7641 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.