4 Themes & 12 ETFs To Focus On In 2015

January 27, 2015

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 is by Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments, LLC, and Kostya Etus, the firm’s associate portfolio manager.

At CLS Investments LLC, we have a team approach to managing our various portfolios and strategies. To help unify and guide our investment methodology, we come up with key themes on a yearly basis.

These themes represent areas of the market (both equity and fixed income) where we see potential for outperformance over a forward-looking, 12-month period. Therefore, we position our portfolios to take advantage of these themes.

With that in mind, here are the themes for 2015: high-quality focus; emerging market opportunities; technology innovation; and tactical fixed income.

Below is a description of each theme, our reason for choosing them and a brief note on ETFs that could be used to represent them.

High-Quality Focus

In almost every case, high quality is superior to low quality, and we believe the same holds true for companies. High-quality companies are those with:

  • Higher profitability: Measures include return on equity (ROE), return on assets (ROA) and net profit margin (NPM).
  • Relatively stable earnings: Companies with higher and more stable earnings growth are able to support stronger dividend growth.
  • Stronger balance sheets: A company’s balance sheet strength (i.e., lower relative debt levels) can be measured in a variety of ways including debt-to-capital (DTC).
  • Higher dividend growth: Managers in stable corporations with confidence in the future are better able to consistently grow dividends.

There is a significant amount of academic support for the high-quality factor. It uses historical data to conclude that high-quality investments tend to offer consistent returns that outperform the broad market over the long term at lower risk levels.

This provides an overall smoother ride and a better investor experience. The reason for the lower risk is quality’s ability to hold up better in downmarkets. “Quality” companies with low debt, high earnings and management confidence are able to weather the storm of market turmoil, thus providing a cushion in corrections.

As you can see in the chart below, MSCI Quality has beaten the S&P 500 in bear markets over the last 30 years:

In the current environment, where economic growth is expected to be below average and interest rates are more likely to rise than fall, we believe higher-quality companies should outperform.

Likewise, let’s not forget about the strong performance of the U.S. market in recent years, leading to elevated valuations and potential for higher volatility in the years ahead. It may be reassuring to know that higher-quality companies typically soften the fall given any potential market weakness.

For high-quality allocations, CLS favors:

  • iShares MSCI USA Quality Factor ETF (QUAL | A-80): Screens domestic markets for companies with high ROE, low debt to equity (financial leverage), and low earnings variability (stable, year-over-year earnings growth). We view it as one of the purest ways to gain exposure to high-quality companies.
  • PowerShares S&P 500 High Quality Portfolio (SPHQ | A-77): Has a screening process that is more qualitative in nature. The S&P Committee determines which companies are the highest quality based on growth and perceived stability of earnings and dividends over the past 10 years and then weights them based on their quality rank.
  • Vanguard Dividend Appreciation ETF (VIG | A-69): Includes U.S. stocks that have a history of increasing dividends for at least 10-consecutive years. It excludes stocks that might have low potential for increasing dividends in the future and also excludes REITs. This allows for pure exposure to dividend growth.

Emerging Market Opportunities

The U.S. stock market has outperformed international stock markets in recent years, and global asset allocators, including we at CLS, have felt the pain. Moving forward, though, we are more enthusiastic about the prospects of international beating the U.S. market.

The reason is the expected returns for the international markets appear more attractive, as do valuations for the overseas markets.

A back-of-the-envelope estimate used to approximate forward-expected returns is to simply add the current dividend yield to the current earnings yield (which is the inverse of the price-to-earnings (P/E) ratio).

For example, Russia currently has an earnings yield of 18.3 percent; add that to the dividend yield of 4.4 percent, and the result is an expected return of 22.7 percent. This is an extreme case, but with many of its major corporations trading at low, single-digit P/E ratios, it really isn’t that unreasonable to expect Russia would significantly outperform in the years to come.

The chart below shows the earnings yield and dividend yield for various regions and countries. Here are a few points that stand out:

  • The U.S. is expected to have one of the worst valuations from both a dividend-yield and earnings-yield perspective, the combination of which leads to the lowest expected return.
  • Other developed markets, such as Europe, appear to be better positioned than the U.S. and offer some potential for outperformance.
  • Emerging markets (EM) appear to be the most undervalued, with some key areas showing deep value.

While valuations suggest positive returns for all stock markets, emerging markets appear to have better prospects.

Source: Ned Davis Research

But valuations are not the only areas we see as favorable in international markets.

There are also significant growth opportunities given the variations in economic conditions. The U.S. economy is healthily recovering from the financial crisis, and the Federal Reserve is planning to raise interest rates in the near future, thus signaling an end to the easing cycle and the beginning of a tightening cycle.

Other areas of the world, on the other hand, such as Europe and Asia, are seeing some recessionary pressures, and their central banks are still in the early stages of easing cycles (or the planning stages).

As these central banks become more accommodative, emerging economies such as those in Russia and China should see stabilization and potential recovery that results in strengthening equity markets, similar to what we have seen here in the U.S. over the last five years and more recently in Japan.

For emerging market opportunities, we favor:

  • iShares Core MSCI Emerging Markets ETF (IEMG | A-99): Provides the broadest exposure to emerging markets, including small-cap companies. It is a low-cost way to establish a comprehensive core emerging market allocation.
  • WisdomTree Emerging Markets Equity Income Fund (DEM B-62): Fundamentally weighted based on dividend yield, and only the highest 30 percent of dividend yielders are included. This provides more of a satellite approach and overweights some of the higher-yielding (undervalued) countries, including Russia.
  • EGShares Beyond BRICs ETF (BBRC | D-38): A unique take on EM, with two distinct criteria. First, it excludes four of the larger EM countries known as the BRICs (Brazil, Russia, India and China). Secondly, it includes 25 percent in frontier markets (FM). By doing this, it focuses its allocation on smaller, less correlated and truly developing countries that have the most potential for growth.

Technology Innovation

Although we see the U.S. equity market producing returns below historic averages, we believe some sectors will perform better than others. There are three key points to focus on:

  • Interest rates
  • Valuations
  • Capital expenditures (capex)

The U.S. has maintained historically low interest rates for quite some time in order to boost economic growth. Now it appears the economy is improving, and the Fed is expected to begin raising rates in the year(s) ahead. Both economic growth and a rising-rate environment tend to be beneficial for cyclical sectors such as technology and hurts defensive sectors such as utilities.

From a valuation perspective, technology is one of the most attractive sectors. Using a composite of five valuation metrics (price/earnings; price/book; price/sales; price/cash flow; and price/dividend) relative to the broad market (Russell 3000) and data from the beginning of 2001 (post tech-bubble), we have constructed the chart below.

The thick red line in the center represents the long-term average relative valuation, and the brighter gold lines represent one standard deviation away from the average. As it makes clear, technology currently falls near the bottom standard deviation line and is therefore poised to revert to the mean, resulting in continued outperformance.

But the level of the line is not the only note of importance; the trend is equally valuable. The trend of technology is moving upward, and trends tend to persist. This can be contrasted with the only sector that may rival technology’s valuation level in recent months: the energy sector, a victim of dropping oil prices. The oil chart appears to be in a free fall, and momentum is not in its favor.

Having both an attractive valuation and an upward slope is the ideal scenario that technology currently exhibits.

The last thing to consider is capex.

U.S. corporations are holding record amounts of cash on their balance sheets. While there are several options for these funds, capex has been somewhat neglected in recent years. Total U.S. capex, as a percentage of gross domestic product, is below its long-term average.

This cannot persist as companies need to update their hardware and software in order to be competitive, especially given the current environment of fast technological growth, such as: 3D printing, robotics, cloud computing, smartphones, tablets, apps, bio- and nanotechnology, etc.

We see capex turning around in the coming year, with technology being the likely beneficiary.

For access to the technology sector, we favor:

  • Vanguard Information Technology ETF (VGT | A-92): Makes an ideal core allocation to technology due to its low cost and breadth of the sector.
  • iShares North American Tech-Software ETF (IGV | A-42): Used as a satellite to complement the overall technology exposure. Software is one of the most undervalued industries within the already-undervalued technology sector, making it that much more attractive. But it also has significant growth opportunities through the capex resurgence.
  • First Trust NASDAQ Technology Dividend Index Fund (TDIV | A-59): A play on both technology and quality. It screens for technology companies that have a steady or increasing common dividend over the past year that is at least half a percent. It is weighted based on dividend size and thus has a unique blend of growth companies with value qualities.

Tactical Fixed Income

Fixed income still has a role in portfolios given its diversification benefits in the face of all-time-high U.S. equity markets. That said, investors have to be more active and vigilant to find opportunities these days.

Last year showed just how substantial the dispersion in returns among fixed-income segments can be. There was a spread in excess of 6 percentage points of performance separating the best and worst performers­­: emerging market debt and bank loans. (By the way, that spread is more than 12 percentage points if you consider preferred securities.)

This dispersion in returns provides an excellent opportunity to add value through active management.

One thing to consider is that not all fixed-income segments experience the same sensitivity to U.S. interest rates. As mentioned earlier, while the Fed is gearing up to raise rates, central banks in many areas of the world are still ramping up, or even just starting, their easing monetary policies.

Investing internationally allows investors to diversify away some of the adverse effects of Fed tightening. Alternatively, Treasury inflation-protected securities (TIPS) provide exposure to real interest rates rather than the nominal benchmark rate managed by the Fed.

Another factor is that large equity/commodity market moves can create opportunities within fixed income. For example, consider the collapse in oil prices in the second half of 2014. It has more than doubled the amount of interest that investors are receiving to compensate for accepting the heightened risk of owning high-yield bonds in the energy sector. Similarly, emerging market bonds have also become substantially cheaper because of the oil price slide.

Our return expectations for the broad, fixed-income market are for lower-than-historical-average returns, but we don’t foresee any large swings as typically experienced with equity markets.

The Fed is going to be slow and steady with its rate increases, and ultimately, bonds still pay interest. Furthermore, though bonds lose value when rates rise, interest can be invested in new, higher-yielding bonds. This explains the reference to bonds as “self-healing assets.”

Within our fixed-income positioning, we currently favor:

  • PIMCO Total Return Active Exchange-Traded Fund (BOND | B): Makes a good core allocation because it is broadly diversified in exposure, but also actively managed to take advantage of opportunities to maximize returns.
  • iShares TIPS Bond ETF (TIP | A-99): Provides access to the domestic TIPS market. Low inflation expectations mean inflation protection is on sale, making this an attractive buy.
  • iShares Floating Rate Bond ETF (FLOT | 77) : Tracks investment-grade, floating-rate corporate bonds with shorter-term maturities, and half of the allocations come from international markets. All of these characteristics make it an ideal instrument in an environment where the domestic interest rate is rising.

At the time of writing, the authors’ firm owned shares of all the securities mentioned on behalf of clients.

CLS Investments is an Omaha, Neb.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Investment Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.

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