Matt Hougan’s Top 3 ETF Picks For 2014

Hougan’s top picks for 2014 are as varied as they are interesting.

Hougan’s top picks for 2014 are as varied as they are interesting.

The story of 2013 was U.S. large caps. In 2014, the tape will focus on Europe, Africa … and municipal bonds.

Before I get to my calls, however, I have to mention the calls of my colleagues, Dave Nadig and Paul Baiocchi.

One of the great things about having colleagues like Dave and Paul is that you can count on them coming to work each day. Why? Because their investment picks are so crazy you know they’re never going to retire.

Baiocchi’s “Top 5 ETFs” speak of a gambler’s optimism that is beautiful to behold but painful to experience. From the Indian rupee to lithium, Baiocchi has scavenged the edges of the ETF universe for Hail Mary investments that would frighten a Silicon Valley venture capitalist hopped up on speed.

The best of his picks, like the iShares MSCI Mexico Capped ETF (EWW | B-94), make all the sense in the world. But balanced against Mexico are choices like the Pimco 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ | C-51).

I love contrarian investing, and I don’t rule out the possibility of interest rates retreating mildly in 2014: from 3 percent on the 10-year Treasury note to 2.5 percent, perhaps.

But incoming Federal Reserve Chair Janet Yellen possesses the same deflationary fears as the man she’s replacing, Ben Bernanke. She won’t let rates slip lower than that. The result gives ZROZ an uneven payoff profile: small upside and large downside if rates jump significantly. That’s not a trade for me.

Paul is a smart guy and a good analyst, but caveat emptor.

Nadig, meanwhile, highlights the Market Vectors Gold Miners (GDX | A-54) as one of his top picks for 2014. I’m intrigued by GDX. Since Jan. 1, 2008, the fund has fallen about 60 percent, while gold prices are up almost 40 percent. That doesn’t make sense.

At some point, GDX will bottom. But when? Goldman Sachs’ Jeff Currie sees gold going to $1,050/ounce in 2014, and if he’s right, GDX will continue to be punished.

GDX is a classic falling knife, and knives always fall further than you think. Wait until the fund bottoms and, again, caveat emptor.

So what do I like in 2014? Here are three picks for the New Year:

3) DB X-Trackers MSCI EAFE Hedged Equity Fund (DBEF | C–51)

I think the defining macro move of the next few years may be a slow but steady appreciation of the dollar against other developed-market currencies.

My reasoning is fairly simple: The Fed is ahead of most other developed-market central banks in its transition from a rate-cutting environment to a rate-raising paradigm. As its starts to taper quantitative easing and eventually starts to tighten short-term rates, interest rate differentials will put upward pressure on the dollar.

This is the near-consensus view on Wall Street right now, with firms like Bank of America calling for the dollar to reach $1.24 on the euro from its current $1.38. That’s a 10 percent move. (The lone contrarian on the dollar right now is Goldman Sachs, which sees the dollar moving to $1.40 on the euro.)

If the consensus is right, you want to shift your international holdings from traditional exposures to currency-hedged exposures en masse. DBEF gives you the same exposure as the popular iShares MSCI EAFE ETF (EFA | A-89) but hedges out the currency. A 10 percent move in the dollar will translate into roughly a 10 percent gain for DBEF versus EFA.

This trade is the opposite of Baiocchi’s ZROZ call. Even dollar bears like Goldman Sachs expect little movement from current levels. But dollar bulls see significant upside. Large upside and low downside? I’ll be moving the bulk of my international holdings into currency-hedged exposure in 2014.

DBEF, by the way, is a good fund. It’s cheap, with an expense ratio of 0.35 percent, or $35 for each $10,000 invested. It’s also well established, with more than $250 million in assets.

It should be traded with care, of course, as its spreads—0.27 percent or 7 cents/share—are a bit wider than we’d like. Still, DBEF is an “Opportunities Pick” in our ETF Analytics rating system.

2) Market Vectors Africa ETF (AFK | D-30)

Emerging markets had a tough year in 2013.

While U.S. stocks rose 30 percent, the MSCI Emerging Markets index ended the year down more than 3 percent. The Market Vectors Africa ETF (AFK) wasn’t much better, eking out a 1 percent return based on a strong last few days of the year.

While the broad-based emerging markets face continued head winds in 2014, Africa looks intriguing.

The IMF expects economic growth in sub-Saharan Africa to accelerate to 6 percent in 2014 from 2013’s 5 percent, making it the second-fastest-growing region in the world, after China’s projected 7.3 percent growth rate. Political and infrastructure improvements and strong demographic trends support the broad-based growth.

Investment in Africa is not easy, and AFK suffers from a relatively high expense ratio (0.80 percent) and wide bid/ask spreads (0.42 percent).

But if you’re looking for portfolio diversification, and a region that’s likely to benefit from the changes to emerging market investing in the coming years, Africa is a risky, but in my opinion, reasoned, bet.

I won’t be making an allocation to AFK in the new year—my personal portfolio is very simple and doesn’t have many satellite allocations—but for someone looking for a satellite diversifier, you could do much worse than AFK.

[Note: I’d prefer to pick the Global X Nigeria ETF (NGE | F-48), as AFK suffers from a 20 percent allocation to slow-growing South Africa. But NGE has just $7 million in assets and is rated as having a high risk of closure in our ETF Analytics system. So, for the time being, I’m steering clear.]

1) iShares National AMT-Free Muni Bond ETF (MUB | A-73)I’m generally lightening up on my bond exposure in 2014, but since Dave and Paul laid out their insane suggestions for bond exposure in their blogs, I thought I’d give a more reasoned choice.

Municipal bonds are an area that no one loves. Headlines about Detroit and other bankrupt cities have people worrying about credit default.

Also, fears of interest-rate increases make people shy away from the duration inherent in a fund like MUB.

But sometimes the numbers are just too attractive to ignore.

MUB is our “Analyst Pick” in the muni space. It owns a diversified portfolio of AMT-free muni bonds with an average credit rating of AA- and a tax-free yield of 3.48 percent.

Let’s consider the risks in order. First: credit.

Anyone worrying about default risk on this portfolio is silly.

According to the Bank of New York–Mellon, the cumulative default rate for muni bonds rated AA over the past 10 years has been 0.01 percent. By comparison, corporate bonds rated AA corporate bonds have defaulted at a rate of 0.92 percent—92 times as frequently as similarly rated muni credits.

The worst bonds in MUB’s portfolio are rated BBB, and these represent less than 3 percent of the portfolio. Over the past 10 years, bonds rated BBB have a cumulative default of 0.30 percent.

Using historical default rates, of the 2,200 bonds in MUB’s portfolio, we can expect one to default about every 20 years.

Interest rates, by contrast, are a real concern. MUB has duration of 8.2 years, so it has a fairly long-dated portfolio. But with a tax-free yield of 3.48 percent—that’s 5.3 percent-plus on a tax-equivalent basis—you have a nice cushion to absorb interest-rate risk.

Compare that 5.3 percent yield with the 3.04 percent yield you get on the iShares 10-20 Year Treasury ETF (TLH | A-69) and it starts to look pretty attractive. In fact, compare MUB’s tax-free yield of 3.48 percent with TLH’s taxable yield straight-up and you can see that things are a bit silly ... particularly when you consider TLH's longer duration.

You don’t usually see muni interest rates higher than Treasurys. As the taper unwinds, that ratio will too.

Charts courtesy of StockCharts.com

Conclusion

There are plenty of other ETFs I like.

I continue to hold the WisdomTree Currency-Hedged Japan ETF (DXJ | B-45) in my personal portfolio, as I did for all of 2013. I think the EGShares Emerging Markets Consumer ETF (ECON | D-51) is well positioned for 2014. I even like Paul Baiocchi’s choice of the Global X Fertilizers/Potash ETF (SOIL | D-39).

Mostly, of course, you should keep your portfolio exquisitely simple. These kinds of articles and picks are fun to write and fun to read, but they mostly deal with the edges.

Save as much as you can, invest as cheaply as you can and hold for as long as you can.

Oh, and hedge your currency risk.

At the time this article was written, the author held long positions in DBEF and DXJ. Contact Matt Hougan at [email protected].