ETF Outlook on the Second Half of 2023

[This article is part of a new series from etf.com highlighting financial advisors.] 

Tom Graff is head of Investments at Facet, an investment advisory and financial planning firm. etf.com's Kent Thune talked with him about exchange-traded fund investment tactics and ideas for the second half of 2023, as well as long-term portfolio management. 

etf.com: How do you use ETFs in your investment tactics and portfolio strategies? 

Tom Graff: Facet uses ETFs exclusively for our strategies. We believe that consistent exposure to markets is one of the keys to good long-term performance, but we also try to optimize the risk/reward balance within our portfolios given today’s circumstances.  

Therefore, much of our ETF portfolio would be considered core holdings, but we generally have some tactical allocations as well. We wouldn’t necessarily think of those as short term, since generally when we make these allocations, we intend on holding for a year or more. 

etf.com: As we move into the second half of 2023, in what ways do you see it looking different than the first half of the year, and how are you adjusting portfolios accordingly? 

Graff: A lot of the first half of 2023 was a rebound from 2022’s losers. This includes some companies where the fundamentals are improving, such as those involved in cloud computing, online advertising and artificial intelligence. But in some cases, it was more of a bounce off the lows, including things like homebuilders and low profitability tech. We have more confidence in the former continuing than the later.  

One ETF in which we are overweight along these lines is the iShares MSCI USA Quality Factor ETF (QUAL), which is made up primarily of high quality, consistently growing companies.  

etf.com: More specifically, do you see any of the big first-half 2023 winners, such as the Invesco QQQ Trust (QQQ), losing momentum and some of the first-half losers, such as the Health Care Select Sector SPDR Fund (XLV), returning to favor in the second half? 

Graff: One first-half winner that we are skeptical of is consumer discretionary, which would include ETFs like the Consumer Discretionary Select Sector SPDR Fund (XLY), that are up 30% year to date. This sector has been on fire this year primarily because consumer spending has not slowed as was feared at the start of the year, leading to strong growth and high margins at these companies.  

I don’t think this margin expansion can continue. Already those companies are seeing unit growth challenges, and so either they're going to lose pricing power, lose unit growth or both. This sector doesn’t have the secular tailwinds that some of the tech winners from the first half have, and therefore I find it hard to get behind them. 

We have investments in value-oriented ETFs, such as the Vanguard Value ETF (VTV) and the iShares Russell 2000 Value ETF (IWN). They absolutely could make a comeback in the second half.  

If the economy really is going to have a soft landing, then some of the more cyclical companies within these ETFs will probably look very cheap to investors. These ETFs also have a decent amount of financials, and we could easily see a continued recovery trade in regional banks as the memory of SVB and First Republic fade. 

etf.com: The yield curve inversion has steepened, possibly pointing to a recession. How does this lead your risk management approach? 

Graff: We very recently added the iShares 3-7 Year Treasury Bond ETF (IEI) and the Vanguard Intermediate-term Corporate Bond ETF (VCIT), two ETFs focused on the middle part of the bond yield curve.  

While it’s certainly possible for the yield curve to get even more inverted, the Fed is probably close to the end of their hiking cycle, and that tends to be when the curve is at its most inverted. Hence the yield curve is likely to normalize at least by some degree over the next several quarters. When that happens, the middle part of the curve tends to outperform. 

etf.com: Which ETFs do you like now for your clients needing income, such as dividend ETFs, bond ETFs and the recently popular covered call ETFs? 

Graff: We think too many investors are overly focused on income. High dividend stocks are systematically lower in profit margin, slower growing and higher leverage companies. That’s led to long-term underperformance for these companies. Moreover, they don’t really save you anything on the downside. In the last 30 years, the S&P High Dividend index has captured 94% of downside periods but only 69% of upside periods. That is a poor trade-off in my opinion. 

Covered call strategies are terrible investments. They retain the overwhelming majority of downside risk while capping your upside returns. If you look at the long-term history of any of these ETFs, such as the Global X S&P 500 Covered Call ETF (XYLD), they badly trail the reference index.  

I wouldn’t put my worst enemy in these funds. Instead of playing with these toxic funds, just buy a traditional fund and sell a little for withdrawals. You’ll be glad you did.