One Strategist’s ETF Playbook For 2018

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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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).

On fixed income, you need to be incredibly selective. Bonds were a tremendous asset class to own in the ’70s, ’80s and ’90s. If you bought the aggregate bond index, you got income, diversification, hedging and carry. Unfortunately, after a 30-year bull market—and particularly in the last seven, eight years when you've had $2 trillion of inflows into bonds—all the historical attributes are gone.

We're cautiously using parts of fixed income only for income. We own preferreds and senior loans in the iShares U.S. Preferred Stock ETF (PFF) and the SPDR Blackstone / GSO Senior Loan ETF (SRLN). And we're using the iShares JP Morgan USD Emerging Markets Bond ETF (EMB) to play the bullish EM story and for some elements of carry.

ETF.com: What ETFs are you using for other attributes of fixed income, like diversification, protection and hedging?

Davi: The IQ Hedge Multi-Strategy Tracker ETF (QAI) is a good liquid alternative. The benefit of QAI is that it manages the downside in a liquid, systematic and rules-based framework. If you look at the 10 worst months with the S&P 500 since 2008, the underlying index for QAI was down about 18%, and the S&P was down, collectively, 57%. That's the downside-capture ratio a hedge fund historically would have given you. So you get the benefit of managing the downside for a very attractive cost.

To further hedge our portfolio risk, we’re using gold—the iShares Gold Trust (IAU)—as well as the iShares 20+ Year Treasury Bond ETF (TLT) and the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ZROZ). Gold is a low-delta call option on the bitcoin bubble blowing up, or to hedge events like a North Korea bomb or even if inflation rises. Gold is uncorrelated, it carries well in the portfolio, and ownership is relatively light—especially if you compare it to cryptocurrencies.

ETF.com: If bitcoin ETFs do come to market, would you be an early adopter? What's your view on the bitcoin phenomenon?

Davi: We would not use bitcoin ETFs in our portfolio even though it's had a tremendous rally. It could go up a lot more, but we focus on asset classes that we can analyze their earnings and discount their cash flows.

ETF.com: What should investors avoid going into 2018?

Davi: You want to stay away from high-yield credit, funds like the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). It’s a poor risk/reward in our view.

Historically, when the Fed has tightened, credit spreads have widened, and valuations are extremely rich. It’s simply not the time of the cycle where you want to own high-yield credit. I’m worried how high-yield bonds will react if there’s a slip in the economy or if liquidity declines. Junk bonds are illiquid and sensitive to the economy. In 2008, high yield was down 25%, and there are a lot more sellers now.

ETF.com: What about commodities?

Davi: This is an out-of-consensus view, but we think it’s prudent to start to incorporate commodity-based strategies within a portfolio. Investors have excluded this asset class at large since 2008, but we think—given where we are in the cycle—they now warrant attention. They’re uncorrelated, under-owned and serve as a call option on inflation.

Contact Cinthia Murphy at [email protected]

You can reach John Davi at [email protected] or @AstoriaAdvisors. For a list of relevant disclosures, please click here.