Thematic Investing with ETFs

by: Roger Nusbaum

The folks at SPDR published a report/marketing piece about several macro themes that could be coming down the pike and how SPDR ETFs fit in to those macro themes. The report was called "SPDR ETF Guide To Changing Markets." I tweeted the link yesterday but have since removed it in case the report was not meant for widespread distribution. I will, however, recap what was discussed.

The first macro theme discussed was called "Opportunities In A Recovering Global Economy." For anyone believing the global economy is recovering, SPDR suggests looking at international small cap, international mid cap and emerging small cap. SPDR has funds for all three with the respective symbols being GWX, MDD and EWX. They say that small and mid caps outperform large caps coming off the bottom, and foreign outperforms domestic.

If I am reading correctly, the data cited for those conclusions go back to 2001, so obviously the last decade greatly favored foreign. I know from other sources that over longer periods of time small outperforms large coming off the bottom in the domestic market. From here, conditions may favor foreign still (I think they do) but it is a little short to draw their conclusion about foreign over domestic simply by extrapolating from the period they studied.

GWX has 28% in Japan and 12% in the UK. At the sector level it is heaviest in industrials, discretionary and financials. MDD has 25% in Japan and 14% in the UK and the heaviest sectors are industrials, financials and materials. As much as I dislike Japan the exposure captured in GWX and MDD is not large cap (obviously) and the newly elected DJP party's policies should favor the smaller non-exporting companies that tend to be smaller companies so it is possible that the Japan exposure in these funds won't be a drag. That is the bull case. I want no part of Japan (at least I have not found any exposure I want), but you can decide for yourself.

I would note that WisdomTree has funds that capture the same space via dividend weighting so if you are inclined to research the concept there is more than one fund to choose from in each segment. iShares has a small cap fund as well and various providers have narrower ETFs that could also fit in.

The concept behind EWX is interesting but for some reason it is 29% Taiwan so not surprisingly it is heaviest in tech at 21% but the industrial and financial exposures are close behind. The WisdomTree version of this space is also heaviest in Taiwan.

The next theme in the report was "Defensive Opportunities During A Market Pullback." It focused on various slices of the bond market; high yield (NYSEARCA:JNK), intermediate term credit (NYSEARCA:ITR), long term credit (NYSEARCA:LWC) and convertible (NYSEARCA:CWB). This part of the report said something that doesn't seem intuitively correct; it said that spreads widen during market declines (that part makes sense) because investors demand higher yields on lower rated bonds (still with them up to this point). "For that reason, spread products such as high-yield bonds, corporates and other credit bonds, as well as convertible bonds, have historically tended to outperform treasuries and equities during market declines." Yeahwhatnow?

Maybe I misread it or maybe there was some context missing about buying during a widening resulting in longer term outperformance once a recovery starts. The implication of widening spreads is usually that yields on lower quality paper goes up (prices down) and yields on higher quality paper goes down (prices up) so I am not sure why you would want to buy lower quality if spreads are going to widen. Be that as it may, if this appeals to you just remember yields are very low right now. Prices could stay high for a very long time but prices are high nonetheless.

Next up on the theme parade is "Opportunities For Investors Facing Higher Tax Rates." This one plays on the idea that federal tax rates could be headed higher. If so, then tax free income that can be had from municipal bonds could be attractive. Unfortunately, something like 48 states have deficits (Montana and South Dakota being the two that don't unless something has changed in the last month or so). Several of the other mountain time zone states have relatively low deficits but there are not a lot of bonds from these states in the indexes underlying the various funds that exist. I posted a while ago about selling what few California munis we had for clients just so no one would have to even think about the state declaring bankruptcy. We still don't have to think about it.

The last two themes seem to overlap. They are "Investments That May Benefit In An Inflationary Environment" and "Investments To Counteract A Falling Dollar." Both Categories include Gold (NYSEARCA:GLD) and foreign TIPS (NYSEARCA:WIP). We own both of those funds. Also included is XLE and several REIT ETFs for the inflation theme and for the dollar falling theme they suggest foreign bond funds.

I have said before I have given up on REITs as diversifiers and both of SPDR's foreign bond funds, symbols BWX and BWZ, are heaviest in Japan which requires an active eye because at some point this exposure could be problematic. We own BWX for some clients and while there is no need to jump out now that could be different in a few years, maybe sooner.

Obviously missing from the report are currency ETFs because SPDR doesn't have any. If either the inflation theme or the falling dollar theme interest you then you should look at and make a decision (yes or no) about currency funds. There are also plenty of other commodity funds out there beside GLD for actual commodities and XLE for commodity related stocks.

If my post seems critical of the report that is not my intention because there is merit to everything they say, but there is also another side of every argument as well as plenty of products from other ETF companies to consider. There is nothing wrong with taking input from someone else and drawing a different conclusion.