With the S&P 500 having risen by almost 30% in 2013, slowing earnings growth and the Fed tapering asset purchases, the outlook for equity markets in 2014 seems more uncertain. Here are a few ETF ideas that might outperform the pack for this year:
1. Barclays ETN+ Shiller CAPE ETN (CAPE).
The cyclically adjusted price-to-earnings ratio, commonly referred to as the Shiller CAPE, Shiller P/E, or even as PE 10, is a variant of the commonly used P/E ratio; but instead of using the earnings of the last twelve months, the inflation adjusted average annual earnings over the past 10 years is used. The Shiller P/E has apparently been a good indicator of future returns. The Barclays ETN+ Shiller CAPE ETN uses this valuation method to invest in industry sectors which are relatively undervalued against their historical average.
The ETN tracks the Shiller Barclays CAPE US Core Sector Index, its proprietary index which uses a modified version of the Shiller P/E ratio. Out of nine S&P 500 sectors, the index initially identifies the five most undervalued sectors, based on their current sector CAPE ratio divided by their historical CAPE ratio. The sector with the lowest price momentum, that is the worst performing sector over the past 12 months, is then eliminated; which leaves the index holding four out of nine sectors. The four undervalued sectors showing stronger price momentum are probably chosen because of evidence of the momentum effect in equity markets, and to reduce the chances of falling into a 'value trap'.
With equity markets seemingly more expensive, it is perhaps time to be more selective with different industry sectors. Backtesting over 10 years has shown that this ETN would substantially outperform the S&P 500, and especially so during periods when the market seems overvalued by the Shiller P/E ratio. The ETN has returned 33.8% since its inception in October 2012; which is only very slightly better than the S&P 500, which would have returned 31.4%. However, past performance does not necessarily imply future results. This ETN is still worth a consideration because of its innovative index methodology and current market conditions.
2. WisdomTree Japan Hedged Equity Fund (DXJ) or the db x-trackers MSCI Japan Hedged ETF (DBJP). Japan's equity market performed strongly in 2013, but with improving corporate earnings, a weakening yen and with some much delayed structural reforms on the way, analysts are still optimistic with the Japanese equity market. These currency hedged ETFs offer protection against further depreciation of the Japanese yen against the U.S. dollar, which could be beneficial as the Fed begins tapering asset purchases. The WisdomTree Japan Hedged Equity Fund had underperformed the db X-trackers MSCI Japan Hedged ETF in 2013 because of its focus on dividend paying Japanese companies with greater foreign market exposure.
3. WisdomTree Europe Hedged Equity Index Fund (HEDJ). Similar to its Japan Hedged Equity Fund, this fund does pretty much the same job, but for the European equity market. With expectations of the Fed tapering asset purchases, whilst the ECB continues to keep monetary policy loose, the euro could weaken against the U.S. dollar. But, with a slowly improving economy in Europe, increasing risk appetite and lower European equity valuations, the outlook towards European equity markets remains optimistic. This currency hedged ETF, which focuses on European large caps that derive at least half of their revenue from outside Europe, could outperform many other European equity ETFs.
4. Global X Guru Index ETF (GURU). The GURU ETF offers individual investors access to ideas from some of the top hedge funds, as the ETF tracks an index which is constructed from information contained in publicly available Form 13F filings. Form 13F contains certain information about the investment holdings of all large hedge funds based in the U.S.; and this is used to generate a portfolio based on the investments made by hedge funds. For this service, the ETF charges a management fee of 0.75%, which is well shy of the typical 2% management fee plus 20% performance fee charged by many hedge funds. Over the past year, the ETF gained 40.0%, significantly higher than the 28.1% total return achieved by the S&P 500.
5. Schwab U.S. Broad Market ETF (SCHB). With an expense ratio of 0.04%, this ETF from Charles Schwab (NYSE:SCHW) is one of the lowest cost ETFs on the market. Holding low cost funds is one of the best ways of improving the chances of achieving higher returns without taking on more risk. The Schwab U.S. Broad Market ETF offers broad exposure across large and small cap U.S. stocks, by tracking the Dow Jones U.S. Broad Stock Market Index, which consists of the largest 2500 stocks listed in the U.S.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CAPE, DBJP, GURU, over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.