Ron Rowland is the founder and editor of Invest With An Edge, a website and weekly newsletter providing free actionable ideas for ETFs, stocks, and mutual funds. He is also Executive Editor and Publisher of the All Star Fund Trader newsletter as well as president and founder of Capital Cities Asset Management, a registered investment advisor providing separate account management and investment research for individual investors as well as advisors and institutions. Outside of CCAM, Ron serves on the Board of Directors for the National Association of Active Investment Managers (NAAIM) and is chairperson of the Active Fund Index committee.
Seeking Alpha's Jonathan Liss recently spoke with Mr. Rowland to find out how he planned to position his advisory clients and newsletter subscribers in 2011 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming year:
Seeking Alpha (SA): Ron, what is your general approach to ETF picking?
Ron Rowland (RR): I tend to operate more from a quantitative and technical perspective. I look at various performance factors first. Three items I consider are anchored price momentum, volatility, and correlation.
SA: Despite predictions of a dip in equities amid slow global growth in 2010, stocks were clearly the better choice than bonds in 2010, especially in Q4 where bonds sold off almost across the board whereas stock returns remained robust. How are you planning to position clients with a longer-term horizon in 2011 in terms of an equities/bond mix?
RR: I’m not counting on much return from bonds in 2011, and so I expect to use them primarily to manage risk and volatility in my asset allocation decisions. I have already eliminated all long-dated bond funds from portfolios and don’t foresee adding them back any time soon. I’ll probably be skewing allocations toward equities, commodities, and cash at the expense of bonds.
SA: Looking back at the year that was, name one ETF investment that worked out particularly well in 2010 and one that was a bust.
RR: One of my best trades in 2010 was JPMorgan Alerian MLP ETN (AMJ). My average holding time is typically measured in a few months, but I recommended this one for my subscribers back in January and we’re still holding it. They have enjoyed 25+% gains this year. Only a small part of this came from the taxable distributions of the ETN structure, so even taxable investors will get to keep most of their gains after the tax man calls. By comparison, those who chose the C-corporation structure of Alerian MLP ETF (AMLP) saw more than 37% of their price gains taken away due to the fund’s tax liabilities.
One investment that didn’t work out so well was Utilities. We moved one of our models into SPDR S&P Utilities (XLU) in late 2009 and sold in February 2010 for a loss of about 6%. It wasn’t so bad on a relative basis, but I consider it a significant loss for what should be a defensive sector.
SA: Are we likely to see a continued sell-off in fixed income ETFs into 2011? Where can income investors turn for safety while still getting a reasonable yield?
RR: Safety with a reasonable yield doesn’t come in the same package anymore. For now, at least, investors must decide which is more important and then sacrifice the other. Even Treasury bonds are only safe if you hold them to maturity. There is no significant yield at the shorter end of the curve.
High quality corporate bonds are probably the closest thing to yield-with-safety, but I would still keep the maturities relatively short. Of course this means sacrificing yield again.
Some people point to dividend-paying stocks as the best way to get income. Investors have already forgotten that dividend ETFs like iShares Dow Jones Select Dividend (DVY) fell 62% in the recent bear market and SPDR S&P Dividends (SDY) fell 54%. I doubt the average income investor wants to endure so much capital risk for the sake of a little extra yield.
MLPs continue to be one of the higher-yielding alternatives, but they are far from risk free. Convertibles have also performed well this year, but their performance is highly correlated to the equity markets. In other words, you have to give up both diversification and safety in order to get a 4% yield.
SA: Other than AMJ, are you recommending any other ‘high yield’ ETFs at present? And with the explosion of new MLP ETNs on the market, are there other MLP funds currently on your watchlist?
RR: We exited our other high-yield positions earlier this year. With the benefit of hindsight, that exit now appears to have been premature. I’m happy with the MLP exposure we currently have, so I am not looking to change or add to it at this time. If I were looking to add MLP exposure from among the new MLP products on the market, I would consider Credit Suisse Cushing 30 MLP Index ETN (MLPN) because I like its equally weighted composition.
SA: In which sectors do you expect strength in 2011 and beyond? Where do you expect particular weakness? What factors are key in coming to your investment thesis?
RR: My favorite sectors for 2011 are Technology, Energy, and Materials. Energy and Materials are tied to my belief that demand for commodities and commodity-oriented equities will remain strong due to global growth, particularly in developing Asia. Technology is the key to increasing productivity – which is something every employer in the world is trying to accomplish right now.
On the downside, I anticipate weakness in Health Care and Financials, at least here in the U.S. We are seeing a long-term trend change in health care spending, partly due to the new legislation and partly due to the sheer amount we all devote to it. It’s unsustainable, and the industry will find it hard to expand much more from here. Financials are also coming under more political pressure that will hit the bottom line.
SA: What are your expectations for commodities, precious metals and the dollar in 2011 and beyond? Will we finally start to see some real inflation in the coming year?
RR: I think we will see continued strength in commodities, although volatility will be high at times. Asia is proving it can continue to grow even with falling export demand from the West. All those new roads, airports, and buildings require a lot of raw material. Moreover, millions of people are moving from sustenance farming into a more robust diet, so I expect agricultural commodities will also stay in high demand. This should benefit equity-oriented funds like Market Vectors Agribusiness ETF (MOO) as well as direct commodities.
As for precious metals, I expect volatility to start increasing significantly. We haven’t seen a really hard fall in recent memory, which is quite unusual for gold and silver. Long-term trends are still bullish, but I think we will see a big correction first.
I expect the dollar to take a hit in real terms. We’re living in a time when the official policy of our government and central bank is to pay its bills by debasing the currency. Other countries are trying to do the same, so the dollar may hold its own on a relative basis. I think inflation is more of a question of when, not if. I thought we would see it in 2010, but we didn’t. Maybe 2011 will be the year.
SA: Let's move on to some specific issues that will affect equity returns in 2011 and beyond. In November, the Fed implemented another round of QE. Will we get a third round of fiscal stimulus in 2011? Which sectors/asset classes do you think are ideal to play the Fed's actions?
RR: I’m not sure about QE3, but any further easing will likely be more of the same. The sectors I mentioned I liked earlier were helped by QE1 & 2. If we get more quantitative easing, then I think they will continue to perform well.
SA: How does the incoming Republican House majority affect the economic outlook for the next two years? Is gridlock ultimately good or bad for equity returns?
RR: I disagree with the premise that divided government equals gridlock. I think the opposite is closer to reality. We’ve seen how a dogged minority on either side can gum up the works. When Congress and the White House are controlled by different parties, everyone is forced to share responsibility, compromise, and get things done. They may be the wrong things, of course, but calling it gridlock is just not accurate. We had this kind of “gridlock” for most of the 1990s and equity returns were pretty good then.
SA: How about the situation in the EU. Have you lightened up on European stock exposure in client portfolios as a result of continuing contagion there? Are there any bright spots you'd focus on in terms of European equity allocation?
RR: We’ve been running an international portfolio since 1994 and I can’t remember the last time we had any significant European exposure. The Nordic region seems to be a bright spot, so I’m keeping an eye on Global X FTSE Nordic 30 (GXF), iShares MSCI Sweden (EWD), and Global X FTSE Norway 30 (NORW).
SA: Can you elaborate on why you think Scandinavian equities are currently a bright spot?
RR: Again, I tend to operate more from a quantitative and technical perspective, so my comment is based more along the lines that this region has already been outperforming the rest of Europe. If you want some fundamental backdrop, I believe that Sweden and Norway’s decision to keep their own currencies has been beneficial. I also believe they are not on the hook to help bail out any other countries.
SA: Same question but for U.S. states like California and Illinois. Will a government bailout ultimately be necessary to backstop state debt as defaults pile up? Are muni bond funds something you're avoiding going into 2011, or do their significant tax benefits still outweigh the possible downside of one or more states defaulting?
RR: I think there is a lot of misinformation and emotion about municipal bonds right now. That means there are probably some good opportunities for investors with intimate knowledge of this market. I do not put myself in that category. Most of the muni ETFs are indexed, which means they have to own the bad with the good. I’ll consider them if they have good relative strength. Right now, they don’t. The average investor looking for muni exposure should focus on quality and short maturities.
SA: The U.S. housing market seems to be in the midst of another prolonged leg down. How are you playing this via ETFs? Is the commercial real estate market a better bet going forward? How much weight are you giving to REIT funds in client portfolios?
RR: Currently we have no real estate allocation in our client portfolios. The REITs that were well capitalized coming into the crisis have a chance to pick up distressed properties for pennies on the dollar. Again, this creates opportunities for some, but the REIT ETFs are indexed and have to own them all. I believe the best way to invest in real estate is through direct purchases rather than real estate securities. Unfortunately, that avenue is not available to many investors, at least not with much diversification.
SA: Finally, one of the great economic stories of our time is the emergence of China and, to a lesser extent, India as global economic powerhouses. How much weight do you recommend for emerging market ETFs in both stock and bond ETF allocations?
RR: My recommendations and allocations are dynamic and typically change every few months. Right now I don’t have any China or India funds. Other emerging markets are a different story. I’ve recommended iShares MSCI Chile (ECH) and iShares MSCI Peru (EPU). Another promising alternative is SPDR S&P Emerging Markets Small Cap (EWX). I believe MSCI currently has emerging markets at about 25% of total international exposure on a cap-weighted basis. On average, I have been significantly overweight emerging markets for a number of years. I expect to do the same for many more.
SA: Why Chile and Peru specifically? Is it simply that they have economies dominated by basic materials producers? Or is there more to this story?
RR: Again, my approach is more quantitative, so I look at various performance factors first. Three items I consider are anchored price momentum, volatility, and correlation. I believe that commodity production in these countries has been a contributing factor to their strong performance. That is also the case with IQ Canada Small Cap (CNDA), but I don’t consider it liquid enough to take positions for clients yet. Growth of the middle-class consumer is also an important factor for Chile and Peru.
Disclosure covering writer, editor, and publisher: Long AMJ, MOO, ECH, EWX, and EPU. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.