Contrarian ETF Portfolio For 2012

by: Scott's Investments

At the beginning of 2011 I featured a Contrarian ETF Portfolio for 2011. The idea is to purchase asset classes that have had multiple down years in a row. The hope is that returns will revert to the mean and the under-performing asset classes will out-perform in the subsequent year, as Mebane Faber lays out in The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets:

A down year two years in a row increases average returns about 4% but only happens about 10% of the time. Three negative years in a row result in median returns of about 30% a year...Extending the test to other assets classes shows similar results. When the past few years were negative, it is a good time to be in an asset class.

At the beginning of 2011 there were very few ETFs with three down years in a row. I noted that at least two of the ETFs on the list, GAZ and UNG, had structural issues related to contango. The third ETF on the list, JJE, was fairly illiquid. Two other ETFs, DXJ, (Wisdom Tree Japan Total Dividend), and DBU (Wisdom Tree International Utilities) were down two of the past 3 years at the start of 2011. LSC (ELEMENTS S&P Commodity Trends Indicator ETN) had two down years in a row so I also put it on my 2011 list.

Thus, 2011 did not truly capture any ETFs accurately representing an asset class with three down years, with the closest being DXJ and DBU. I tracked hypothetical returns for a portfolio of DXJ, DBU, LSC, and JJE and excluded GAZ and UNG. A starting hypothetical portfolio of $10,000 on 1/1/11 would have ended 2011 with a value of $8515, including dividends. This is a loss of -14.85%, not very good when the S&P 500 via SPY finished the year down -.95% excluding dividends; however, given the international exposure in the portfolio it performed similarly to EFA (iShares MSCI EAFE), which returned -15.49% excluding dividends.

For 2012 there is again a limited number of ETFs to choose from using a contrarian strategy which seeks ETFs with negative annual returns for 2009, 2010, and 2011. We also see many of the same names as last year:

GAZ ipath UBS Natural Gas Sub Total Return ETN
UNG United States Natural Gas
CHIX Global X China Financials ETF
LSC ELEMENTS S&P Commodity Trends Indicator ETN
JJE ipath UBS Energy Sub Total Return ETN
MNA IQ Merger Arbitrage ETF
DXJ Wisdom Tree Japan Total Dividend
UNL United States 12 Month Natural Gas
DBU Wisdom Tree International Utilities

Two names on the list, CHIX and MNA, have no return data for 2009 and MNA also has very low average volume. DXJ and DBU both had small positive returns in 2009, but are relatively liquid and better represent asset classes than the other names on the list. We also find GAZ, UNG, and UNL on the list, which, as already mentioned, have additional risks to consider due to their structure and contango risk. JJE continues to have low daily volume.

With these considerations in mind, I will track a 2012 hypothetical contrarian portfolio containing the following ETFs:

CHIX Global X China Financials ETF
LSC ELEMENTS S&P Commodity Trends Indicator ETN
DXJ Wisdom Tree Japan Total Dividend
DBU Wisdom Tree International Utilities

Re-balancing is another an easy way to gain exposure to under-performing asset classes. For example, if you have a target of 50% stocks and 50% bonds and stocks have recently underperformed causing your allocation to shift to 45% stocks and 55% bonds, re-balancing to your target weight of 50% stocks would require purchasing the under-performing asset class.

Disclosure: None

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