ETFs In Focus: QUAL Looking Attractive; A Dividend Aristocrat ETF To Avoid; AWTM An Intriguing New Yield Enhanced ETF

by: Dave Dierking, CFA

The momentum and low volatility factors have traded leadership over the past two years, but the quality factor is looking the best at the moment.

Retail sales numbers look disappointing, but don't abandon the Online Retail ETF yet.

KNG is targeting a 5% dividend yield from dividend aristocrats, but it's not living up to its promise so far.

AWTM is a new yield-enhanced bond ETF that targets a 1% yield premium above T-bills. It has the look of a winner if it can grow a bit bigger.

I'll offer trade recommendations for each ETF on the list and discuss if/how each could fit into our model portfolios.

Note: This article was first released exclusively to ETF Focus subscribers 2 weeks ago.

The "ETFs in Focus" list is used to highlight ETFs that I feel are short-term trade opportunities. As such, these ideas may be more appropriate to those investors looking to be more active traders in their portfolios, but I'll also discuss how they could fit into our ETF Focus model portfolios (which tend to have more of a buy-and-hold strategy). You'll get an idea of how it'll work as you read through this week's article but, as always, feel free to reach out with any questions or concerns.

Let's take a look ahead at the ETFs to watch over the next few weeks!

The Equity ETF Idea

You probably saw the news this week that U.S. retail sales in the 4th quarter came in way below expectations dropping by 1.2% in what was at least thought to be a healthy-looking holiday season.

There are two ways to look at this number - as a one-off event or as the potential beginning of a larger trend. Several pundits were clearly caught off guard by the number, given the economic backdrop and considering that holiday sales figures generally painted the picture of a relatively healthy buying environment. Should this just be considered some kind of fluke, and should we be paying more attention to the larger economic picture?

On the other hand, the global economic slowdown is real as we've already seen with results coming out of Germany, Italy, and China. Q1 earnings estimates for S&P 500 companies are getting cut to the point where year-over-year growth is expected to turn negative. The Fed has already effectively halted rate hikes for the foreseeable future in order to prevent the chances of recession. Are investors feeling less optimistic about their personal financial situations?

The fund I want to focus on when answering these questions is the Amplify Online Retail ETF (IBUY). Traditional retail businesses have continued to struggle, but companies that conduct most of their sales online have done pretty well. IBUY has outperformed the SPDR S&P Retail ETF (XRT) by an 86% to 4% margin since IBUY's inception in early 2016 and clearly remains the segment with the most opportunity going forward.

Here's what I think of when I look at this number. It's at least partially shutdown affected. We know that the number of furloughed federal workers in relation to the overall workforce is relatively low, but these folks were going without pay for what at the time appeared to be an indefinite period. It's difficult to assess to what degree the shutdown impacted these numbers, but now that the shutdown is over, it's reasonable to think that these numbers could rebound. Also, I look at the overall state of the economy. Unemployment is low, wages are growing nicely, and consumer sentiment figures still remain well above long-term averages. Throw in very muted inflation expectations and everything looks pretty positive for the retail consumer.

Recommendation: Hold

Model Portfolios It Could Be Considered For: None

I think if you look at the big picture, the decline in December retail sales looks more like an aberration than a trend. The economic environment for consumers still looks strong, and most other data suggests that people are still feeling financially comfortable. With the shutdown behind us, I'd expect a boost in the near future.

That being said, I'm not sure I'd be adding to positions here. There are still some concerns about economic growth going forward, and there's a bit of a ceiling in place until we get a sense of how the U.S./China trade situation resolves itself. IBUY still looks a bit more attractive than not here.

The Fixed Income ETF Idea

If you're looking for the top-performing fixed income ETF group of 2019, it's junk bonds (narrowly edging out emerging markets government bonds and long-term corporates). The Fed's halt on rate hikes and an economy that still shows low unemployment and good wage growth have investors hungry for risky assets again after last year's late selloff. But given the global economic backdrop, junk bonds seem like a poor choice.

I could probably repeat what I said earlier about weakness in China and the Eurozone along with trade concerns, but any of those factors could have investors seeking safer harbors if they flare up. As potential recessionary fears grow, investors could ultimately flee junk bonds and in a big way.

The four biggest junk bond ETFs - the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the iShares 0-5 Year High Yield Corporate Bond ETF (SHYG), the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) and the SPDR Bloomberg Barclays Short Term High Yield Bond ETF (SJNK) - have taken in more than $3 billion in new money between them as investors seek to capture above-average returns. Spreads on junk debt have come down considerably in 2019 to the point where it looks like a lot of the upside has already been captured.

Recommendation: Avoid

Model Portfolios It Could Be Considered For: Target 5% Yield Portfolio, Monthly Dividend Income Portfolio

I currently have short-term junk bond ETFs as small positions in each of these long-term portfolios. It's in Monthly Dividend Income as a diversifier and in Target 5% Yield for its high dividend. In actively managed portfolios, I wouldn't be adding junk bonds here.

The International ETF Idea

The troubles in the Eurozone are well documented. Eurozone economic sentiment just dropped for the 7th straight month and now sits at multi-year lows. Italy is already in the midst of a recession. Brexit still has no certain outcome. Now, Germany is headed in the same direction. Germany just reported the slightest of growth output gains in the 4th quarter of 2018 at 0.02%. Following on the heels of Q3's 0.2% contraction, it avoids meeting the traditional definition of a recession by the narrowest of margins.

For all intents and purposes though, Germany is pretty much in a recession. Retail sales dropped by more than 4% in December compared to last year, and general economic weakness continues as troubles in China and other Eurozone nations persist. The iShares MSCI Germany ETF (EWG) is down about 17% over the past year and is roughly 24% below its all-time highs.

The natural reaction here is to avoid the country, but I'm not so sure that's necessarily the way to go. The European Central Bank concluded its program in December, but rumors swirl that it may be prepared to restart it again should the numbers continue to look weak overall. We need to look no further than the Fed's pivot towards a more dovish stance to see how positively equities can react to fiscal stimulus. There's undoubtedly still risk, but much of that may already be priced in. The possibility of further assistance could mean there's more upside than downside to EWG right here.

Recommendation: Wait and see with a lean towards buy

Model Portfolios It Could Be Considered For: None

Turkey is another good example of buying when things still look dark. It's still about 38% below its all-time high, but it's also gained 47% since its August 2018 lows. It's impossible to predict when a bottom might actually be in, but with a P/E of just 12 right now, EWG might be interesting target for those willing to take a swing.

The Dividend ETF Idea

With Treasury yields drifting back downwards again and the S&P 500 (SPY) still yielding a meager 1.9%, investors are once again looking for ways to boost the yield coming from their portfolios. I came across an article a while back recommending the CBOE Vest S&P 500 Dividend Aristocrats Target Income Index ETF (KNG) as a high yield equity option. I've studied this ETF since it debuted nearly a year ago, and I have to disagree.

KNG starts targeting the dividend aristocrats from the S&P 500 (defined as those that have increased their annual dividend for at least 25 consecutive years). In order to enhance the fund's yield, it writes covered call options on a portion of the stocks it holds in order to generate an overall yield 3% above that of the S&P 500. It sounds like a reasonable strategy on the surface. The aristocrats are among the sturdiest and healthiest companies in the world. The idea of generating a roughly 5% yield from this group (the ProShares S&P 500 Dividend Aristocrats ETF (NOBL) offers a yield of about 2.3%) seems pretty appealing. Dig a little deeper and you get a bit of a different story.

I get cautious immediately when I hear of ETFs that offer target or guaranteed yields (the Strategy Shares Nasdaq 7HANDL Index ETF (HNDL) is another). If the fund generates enough income to meet its yield target then there aren't any issues. But it often doesn't, and when that's the case, the fund executes a return of capital to make up the difference. ROCs are destructive to the fund's share price and ultimately show up in the total returns.

Sure enough, take a look back at KNG's short history, and we have a return of capital distribution.

This is from June's quarterly distribution. A full 59% of the total distribution was return of capital. On top of that, KNG's annualized yield currently stands at 4.3%, short of its 3%-above-S&P 500-yield target. Option writing isn't a cheap strategy either. The fund's expense ratio of 0.75% is also unpalatable making it even more difficult to achieve its target, given that the yield is net of expenses.

Recommendation: Avoid

Model Portfolios It Could Be Considered For: None

The temptation would be to consider KNG for a spot in the Target 5% Yield Portfolio, but I'm not ready to make that leap yet. KNG is still less than a year old, so perhaps it needs a little more time to work out some of its issues and grow its asset base a little larger. The high expense ratio, the inability to hit its yield target and the return of capital distributions make this one you should stay away from for the foreseeable future.

The Smart Beta ETF Idea

While it's generally accepted that there are five major investment factors in all - size, quality, low volatility, momentum, and value - the two that tend to get the most attention are momentum and low volatility. Momentum was the clear winner in 2017 and into 2018 before low volatility took leadership during the second half of the year. Investors may be weighing the two again as we make our way through 2019 (after the surprise rebalance that the iShares Edge MSCI USA Momentum Factor ETF (MTUM) executed last month, the two are starting to look more alike anyway), I think it's a different factor that may serve investors better right now.

The iShares Edge MSCI USA Quality Factor ETF (QUAL) identifies and invests in large- and mid-cap companies based on three fundamental variables - high return on equity (ROE), low earnings variability, and low leverage. These variables, both individually and collectively, have delivered market-beating returns over time.

Companies with the highest ROEs tend to produce the biggest performance gains relative to those with the lowest ROEs, but the quality factor overall (defined as the combination of the three) does even better.

Quality has been the forgotten factor in a market environment that's been dominated by growth stocks, but investors may finally be warming up to the idea. Year to date, QUAL has gained more than $1.8 billion in new assets, putting it just outside the top 10 among ALL funds this year. Part of that is thanks to an increased focus on financially healthy firms in a volatile market, but part of it is also performance-related. QUAL has returned 12% year-to-date compared to an 11% return for the S&P 500.

You can generally feel comfortable buying the types of companies owned by QUAL at just about any time, but now might be an attractive time, especially to consider loading up. The portfolio isn't especially cheap (its P/E ratio is about on par with the S&P 500), but investors could be inclined to initiate the proverbial "flight to quality" (no pun intended) if economic activity slows.

Recommendation: Buy

Model Portfolios It Could Be Considered For: Core Conservative Growth Portfolio

QUAL could easily slide into the core segment of most portfolios as its 0.15% expense ratio makes it attractive. The fund's yield of 1.8% probably doesn't make it a replacement for at least some of the dividend ETFs in our model portfolios, but taking a part of an S&P 500 or total stock market ETF allocation and putting it towards QUAL makes sense as a potential way to tilt your portfolio.

The Brand New ETF Idea

With treasury bills now yielding somewhere in the area of 2.4%, cash is no longer the zero-return investment it used to be. Still, I think there are good ways to improve upon the yields you can earn on the most conservative segment of your portfolio. That's why I'm fairly interested in the new Aware Ultra-Short Duration Enhanced Income ETF (AWTM).

AWTM advertises itself as an actively-managed treasury management ETF. The goal is to target a yield of 0.75% to 1.00% over the 3-month treasury bills, which would put the fund currently at around 3.35%. According to the fund's prospectus, AWTM invests in U.S.-dollar denominated investment-grade fixed- and floating-rate bonds, debt securities, and other instruments with an overall effective duration of less than one year under normal circumstances. That means credit quality is high, interest rate risk is low, and share price movement on a daily basis should be relatively minimal.

I tend to like funds such as these because I think there's a good opportunity to get a significant yield boost with relatively little additional risk. Most of the portfolio is invested in short-term investment grade corporates, but it also gets balanced with Treasuries and other securities.

A full one-third of assets go to AAA-rated bonds, but there's also a significant chunk residing in the lower rated A and BBB categories. Some may be concerned with 50%+ allocation to these notes, but default rates are still very low, and diversification within the portfolio will make any potential impact negligible.

Recommendation: Wait and see

Model Portfolios It Could Be Considered For: Monthly Dividend Income Portfolio

The fund's duration of 0.7 years and yield of 3.35% make this an ideal risk/reward tradeoff for those interested in making a small move away from purely T-bills. I don't know if I'd consider this as a cash alternative since there's a bit more risk involved, but I think this has the potential to be a viable candidate for income portfolios. I would hold off now until the fund builds a bigger asset base and trading costs come down, but keep this one of your radar.

The Bonus ETF Idea

I own the ETFMG Alternative Harvest ETF (MJ), aka the Marijuana ETF, in my personal portfolio, but I've started to trim my position (as I detailed here earlier). MJ is up about 41% year to date and about 50% since the Christmas Eve lows.


Data by YCharts

Marijuana stocks are going to be overvalued by any traditional measure, but even by their lofty standard, they're starting to look pricey. I'd encourage you to check out the link above to get the full breakdown.

Recommendation: Reduce

Model Portfolios It Could Be Considered For: Core Conservative Growth Portfolio

I only mention it's a consideration for the Core Conservative Growth Portfolio in that I have a 7% allocation dedicated to sector and thematic ETF picks that balance out the conservative dividend ETFs that dominate it. Right now, the portfolio holds positions in tech and MLPs but a high risk/high return potential ETF such as MJ could easily slide in here. Beware of adding it at these lofty levels, though.

Disclosure: I am/we are long MJ. 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.