Jack Reutemann Jr. of Research Financial Strategies in Rockville, Md., for example, avoids market-cap-weighted ETFs that follow the S&P 500 index because he says they have a strong large-cap bias and are swayed by the returns of the 100 largest companies. "Large companies have thinner profit margins than smaller ones, their products are mature, and they are overbought by the mutual funds," he says. "And historically, their stocks have not performed as well as mid-caps and small caps."
Instead, to spread investments more evenly, he uses the Rydex S&P Equal Weight fund (RSP), an equal-weighted version of the S&P 500, as a core position. Over the five years that ended in the first quarter of this year, this equal-weighted index was up an annualized 4.37% while its market-cap-weighted S&P 500 cousin rose only 1.92%. For the year, the equal-weight index fund was up 75%, while the market-cap-weighted fund rose only 50%.
Advisors might also use less-well-known indexes to emphasize particular areas of the market. Paul Frank, manager of the $60 million ETF Market Opportunity Fund, has been migrating from large caps into mid-caps because he believes the latter may be acquisition targets for larger, cash-rich companies looking to expand. He implements this strategy using the MidCap SPDR Trust fund (MDY) and the Revenue Shares Mid Cap fund (RWK).
Harry Clark, president of Clark Capital Management in Philadelphia, believes that with the economy in expansion mode, small and mid-cap stocks will outperform large caps through the end of the year. To emphasize the value side, which he says is showing better relative strength than growth, he uses the iShares Russell Mid-Cap Value ETF (IWS) and the iShares Russell 2000 Value Index ETF (IWN).
Add to cyclical holdings. Standard & Poor's equity investment strategist Alec Young sees a number of signs pointing to a continued economic recovery rather than a double-dip recession. "The global yield curve is steeply sloped, and historically that has been a predictor of stronger economic growth ahead," he says. "While housing and employment numbers are improving slowly, the stock market seizes on direction, not absolute levels. And rapid growth in China is offsetting slow growth in Europe." Any market pullbacks during the year should be viewed as a buying opportunity rather than a longer-term sign of things to come, he adds.
With a recovery scenario in mind, Young recommends lightening up on ETFs in more defensive sectors such as utilities, telecommunications and consumer staples. On the other hand, he believes cyclical industrials will do well as the economy improves. He also favors information technology companies because they are cash-rich and stand to benefit from pent-up demand for system upgrades. Tech stocks are also selling at a slightly higher premium to the overall market, he says, yet have much better prospects for earnings growth. ETFs that focus exclusively on technology include the iShares Dow Jones U.S. Technology fund (IYW), the Technology Select Sector SPDR fund (XLK) and the iShares S&P North American Technology fund (IGM).
Look for continued weakness in Europe. For most of last year, the dollar weakened against the euro, boosting returns from overseas markets in Europe. But more recently a strengthening dollar, along with the flailing economies in Greece and other southern European countries, has sucked some of the wind out of European markets. Thus, the MSCI EAFE index has trailed domestic market performance since the fourth quarter of last year, mirroring the lag in all developed international markets. The further stabilization of the dollar, along with weak economic growth, points to persistent headwinds in Europe this year.
Emerging markets are a different story, Young argues. Even though stock markets in China have lagged the U.S. so far this year, that economy and others in the emerging space continue to see solid growth. Young recommends investors seek diversified ETFs following broad emerging market indexes rather than one of the numerous single-country opportunities and frontier offerings popping up in recent years. "Returns are all over the board in emerging market countries, and if you don't pick the right box to land on, it's easy to get burned," he says. Popular broad-based emerging market ETFs include the iShares MSCI Emerging Markets Index Fund (EEM), the PowerShares FTSE RAFI Emerging Markets Portfolio (PXH), the SPDR S&P Emerging Markets ETF (GMM), and the Vanguard Emerging Markets ETF (VWO).
Protect against rising interest rates. While the Fed continues to rein in short-term rates, many believe the bellwether 10-year Treasury bond's rate rise to 4% in April could portend increases at the shorter end of the yield curve. Currently, the fed futures markets say there's a 75% chance the Fed will raise the short-term fed funds rate by November 2010.
In this kind of environment, stocks tend to do better than bonds, observes Liz Ann Sonders, chief investment strategist at Charles Schwab. Six months after the first rate hike, she says, stocks usually trade flat before heading up again. In the six months before a rate hike, bond returns begin moving into negative territory. After the rate increase, bond prices consistently move downward.