Back in January, the start of the credit crisis saw money managers touting large-cap, multinational stocks as a safe haven for investors. Large caps outperformed small caps last year, but this year, smaller stocks managed to claw back some ground as the financial sector slumped on indexes like the S&P 500. But Neil Michael, head of quantitative strategies at SPA ETF, says volatile markets still favor big, well-capitalized names with exposure to international markets, and outlines how his firm's indexes can keep investors from some of the more troubled bits of their index funds.
As an asset class, this is the first big downturn for ETFs. Is it tougher getting retailers interested in ETFs right now?
Yes. ETFs, especially in the space we operate in, are largely based on long-only equity portfolios and equity markets are going through a severe correction since they peaked last October. Having said that, if you're selective in terms of sector exposure, even though performance may have been negative during the drawdown, you could still have outperformed the S&P 500 by getting your sectors correct.
Which sectors are poised to do better?
Large-cap indices are rebalancing. Weightings are changing. They're moving away from financials and taking into account the rebalancing in the U.S. economy. We see a move toward sectors that are doing very well because of the very cheap dollar. The dollar is still the cheapest it's been since 1967 on a trade-weighted basis. It's making U.S. exports incredibly competitive, and U.S. multinationals very profitable. Sectors like industrial and information technology are benefiting.
Does that mean large-cap indices will do better later this year?
Going forward, as weightings of financials reduce and ratings of industrials and IT increase, that should bode well for large-cap indices, especially since large-cap stocks have a greater international footprint. They'll benefit from continued economic activity in emerging markets in particular.
Is the energy and commodity leadership in the market changing?
Energy and basic materials have been very prominent. That hinges on whether the commodity boom continues and if we are in a long-run commodity supercycle. At the moment people may think we're headed for a correction, but it depends on whether growth in emerging markets slows down significantly. I don't think you'll see a severe slowdown. Growth may slow, but it's a slowdown from an extremely high level. Therefore, commodity-based sectors like energy and materials will still do very well.
Does volatility in markets historically help large or small stocks?
Historically, large-cap stocks outperform small-cap stocks during periods of heightened volatility because investors look for visibility and stability of earnings. They find that in large-cap stocks. Maybe not in financials at the moment, but everywhere else.
Are large caps a better long-term investment than small caps?There may be short periods of time where small outperforms big, but in the long run, there's a reversion to the mean. That's what we're seeing at the moment. Since 2003, small caps outperformed, but that corrected last year. The historical spread between small caps and large caps is starting to revert. That means small caps will continue to underperform large caps until the equilibrium between the two is restored.
Describe your brand of ETFs.
Our SPA ETFs, based on the MarketGrader methodology, which is a quantitative stock-picking model that's been encapsulated in an index, have aggressively reduced their weightings to financials in the last few months and have been consistently overweight energy. The SPA ETF Large Cap has significantly outperformed the S&P 500. It's tough to create positive equity returns when markets are correcting so negatively. By getting allocation right, you can outperform on a relative basis.
Are these funds more like indexes, or more like mutual funds?
They're more similar to an active mutual fund. That's the space they're competing with. In the case of the MarketGrader Large Cap ETF, it looks at the reports of large-cap stocks and selects a basket of 100 stocks with the highest fundamental attractiveness based on things like earnings growth, price-to-earnings ratios, return on equity, profit margins, cash flow, and such like. The S&P is a capitalization weighted index. The MarketGrader is a fundamental weighted index. It rebalances fairly frequently, twice a year.