iShares’ Stephen Cohen outlines four ETF strategies for an uncertain quarter

May 13th, 2013 | By | Category: Equities

Asset class performance has been very mixed so far this year with currency volatility re-awakened and softening global economic data suggesting more difficult times ahead, according to Stephen Cohen, Head of EMEA Investment Strategy & Insight at iShares, part of BlackRock.

iShares’ Stephen Cohen outlines four ETF strategies for an uncertain quarter

Stephen Cohen, Head of EMEA Investment Strategy & Insight at iShares.

He says: “Recent moves by the Bank of Japan have confirmed that central banks remain the fundamental drivers of today’s markets. This quarter, questions continue over the Fed’s ‘to exit or not to exit’ QE strategy, whilst the ECB’s OMT programme is still the psychological backstop for Europe. The divergence between the US and Europe remains stark and emerging markets have under-delivered on expectations so far this year.”

So what can investors do to manage their portfolios to better cope with this uncertainty? Cohen proposes four strategies: overweighting defensive equities and equity income; using developed market equities to access emerging market opportunities; playing Japan via a currency-hedged solution; and mitigating interest rate risk in fixed income and looking at local currency emerging markets debt.

Let’s look at each of these themes in turn:

1) Defensive equities and equity income

Broad equity valuations remain attractive but macro data has been worsening. Investors are searching for income: dividend income and minimum volatility strategies provide equity exposure with a defensive tilt.

There are numerous products in this space including iShares’ suite of minimum volatility ETFs, such as the iShares MSCI World Minimum Volatility (MVOL), Ossiam’s minimum variance ETFs, and SSgA’s range of ‘dividend aristocrats’ ETFs, such as the SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV).

2) Think developed markets for emerging markets

Emerging market equities continue to struggle and have underperformed their developed market counterparts by 10% year-to-date. Investors could look at alternative ways to play the theme such as dividend strategies which may have better risk-reward characteristics. Certain developed market large-cap companies and indices such as the DAX and the FTSE can also be attractive ways to access emerging markets indirectly.

Popular DAX and FTSE ETFs include the iShares DAX ETF (DE) (EXS1), the db X-trackers DAX UCITS ETF (XDAX), the iShares FTSE 100 ETF (ISF) and the HSBC FTSE 100 ETF (HUKX). For an emerging markets dividend play, possible funds include the iShares Dow Jones Emerging Markets Select Dividend ETF (SEDY), the db X-trackers MSCI AC Asia Ex Japan High Dividend Yield Index UCITS ETF (XAHG ) and the SPDR S&P Emerging Markets Dividend UCITS ETF (EMDV).

3) Japanese equities, but currency-hedged

Japanese equities have already rallied more than 40% since November last year on expectations that the Bank of Japan actions will compress risk premiums. They are however the most potent example of the rise in currency volatility and its impact on returns, as the Yen has weakened aggressively versus all major currencies. Japanese equities should continue to outperform other markets given the significant easing coming into the system, but a currency hedged strategy remains opportune.

Funds in this space include the db X-trackers MSCI Japan GBP Hedged TRN Index ETF (XMJG) and iShares MSCI Japan Monthly GBP Hedged ETF (IJPH) for sterling-referenced investors, and the iShares MSCI Japan Monthly EUR Hedged ETF (IJPE) and Amundi ETF Topix EUR Hedged Daily (TPXH) for euro-based investors.

4) Mitigating risk in fixed income, and looking at local currency

Bond portfolios carry more risks than in the past and more risks than many investors realise. For example, rate volatility is near multi-year highs in Europe compared to equities, and credit spread volatility still down near pre-crisis lows. So far in 2013, rate movement has accounted for a high percentage of monthly investment grade index returns – both good and bad – in the US and Europe. This situation favours interest rate hedged corporates. Another area that continues to benefit from the search for yield is emerging market debt, where local currency debt currently offers better value than external debt, especially given the duration risk of USD debt.

For interest rate hedged products, the iShares Barclays Capital Euro Corporate Bond Interest Rate Hedged ETF (IRCP), which hedges out interest rate risk by shorting German government bond futures, could prove a useful portfolio tool, as could Deutsche Asset & Wealth Management’s CDS range, such as the db X-trackers iTraxx Europe 5-Year TR Index ETF (XTXE), which allows investors to take on pure credit risk exposure. For emerging markets local currency debt, popular funds include the iShares Barclays Emerging Market Local Govt Bond ETF (SEML) and the SPDR Barclays Emerging Markets Local Bond UCITS ETF (EMDL).

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