Re-Allocations of ETFs Under the Specter of Recession

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With the S&P 500 now officially in bear market territory, a major specter hanging over the market right now is the prospect of recession.  Many experts say it is now inevitable.  Morningstar’s research legend John Rekenthaler explained in a column Thursday that this bear market does not necessarily portend a recession and I agree.  An underlying characteristic of any recession is a surplus of supply without matching demand.  That said, most experts and most investors seem convinced that a significant near-term recession is inevitable.  

Between the fears of the experts and a brutal first half in both the stock and bond markets in 2022, many industry colleagues and financial advisors spent a major portion of their time trying to explain that pulling money out of the markets altogether following a 20% decline is a very bad idea  In some cases, it takes a while for some to grasp that the “safety” of keeping that money in a savings account earning less than 0.1% as inflation persists at 8% or more is not safety at all.  It is the equivalent of locking in a loss of 50% in real dollar terms within 5 years.  Therefore, even in a doom-and-gloom scenario where the bear market continues through the end of 2023 and the US GDP declines for four straight quarters, investors who anticipate needing to access part of their nest eggs within the next 3 – 10 years are better of re-allocating current fund positions than divesting. Considerations and strategies for reallocation are the focus of this article.  

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First, let’s briefly discuss investors who should not worry about reallocating.  For money that is unlikely to be needed in the next 10 years, it probably would make sense to maintain allocations to funds and ETFs based first on capital appreciation and secondarily for income and low volatility considerations. For instance, someone for whom it was age and risk-category appropriate to own something resembling a 60% allocation to Vanguard Total Market ETF, VT and a 40% allocation to iShares Aggregate Bond ETF, AGG before the current bear market is probably best off ignoring the potential upcoming recession and maintain the current course.

Investors not in this situation may wish to consider shifting some funds away from growth-oriented ETFs such as VOO and QQQ to more all-weather ETFs.  At the end of 2021 when fears of recession were surfacing, Investopedia published an article about what types of stock ETFs to own and not to own for investors expecting an economic recession.  Based on history, the article offered the following advice:

  • During a recession, most investors should avoid investing in companies that are overvalued relative to fundamentals, highly leveraged, cyclical, or speculative, as these companies tend to do poorly during tough economic times.
  • A better recession strategy is to invest in well-managed companies that have low debt, good cash flow, reasonable valuations and strong balance sheets.
  • Some industries are considered more recession-resistant than others, such as utilities, consumer staples, health care, and discount retailers. 

With these factors in mind, they suggested three top-tier ETFs to consider:

  1. The Vanguard Dividend Appreciation ETF, VIG. This low-expense ETF tracks the performance of US-listed firms that have increased their dividend payments for the past 10 years, while excluding the top 25% highest-yielding firms.
  2. The Consumer Staples Select Sector SPDR ETF, XLP. As mentioned above, Consumer Staples is considered one of the most resilient industries to own during a recession.  Demand for these goods is relatively inelastic regardless of the economic environment and the leading companies tend to be mature companies with strong balance sheets.  Its holdings are nearly all large-caps. XLP seeks to provide exposure to stocks in the following industries: food and staples retailing, beverage, food products, tobacco, household and personal products. The index is reconstituted and rebalanced on a quarterly basis.
  3. The iShares US Healthcare Providers ETF. IHF which provides well-rounded, cap-weighted exposure to US companies engaged in managed health care, facilities and insurance. This niche segment excludes pharmaceutical companies.

Taking a look at two other articles about the best pre-recession ETFs to own in anticipation of an upcoming recession, I selected two from each:

  1. The iShares MSCI USA Quality Factor ETF, QUAL. Seeking to capture higher quality stocks, QUAL tracks an MSCI index of US large- and mid-cap stocks, selected and weighted by high ROE, stable earnings growth and low debt/equity, relative to peers in each sector. 
  2. The Invesco Defensive Equity ETF, DEF.  This defensive strategy ETF mimics an active management process using a proprietary and complex four-step process taking a number of fundamental factors, probability estimates, Beta and downside price volatility into account. 
  3. The Invesco Pure Value ETF, RPV.  This indexed ETF offers pure exposure to the large-cap value space. The highest weights go to stocks with the strongest historical sensitivity to known value factors. Securities within the S&P 500 with the highest value scores based on Price/Earnings, Price/Book and Price/Sales Ratios are selected for inclusion in the index.
  4. The Pacer Cash Cows 100 ETF. COWZ is based upon the investment thesis that higher free cash flow is a mark of stability. Starting with the Russell 1000 selection universe, COWZ screens companies based on their average projected free cash flows and earnings (if available) for the next two fiscal years. Companies without these forward year estimates will remain in the index universe, however, firms with negative earnings or free cash flow are filtered out. The remaining companies are ranked according to their twelve-month free cash flow yield and the top 100 names are included in the index. 

The below analytic table compares these seven ETFs with VOO, the Vanguard S&P 500 ETF. 

Current ValuEngine reports on these ETF’s can be viewed HERE
220624 Blog table

Note: Bold figures represent best values in row for the category.

Current ValuEngine reports on these ETF’s can be viewed HERE

Observations

  1. These ETFs were recommended by experts for a pre-recessionary period, not explicitly for a bear market. However, since a bear market is thought to generally precede a recession, these were implicitly projected to stand up better than allocations to the S&P 500 during a bear market.
  2. In fact, 6 of the 7 ETFs held up better during the bear market so far than the miserable -19.9% price return registered by Vanguard S&P 500 ETF VOO.  The exception was QUAL, the iShares MSCI US Quality ETF.  At $360 Billion in assets under management (AUM), it’s the largest ETF in the sample.  Flights to quality are often characteristic of markets with increasing fears that the economy is going into recession.  The ETF’s share price has risen from demand to the point that its valuations as measured by P/E, P/B and dividend yield are all more expensive than those of VOO.  QUAL is rated an average 3 by ValuEngine models for 6-month-to-one year performance.  DEF has a great ticker symbol for a bear market potentially leading to a recession.  It also is the most diversified ETF in terms of holdings in the bunch.  Another plus is a 4 rating from ValuEngine projecting it to outperform most ETFs during the next six to 12 months.  Its historical performance has been competitive in all of the different periods, not underperforming the S&P 500 by very much in the five-year period and outperforming in the other periods.  It is another solid choice but the 0.53% expense ratio is the highest in this group.
  3. On a year-to-date basis, the best two performers were COWZ, the Pacer US Cash Cow ETF and RPV, the Invesco S&P 500 Pure Value ETF with relative year-to-date price changes of -3% and -4.2% respectively.  This is much less frightening than having lost nearly 20% of one’s equity allocation year-to-date.  The valuations of both of these ETFs are also much lower than those of the S&P 500.  Both took advantage of the market’s relative rotation from growth to value.  Both have much lower valuations than the S&P 500 and have 80% or more of their individual holdings rated as undervalued by ValuEngine.  Our predictive models, however, suggest that their outperformance runs may be nearing an end. They are both rated below-average for projected performance during the next 6 to 12 months.  That said, COWZ has been a spectacular performance even when 1- and 5-year numbers are taken into consideration showing the power of free-cash-flow yields to hold up in different market environments.  It was the only ETF in the sample to deliver a 12-month gain.  Its +2.9% one-year number trumped VOO by +15.80% or 1580 basis points which is an amazing accomplishment for such a short period.  COWZ also outperformed VOO for the 5-year period on an annualized basis by 250 basis points in a period that the S&P 500 was very tough to beat. The one desired characteristic for bear and recessionary market investors that COWZ does not provide is low volatility.  Its 5-year monthly standard deviation and Beta were the highest for the sample.
  4. XLP, the Consumer Staples Select SPDR ETF provided by State Street global advisors is the oldest ETF of the sample.  Its 3-month performance has been the best and its 12-month performance has been second-best.  This is a very stable group with the lowest Beta and Standard Deviation. This lack of market sensitivity minimizes drawdowns in most tough times for the S&P 500 Index but also generally means 50% or less upside participation in strong bull markets. A bonus is that XLP receives ValuEngine’s top rating of 5 for year-ahead price gains and our models expect it to outperform strongly during the next six-to-twelve months.  One unpleasant surprise is that this sector ETF has the worst valuation metrics, other than highest dividend yield, by a wide margin.  This is unusual and indicates to me that the market has found the stability of stocks in this sector most desirable for a rotation destination away from tech-related growth stocks. A noteworthy development, XLP’s outlier negative one-month performance reflects earnings disappointments that have been associated by analysts with the sharp spike in unexpected inflation.  That spike has prompted Fed rate raising that has also factored into rising expectations that a recession is on the way.
  5. IHF, iShares US Health Care Providers is a highly concentrated cap-weighted ETF that has held up remarkably well during bad and good times, with superior price returns in all the periods measured, Its valuation data points are superior to those of VOO. Its price volatility is higher than the S&P 500 and the third highest in the sample but its Beta is less than 1.00.  Its Sharpe ratio indicates how much return investors derive per unit of ETF volatility and is the second highest in the sample.  So, this has been a solid specialty industry ETF.  One reservation is that its 0.42% expense ratio is very high for a cap-weighted industry index, especially for the generally highly competitively priced iShares family.  That said, the performance during the past 5years could more than justify the fee, still meager compared to actively managed funds and mutual funds using the inefficient redeem-at-distributor model.
  6. Last but not least, VIG has a solid investment thesis that is particularly applicable to the current market and projected economic environments.  It is an all-weather strategy that is somewhat similar to, albeit broader than, NOBL, the ProShares S&P 500 Dividend Aristocrats ETF.  It has very competitive historical returns beating VOO handily in the 4 shortest periods and getting edged in the longest period.  It combines these positive traits with low volatility, the lowest expense ratio and the top Sharpe Ratio in the study. ValuEngine’s models also rate VIG to outperform. 
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Conclusions

The collected ETFs for shifting growth and growth-and-income US equity allocations did very well relative to VOO, the Vanguard S&P 500 ETF for the most part.  The exception was QUAL, the ETF focused on the highest earnings and balance-sheet quality ETFs.  That could be because thus far despite aggressive Fed rate hikes, the US is not yet in a credit crunch.  Should that happen, QUAL may hold up better than other broad market alternatives. DEF held up better and is rated by our models to outperform.  Its high expense ratio is off-putting but for investors needing to play defense and have good reason to fear highly leveraged and speculative companies avoided by DEF. Reallocating some growth-and-income exposure to DEF could well be something worth researching further.

Taking a look at the two most narrowly focused and market-cap-weighted ETFs, XLP focused on the Consumer Staples sector and IHF represents the healthcare industry group ETF. XLP and IHF both graded well on a performance basis.  They are also rated by ValuEngine models to outperform during the next 6 to 12 months with XLP getting the highest rating of 5.  Investors choosing to re-allocate core funds to either or both of these ETFs should understand that the relative success produced by these ETFs in the current macroeconomic, political and market environments will almost inevitably lead to opportunity costs relative to VOO in more prosperous environments and bull markets.   That does not mean that no investors should shift into these two ETFs but that they need to be aware that on a long-term basis they may sacrifice some long-term extra returns for stability, resilience, and better dividend yields.  

The Invesco Pure Value ETF, RPV, is the second best performer year-to-date and in other periods but is rated to underperform in the next 6-to-12 months.  More to the point, investors shifting core allocations to pure value need to be aware that when value is out of favor by the markets, returns will lag VOO badly.  If an investor feels confident that pure value will continue to be the pre-eminent factor for the next year or more, then allocating some core funds to RPV is worthy of consideration.  Just be aware that when these types of market preferences change, the change can be very powerful and abrupt.  Most attempts at style rotation encounter great difficulty.

Investors may wonder how COWZ, an ETF with robust relative historical performance and a solid methodology and empirically sound thesis such as free-cash-flow yield, could get ValuEngine’s lowest rating of 1 projecting it to greatly underperform the US-stock ETF universe in the next 6 to 12 months. There are several potential reasons.  Characteristics of the ValuEngine models include calibrated mean-reversion factors against certain return historical return patterns, especially if superior historical performance is not supported going forward by superior enough estimated earnings growth.  As with all models, sometimes these historically proven rules turn out to be helpful in predicting what will happen in the past year and sometimes the reverse is true.  Perhaps allocations to COWZ from core growth equity should be limited because it has greater than average volatility.  It may turn out to be a strategy that works in most environments but it is not an all-weather strategy.  

The ETF in this sample that is perhaps the closest to all-weather is VIG.  Any investor contemplating some reallocation should take a look at the sound strategy, expense efficiency and ability to be competitive in almost all historical environments that accompany this ETF.  The higher level of yield provides an additional cushion relative to VOO.  

Historically, market rotation strategies are popular with a number of advisers and some do well but at least just as many fail to outperform merely sticking with an S&P 500 ETF or with an identically priced total market ETF such as VTI.  Safety is always an important consideration but pulling entirely out of the market ensures significant loss of wealth.  This is the reason today’s column focuses on reallocation strategies.  The main investor issues on whether to attempt to reallocate core equity funds include probability of needing the funds within the next five years and personal considerations in measuring the investors’ capability to sustain medium term losses.  

By Herbert Blank
Senior Quantitative Analyst, ValuEngine Inc
www.ValuEngine.com
support@ValuEngine.com
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