Where to Invest $10,000 Right Now

Five experts reveal the opportunities they see around the world.
Illustration: Steph Davidson
By Suzanne WoolleySuzanne Woolley

Another three months, another nice run for the S&P 500 Index, which rose 4 percent in the year’s third quarter. That jump came in the wake of last quarter’s talk about a “frothy” market and an aging bull.

The market’s continued gains can make being cautious—moving some money out of stocks into cash, sitting on the sidelines—feel particularly painful. But if investors are getting jittery, well, October 19 marks the 30th anniversary of the 1987 crash, and October is a month known for nasty surprises.

That shouldn’t mean a heck of a lot for investors who have well-diversified portfolios and the financial basics well in hand—a savings plan on autopilot and a healthy financial emergency fund, for example. Well-prepared, long-term investors are in a good position to weather whatever October may throw at them. Check out The Seven Habits of Highly Effective Investors.

The five investing experts featured in this quarterly series have survived many stock market cycles, and just one sounds a note of caution this time around. They see opportunities across a broad spectrum, stretching from health-care plays in China to battered value stocks; a couple are doubling down on previous calls. To see what they’ve recommended over the past year or so, click on one of the tabs below their names. 

The strategies and investing themes that our experts suggest can be found in the mutual funds or investment portfolios some of them manage for clients. For do-it-yourself investors who like to use exchange-traded funds, Bloomberg Intelligence analyst Eric Balchunas chooses ETFs that are plays on the experts’ investing ideas and sums up the performance of the ETFs he highlighted in last quarter’s entries.

Here’s hoping for a boring October.

Richard Bernstein

Chief executive officer, chief investment officer, Richard Bernstein Advisors

It’s Simple: Overweight Equities

The 2008 bear market and recession appear to have permanently damaged investors’ psychology. Despite the ongoing bull market, investors generally remain quite scared of a market sell-off. Although some surveys are beginning to show increasing enthusiasm for stocks, actual public equity allocations among individual investors, pensions, endowments, foundations, and hedge funds remain more focused on limiting the downside risk of public equity holdings than on potential opportunities.  

Individual investors’ seemingly insatiable thirst for income more likely reflects risk aversion than demographics. Despite an extended period of very low equity market volatility, pensions, endowments, and foundations remain scared of public equity volatility and prefer illiquid and more expensive alternative assets. Even hedge funds have rejiggered strategies to focus on “absolute return” and “low net” rather than accept the risk associated with levered long-equity portfolios.  

From 1926 to the present, the S&P 500 has produced positive 10-year returns 95 percent of the time, and positive five-year returns 88 percent of the time. Even quarterly returns have been positive 68 percent of the time. To myopically focus on the downside risk of public equities seems to be fighting history.  

Some have argued that stocks are in an extended period of low returns, but the 10-year S&P 500 total return through September 2017 was 7.4 percent a year. That return is indeed below the 10-year median return of roughly 10 percent, but it does not at all suggest investors should punt equity allocations. The decade ending in December 2010 was actually the period of low returns. The S&P 500 returned a paltry 1.4 percent over that period. Since 2010, it has returned about 13 percent a year vs. bonds at 3.3 percent. Shouldn’t investors have significantly reallocated toward the superior returns of equities at some point in this cycle?

Investors should ignore the noise about short-term volatility and imminent market collapse and get back to the basics of asset allocation. My guess is that very few readers are significantly overweight public equities within their portfolios. Where to invest?  Equities, plain and simple. 

Way to play it with ETFs: The way most investors are buying equities in one shot with ETFs is via the iShares Core S&P 500 ETF (IVV). It serves up the S&P 500 Index for a fee of 0.04 percent. This simple strategy for a microscopic fee is why it leads all ETFs in year-to-date flows by a country mile.

Performance of last quarter’s ETF plays: Balchunas suggested the Vanguard Consumer Discretionary ETF (VCR) as a way to play Bernstein’s strategy last quarter. The ETF gained 1 percent.

Favor Cyclicals Over “Disrupters”

Today seems like a mini version of 1999.  Back then, investors thought the only sector for growth was TMT (technology, media and telecom) and bid those stocks to ridiculous valuations, even though the average S&P 500 company was increasing earnings by nearly 20 percent. Buying supposed growth companies with astronomical valuations might remotely make sense during a recession, but it proved ludicrous in an environment of accelerating growth. TMT’s bogus growth forecasts eventually gave way to the actual earnings growth of companies operating in the real economy.

Today, investors have rushed to the “disrupters,” which, just like the internet stocks of the late 1990s, are promising out-of-this-world growth. “Out of this world” is not a figure of speech—three companies are vowing to go to Mars. Meanwhile, the average forecast earnings growth rate of companies here on Earth is more than 20 percent (based on the constituents of the MSCI ACWI index, the All Country World Index).  

The disrupter companies have feasted on the Federal Reserve’s low interest rates. Investors can easily speculate when the risk-free rate is close to zero percent. These companies will have to produce earnings and cash flows as the Fed raises interest rates and the companies’ cost of capital is no longer free.  

History suggests that traditional cyclical companies tend to outperform when the interest rate cycle heats up. Companies with accelerating earnings and cash flows have the ability to win the tug of war against the negative effects of rising rates. 

Despite the post-election disappointment over Washington policy and the resulting underperformance of cyclicals, these stocks seem attractive relative to disrupter stocks. Earnings are still revving up, and the Fed seems intent on raising rates.  Accelerating reported earnings growth and rising interest rates have never been a good combination for dreams of a utopian future.

Way to play it with ETFs: The Vanguard Consumer Discretionary ETF (VCR) is cheap, deep, and liquid. It’s a good buy-and-hold sector ETF while you wait for rates to rise.

Performance of last quarter’s ETF plays: For ways to play Bernstein’s interest in inflation-sensitive assets, Balchunas cited the Materials Select Sector SPDR Trust (XLB US) and the Financial Select Sector SPDR Fund (XLF). The ETFs gained 3.2 percent and 4.2 percent, respectively. The Energy Select Sector SPDR Fund (XLE) fell 6.6 percent.

Get Ready for Inflation

The past nine years’ financial markets have been dominated by deflationary pressures, both within the U.S. economy and emanating from the global economy. The trend has lasted so long that investors generally consider deflation the norm. They have finally accepted the “new normal” as, well, normal.

The global economy is changing, however, and investors should be considering whether the era of global deflation might actually be ending. Data from around the world are beginning to show distinct improvement, suggesting portfolios should be geared for inflation rather than for deflation.

U.S. inflation expectations, measured by TIPS [Treasury inflation protected securities] spreads, actually troughed in February of 2016 (i.e., a year ago). [The TIPS spread compares the yields on a TIP and a U.S. Treasury of the same maturity.] Spreads in the United Kingdom, Germany and Japan have shown similar patterns. Headline inflation in the U.S. has risen from -0.2 percent roughly two years ago to 2.5 percent through January 2017. The ISM Prices Paid Index has more than doubled since the beginning of 2016, meaning that twice as many supply-chain managers report paying higher prices. The University of Michigan consumer forecasts of 12-month inflation may be breaking its multiyear downtrend.

Recent public policy is also signaling upward inflation risks. Trade tariffs (politically called border adjustment taxes), tight labor markets and the potentially potent cocktail of tax cuts, deregulation and fiscal spending, mixed with a nonrecessionary economy, all could be inflation fillips.

Despite this changing backdrop, investors still focus on investment themes that tend to outperform during periods of deflation, such as high-quality equity income, defensive sectors and traditional fixed income. Textbook investing during periods of accelerating nominal growth (i.e., real growth + inflation) says that investors should do the exact opposite. They should overweight lower-quality and more cyclical sectors such as energy, materials, and financials. Fixed-income investors typically need to shorten the duration of their portfolios significantly, and gold and gold miners could outperform. Our multi-asset portfolios have had these progrowth characteristics for nearly a year.

Whether we are seeing a cyclical pause in deflation or the beginning of a new era of inflation, U.S. and global data are increasingly directing investors toward inflation-sensitive assets.

Ways to play it with ETFs: Investors can play energy, materials and financials by using any number of sector ETFs. For the most basic exposure in a cheap, liquid product, the sector SPDRs work well. In this case, that would translate to the Energy Select Sector SPDR Fund (XLE) , the Materials Select Sector SPDR Trust (XLB US)  and the Financial Select Sector SPDR Fund (XLF) . All of them charge 0.14 percent.

Performance of last quarter’s ETF plays: The ETFs Balchunas chose for Bernstein's entry last quarter were the iShares Core S&P Small-Cap ETF (IJR)  and the iShares US Consumer Services ETF (IAU) . They rose 1.1 percent and 7.3 percent, respectively, over the three months ended Mar. 31.

Play the Cycles

There's an old saying that it’s “chess, not checkers,” which implies that a situation is quite complicated. When it comes to investing today, we view it more as checkers, not chess, because what's happening seems quite straightforward.

In my 35-year career, there has never been a time when the U.S. economy was approaching the eighth year of an expansion and Washington began proposing significant fiscal stimulus. That has probably never happened in the post-war period. Sizable fiscal spending programs typically start at the depths of a recession, when excess capacity in the economy cannot be filled by private sector demand.

Today, the economy is healthy, albeit not booming, and recession-induced overcapacity is harder to find. Labor markets are relatively tight, and real income and corporate profit growth have begun to accelerate.

In addition, global economic data suggests the post-bubble deflation may be ending. Inflation expectations in the U.S., the United Kingdom, Germany and even Japan have been rising for nearly a year. Pricing power, although still minuscule, seems to be gradually returning. Also, leading indicators around the world are beginning to accelerate.

This backdrop suggests that global nominal growth is poised to accelerate. Our portfolios are overweight sectors and countries that are highly cyclical and have embedded operating and financial leverage: small-caps, lower-quality companies in cyclical industries, emerging markets and gold.

The combination of a healthier global economy and U.S. fiscal stimulus might be good for stocks and a nightmare for fixed income. Our fixed-income portfolios have extremely short duration (about 33 percent of benchmark duration). We see potential for a bearish steepening of yield curves in response to accelerating nominal growth and because of fixed-income investors’ over-enthusiasm.

The summer of 2016 may have been the bond market’s March 2000, when equity investors recklessly bought technology shares, whose valuations were extreme. Bond investors flooded into bond funds and ETFs in 2016, when the overall bond market’s duration (interest rate sensitivity) was the longest in history.

Given the unprecedented proposals to add significant stimulus to a healthy economy, our portfolios have been focused on investments that traditionally outperform when nominal growth accelerates: cyclical stocks, short-duration bonds, and gold.

It’s checkers, not chess.

Ways to play it with ETFs: For small-caps, the iShares Core S&P Small-Cap ETF (IJR)  is the fastest-growing small-cap ETF and costs 0.07 percent. For gold exposure, the iShares US Consumer Services ETF (IAU) , which physically holds the gold in vaults in New York, London, and Toronto, is ideal for retail investors, due to its liquidity and its low fee of 0.25 percent. (Since this is Bernstein’s first time in the quarterly Where to Invest $10,000 series, there is no performance tally from last time.)

Sarah Ketterer

Chief executive officer and fund manager, Causeway Capital Management

Invest in China’s Health Care Demand

Shifting from an emerging to a developed country, China can’t escape its demographics. As a byproduct of the one-child policy, China’s enormous population increased at only 0.6 percent per year from 1996 to 2015. That compares with the U.S. population’s expansion of 0.9 percent a year over the same period.

Low growth implies an aging population, and aging has its societal costs. Many Americans are struggling to pay for health care, and the Chinese are facing an even bigger tab. By 2050, roughly a quarter of China’s citizens will be older than age 60. With less than 6 percent of gross domestic product spent on health care (vs. 9 percent to 12 percent in most developed countries), the Chinese will likely devote more of their resources to staying healthy.

With rising disposable income per capita, China’s demand for health care, especially top-tier hospital services, exceeds supply. The central government recognizes the problems and aims to relieve congestion at the most reputable public hospitals by welcoming private capital into the industry. This flow of funds should improve conditions and spawn many higher-quality private hospitals. Other reforms include the elimination of unneeded middlemen in drug distribution, as well as prohibiting the markup of drug and medical devices.

Hospitals had become heavily dependent on drug sales to keep the lights on. To supplement their measly salaries, doctors accepted prescription-related bribes from pharmaceutical manufacturers. After a successful pilot program, zero markup of drugs became reality for most hospitals across the country this year. To speed up the approval process for efficacious drugs, the China Food and Drug Administration quadrupled its staff in 2015-16 and is on track to increase staff by 50 percent this year.

China’s health-care industry reforms, combined with the inevitable consolidation or demise of smaller or weaker players, will likely result in much greater efficiency and profitability in such areas as hospital management, drug and medical equipment distribution, private supplemental health insurance, and new-drug discovery and launch.

To complement reforms, the Middle Kingdom boasts a rising supply of young scientific talent, who are paid about a third as much as their peers in the developed world. Add to the mix a 15 percent corporate tax rate plus government subsidies to spur innovation, and the investment landscape looks very promising for Chinese health-care companies. (The standard Chinese corporate income tax rate is 25 percent, but the rate could be reduced to 15 percent for qualified enterprises engaged in industries encouraged by the Chinese government. Indigenous Chinese health-care companies are included in that category.)

Way to play it with ETFs: There are many China ETFs but none specific to the health-care sector, and most broad China ETFs have next to nothing in health-care exposure. The ETF with the most exposure to health care is the Global X China Consumer ETF (CHIQ), which has about 8 percent of its assets in the sector.

Performance of last quarter’s ETF plays: The Energy Select Sector SPDR Fund (XLE) rose 5.6 percent in the quarter ended Sept. 30. Top holdings Chevron Corp., Schlumberger Ltd., and Exxon Mobil Corp. rose 12.6 percent, 6 percent, and 1.6 percent, respectively. 

Fuel Up on Energy

Buy high-quality energy. Investor skepticism weighs heavily on the sector, making this one of the more promising areas in this mature bull market.

Oil and gas companies exhibit cyclicality in sales and earnings, traits that investors have shunned in recent years in favor of steady growth. Relative to high-flying technology stocks, the recent performance of energy equities looks abysmal. Over the past 12 months, global energy indexes have underperformed global technology by more than 30 percent and are trading at a sizable valuation discount.

The forces of supply and demand dictate the price of semiconductors as well as oil, with the lowest marginal cost producers having a distinct advantage over the competition. Advertising, including the internet, also has a cycle. The last time markets ignored the cyclicality of technology was in the late 1990s, a rough period for the most overvalued stocks.   

Investors may be worried about a global glut of crude oil, especially from rising U.S. shale oil production. U.S. shale productivity continues to surprise on the upside, especially in the Permian Basin. As marginal costs have fallen from 2014, oil producers have increased wells and drilling volumes. The threat of a possible lack of OPEC production discipline also clouds the oil price outlook.

But exploration and production costs have recently turned upward in pressure pumping, sand, rail, trucking and labor. Oil-producing nations, including OPEC members as well as U.S. shale producers, cannot afford to spend more cash than they generate. As industry profits get squeezed, oil and gas companies’ credit ratings deteriorate, constricting lending to energy. At current spot prices, the world’s oil and gas industry doesn’t generate enough cash flow to sustain the spending required to expand capacity. In U.S. shale, production volumes per well decline particularly rapidly without additional investment. 

On the demand side, the energy industry will not thrive in a recession. But technology doesn’t fare well in that scenario, either. Expect at least two more decades of rising demand for crude oil and gas, as electric vehicles will only gradually substitute for gasoline. 

Look for companies with productive acreage and experienced management, financial strength, and cyclically low valuations. As the crude oil price recovers—perhaps approaching $60 per barrel, with natural gas reaching $3.25 per thousand cubic feet—energy sector share prices should prove rewarding.

Way to play it with ETFs:The Energy Select Sector SPDR Fund (XLE) is high-quality energy. Top holdings Exxon Mobil Corp., Chevron Corp., and Schlumberger Ltd. make up more than 40 percent of the portfolio. There’s a liquid market for the ETF, and it's cheap, with a fee of 0.14 percent.

Performance of last quarter’s ETF plays: The SPDR S&P International Health Care Sector ETF (IRY) was Balchunas’s pick as a way to play Ketterer’s focus on big pharma companies selling at a discount. It returned 7.9 percent from Mar. 31 to June 30. 

Buy the Pharma Discount

Why do several of the large global pharmaceutical stocks trade at above-market dividend yields and below-market price/earnings ratios? Perhaps the repeated threats by President Trump to cut drug prices have scared investors.

The president will likely claim victory for something that is already happening. The large buyers of U.S. pharmaceuticals, such as pharmacy benefit managers and health insurers, continue to exert tremendous pressure on drug companies to discount prices. This is evident in 2016 data from Express Scripts that show year-on-year price percentage shrinkage in traditional pharmaceuticals and a slowing, mid-single-digit percentage increase for specialty drugs.

Importantly, utilization growth rates are greater than unit cost rises, indicating product efficacy. If the drugs weren't effective, doctors wouldn't prescribe them. Assuming buyers will pay for efficacious drugs, then the prognosis for the more innovative pharmaceutical companies is good.

Notably, several of the European drug giants with promising pipelines trade at valuation discounts to the health-care sector and to their own historical averages. Examples include Novartis AG, AstraZeneca Plc, Roche Holding AG and GlaxoSmithKline Plc. These well-managed, shareholder-friendly companies generate plenty of surplus cash to reward investors. Many of them have dividend yields at least a full percentage point in excess of the global pharmaceutical and biotech industry and well above overall equity market averages.

Famously profitable, the best-managed pharmaceutical companies should be able to offset reduced unit prices with volume growth. In their report dated January 2017, Evercore ISI analysts Umer Raffat and Akash Tewari note that most of Medicare/Medicaid spending increases are due to higher enrollment, not because of pharmaceutical costs. While total U.S. health-care spending continues to increase, the percentage attributable to prescription drugs has stayed flat, at around 10 percent.

Proposed drug pricing reforms, such as bidding, reimportation, Medicare negotiating prices and value-based pricing either already exist or have serious, likely insurmountable flaws, such as public safety. Even Medicare, the colossus of U.S. pharmaceutical buyers, probably can't negotiate prices more favorable than under current law without being forced to restrict access, as drug demand may rise. Aging demographics imply increased drug usage over at least the next decade. The most innovative pharmaceutical companies will likely benefit, even as traditional branded drug prices fade.

Ways to play it with ETFs: The  SPDR S&P International Health Care Sector ETF (IRY) has the most exposure of any ETF to international pharma companies such as Novartis AG and AstraZeneca Plc. Those companies are in the top 10 holdings. The ETF has 75 percent allocated to pharma companies, 25 percent of which are based in Switzerland. IRY comes with a fee of 0.40 percent.

Performance of last quarter’s ETF plays: The  iShares MSCI India ETF (INDA) rose 16.9 percent over the past three months. Balchunas's other pick, the  PureFunds ISE Mobile Payments ETF (IPAY), gained 10 percent.

Think Long, Think Far

India is far. Flying from Los Angeles to Mumbai via Hong Kong takes about 24 hours, several meals, and almost 10,000 miles. Despite the distance, Causeway has this populous country on our investment radar. India’s demographic bulge of young consumers want to buy smartphones, cars, and homes, and their spending power rises annually.

India’s 2016 real gross domestic product growth of 7.3 percent tops the charts, beating all major countries including China. The recent demonetization to encourage a shift from cash to a digital (taxable) economy should ultimately fuel growth. Rising tax revenues facilitate fiscal spending on roads, bridges, highways, hospitals, etc., thereby boosting commerce. India’s stock market, which is severely lagging most global markets this year, has become a source of investment ideas for our clients.

Imagine a country with 90 percent of all transactions in cash. Of the roughly $240 billion of currency in circulation, the government has recently made 86 percent of that currency illegal. Exchange your soon-to-be-obsolete bank notes or they become worthless. A shortage of legal tender has placed severe working-capital constraints on businesses and harmed roughly half the population without a bank account.

Poorly implemented, the demonetization has dragged on the country’s economy as the banking system could not meet the demands of cash distribution. Longer term, the formal, taxable economy should prosper, and the central and state governments can proceed with much-needed infrastructure projects. The payment and growth inefficiencies of a cash economy should lessen.

We expect the population to open hundreds of millions of new bank accounts, resulting in a lower overall cost of funding for the country’s banking system. Prime Minister Modi's demonetization offers India an opportunity to leapfrog several banking stages, avoiding checks and bank cards and moving directly to digital payments. We believe non-cash transactions should grow 50 percent annually through to 2025 and account for 40 percent of payment transactions. Banks that already have scale in credit and debit cards, point of sale, and mobile banking should see a substantial pickup in market share.

Way to play it with ETFs: The iShares MSCI India ETF (INDA)  is the fastest growing and cheapest of the India ETFs, with an expense ratio of 0.68 percent. There is an ETF that specifically tracks the move to mobile payments, called the PureFunds ISE Mobile Payments ETF (IPAY) , but it holds 80 percent of assets in U.S. companies, with just a dash of international exposure. It's also a little expensive, with a fee of 0.75 percent, and doesn’t trade a lot, so potential buyers should use a limit order that specifies the price they want to pay.

Performance of last quarter’s ETF plays: The ETF Balchunas chose to track Ketterer's advice back in October was First Trust NASDAQ Technology Dividend Index Fund (TDIV) . It rose 3.6 percent for the three months ended Dec 31.

Invest in Corporate ‘Self-Help’

In this seemingly endless environment of economic stagnation, what will drive revenue and profit growth? Central banks may be running out of monetary solutions to stimulate credit and demand. While we wait for the political landscape to become less muddled, investors can get access to companies engaged in operational restructuring or “self-help.”

These companies, boasting strong balance sheets and modest levels of debt, typically have managements committed to a continuous and inexorable process of cost cutting and increased efficiency. In mobile telephony, especially in Japan, China, and South Korea, several of the largest listed companies have found increasingly ingenious ways to extract above-industry-average returns from the mature telecommunications market. [China Mobile Ltd. and SK Telecom Co. Ltd. were in the top 15 holdings of the Causeway International Value Fund (CIVIX), as of June 30.] Smart self-help moves by senior managements of these companies have led to a reduction in capital expenditures and operating costs.

These companies are typically creating innovative and value-added services, introducing popular data plans and benefiting from supportive local regulations. Similarly, in the more mature segment of technology, “legacy tech” companies also have managements committed to reinvigorating growth. Even though these companies have valuable proprietary technology, sell-side analysts put some of them in the dinosaur category. But the analysts often take a short-term view. Market pessimism can give investors a chance to buy world-class technology franchises in transition.

For example, large enterprise software companies must make a successful transition from an on-premises licensing business model to a cloud-computing subscription-based model. Semiconductor companies currently expert in mobile wireless technology are making measurable progress to deliver next-generation technology. Look for efficient operations, focused and shareholder-friendly managements, as well as inherent advantages in research and development expertise and resulting defendable intellectual property. [SAP and Samsung Electronics are CIVIX holdings.]

Economic malaise aside, these great companies, albeit often labeled mature and in transition, still trade at valuations that imply the potential for above-market returns.

Way to play it with ETFs: The First Trust NASDAQ Technology Dividend Index Fund (TDIV)  holds tech companies that pay the highest dividend, which means it has the largest percentage of “legacy tech” names such as Intel Corp., Microsoft Corp., Cisco Systems Inc., and Oracle Corp. This “I love the 90s” portfolio has the lowest volatility, lowest average price-to-earnings ratio, and highest dividend yield of the technology ETFs.

Performance of last quarter’s ETF plays: The ETF Balchunas chose to track Ketterer's advice back in June was The WisdomTree Japan Hedged Equity Fund (DXJ) . It rose 11 percent for the three months ended Sept. 30.

Play Japan

Something interesting is happening in the Land of the Rising Sun. The Japanese equity market has slipped 20 percent from its five-year high, reached last August, reflecting an economy unresponsive to monetary stimulus. Despite this gloom, many Japanese companies have the financial wherewithal to reward shareholders with dividends.

As of late May, over 200 Japanese stocks with market caps above $1 billion also have dividend yields greater than 2 percent (several offer yields of 4 percent), with dividend payout ratios less than 50 percent. In other words, these dividends should be well covered by earnings, and (thanks to the low payout ratios) have room to grow.

Some of the best-managed companies with generous dividends include Sumitomo Mitsui Financial Group Inc. (4 percent yield), Japan Airlines Co. (3 percent), Komatsu Ltd. (3 percent), KDDI Corp., and Hitachi Ltd. (both 2.5 percent). Bonds can’t compete. The 10-year Japanese government bond yield is negative, making generous dividends all the more appealing.

In the U.S., investor demand for high-dividend-yielding stocks, and exchange-traded funds that track such stocks, has risen sharply in our own prolonged low-interest-rate environment. Perhaps the same will happen in Japan. Mrs. Watanabe, the proverbial Japanese retail investor, wants income. It may make sense to own some of these income-generating, better-quality Japanese stocks before she does.

Ways to play it with ETFs: The WisdomTree Japan Hedged Equity Fund (DXJ)  goes long the stocks mentioned by Ketterer, and many more, said Balchunas. It also shorts—bets against—the yen, and weights stocks by the size of their dividend. It yields 3 percent.

Barry Ritholtz

Chairman and chief investment officer, Ritholtz Wealth Management; Bloomberg View columnist

Pick Emerging Markets for the Long Run

I’ve discussed the appeal of emerging markets in previous quarters. I am going to re-up that position, as this is a decade-long trade (some would call that an investment) which is still in its early innings.

Consider recent history. During the 10 years ending in 2016, the total returns (with dividends) for the MSCI Emerging Markets Index (ticker: EEM) was minus 16 percent. Over that same period, the S&P 500 was up almost 85 percent. Note that this period also encompasses the entire financial crisis and recovery.

When we look at the spread between these two indexes, we note it is about as wide as it ever gets over time. Mean reversion being what it is, I expect that the spread is already beginning to narrow and will eventually invert, with the S&P 500 lagging emerging markets for an extended period of years. This has happened repeatedly in the past; it is already beginning now.

Emerging markets had a strong 2016, but four of the five prior years were negative. While the S&P 500 continues to make record highs, the EM index remains far below its 2007 peak—about 15 percent lower.

Both the U.S. and EM regularly experience lost decades. From 2000 through 2009, the S&P 500 fell 9 percent (with dividends reinvested). Since, then, it has been off to the races. Emerging markets, too, experienced a lost decade, from 1994 through 2003, gaining a mere 1 percent over those years.

Emerging markets have lagged behind the U.S. since the financial crisis ended in 2009. More attractive valuations and recent momentum could attract more investor attention to the sector. I expect this to be an investment that can outperform over the next decade. ETFs to consider: Vanguard Emerging Markets Stock Index Fund (VEIEX; 0.32 percent expense ratio); DFA Emerging Markets Value Portfolio (DFEVX; 0.56 percent expense ratio); iShares MSCI Emerging Markets ETF (EEM; 0.72 percent expense ratio). 


Way to play it with ETFs: Balchunas calls all of the above fine choices. For investors who really want the cheapest of the cheap, he notes that the Schwab Emerging Markets Equity ETF (SCHE) covers the same ground as EEM and its peers but for a fee of just 0.13%.

Performance of last quarter’s ETF plays: The Vanguard Value ETF (VTV) gained 3.4 percent, the iShares Edge MSCI USA Value Weighted Index Fund (VLUE) rose 5.1 percent, and the actively managed ValueShares US Quantitative Value ETF (QVAL) had a 6.5 percent gain for the quarter. 

Buy Value

The last two times out, we looked at two out-of-favor asset classes. The first was emerging markets, which were not only cheap but are widely underrepresented in American portfolios. The second was European equities, also cheaper than U.S. stocks and wildly out of favor (and also underrepresented). 

They each worked out much sooner than expected. This one, I promise you, will take longer. But it will be worth your patience to see it through. 

Buy large-cap American value.

The academic research has demonstrated time and again that value beats growth over time. The problem is, growth can get hot and trounce value for long periods—like pretty much all of the past decade. Based on the Russell indexes, large-cap growth has been the No. 1-performing equity asset class for the past three, five and 10 years. The 10-year returns have averaged 8.9 percent. Pretty good, considering that decade includes the financial crisis of 2008-09.

Eventually, mean reversion rears its head. The underperforming value stocks start doing better; the overperforming growth stocks start doing worse. Timing this is all but impossible, but when the spread between the two becomes inordinately wide, value becomes increasingly more attractive. 

Currently, the spread between the performance of value and growth is about as wide as it gets. Which means even though we are likely early, this is usually a good time to start legging into more value holdings. 

Investors wanting to participate can get inexpensive exposure by buying an exchange-traded fund or mutual fund. My default setting is inexpensive Vanguard funds. Try VTV, their large-cap value ETF. It has about $31 billion in assets, and its holdings have an average market capitalization of $83.4 billion. It has a dirt-cheap expense ratio of 0.06 percent.


Way to play it with ETFs: The Vanguard Value ETF (VTV) is the fastest-growing smart-beta ETF and very cheap, with a fee of 0.06 percent. The price-earnings ratio, however, is about the same as that for the S&P 500 Index. For investors who want deeper value and a lower P/E, options Balchunas also likes include the iShares Edge MSCI USA Value Weighted Index Fund (VLUE) and the actively managed ValueShares US Quantitative Value ETF (QVAL).

Performance of last quarter’s ETF plays: Ritholtz and Balchunas were both fans of the Vanguard FTSE Europe ETF (VGK), which had an 8.3 percent return, and the SPDR EURO STOXX 50 ETF (FEZ), which gained 25.5 percent.

Hold Your Nose and Buy Europe

Pity U.S. investors who have put capital into Europe for the past 10 years. Including reinvested dividends, they have almost nothing to show for their European vacation.

Have a look at two funds that focus on Europe: Vanguard’s FTSE Europe ETF (VGK) and the SPDR EURO STOXX 50 ETF (FEZ). The big difference between the two is that FEZ doesn't have United Kingdom exposure, while VGK is about 30 percent U.K. stocks.

That’s a distinction without a difference. Each of these funds has been going nowhere for a decade. Before reinvesting dividends, VGK is down 27.3 percent through the end of March. Even with dividends reinvested, the returns were less than 1 percent annually (9.8 percent). FEZ did even worse. It's down 34.7 percent over the decade; dividends change that number to a negative 5.5 percent. Ouch!

Had you invested in the S&P 500 over the past decade, you would have doubled your money, with a 105 percent return. That’s 7.5 percent per year. The last time there was this big a performance gap between Europe and the U.S. was in the 10 years ended in 2002. (Over the ensuing 10 years, European stocks, measured by the MSCI Europe index, gained 69 percent, significantly outperforming the S&P 500.)

But the premium that U.S. stocks have earned has stretched their valuations somewhat. Value investors should hold their noses and buy into the Continent. It may sound like a terrible idea, but that’s a hallmark of a good contrarian concept. It's a particularly good idea for those who succumb to home country bias and are overexposed to the U.S. stock market.

Consider how inexpensive Europe is relative to the Shiller CAPE, the cyclically adjusted price/earnings ratio, for U.S. stocks, at about 30. The CAPE of developed Europe is 16.6, and the CAPE of emerging Europe is 8.6. Value investors should note that eight of the 10 cheapest countries in the world are in Europe.

Ways to play it with ETFs: Bloomberg Intelligence's ETF analyst, Eric Balchunas, likes both of Ritholtz's picks, the  Vanguard FTSE Europe ETF (VGK; it has a 0.10 percent fee) and the  SPDR EURO STOXX 50 ETF (FEZ; the fee is 0.29 percent).

Performance of last quarter’s ETF plays: The ETFs Balchunas chose to pair with Ritholtz's advice were the Vanguard FTSE Emerging Market ETF (VWO) and the  iShares Core MSCI Emerging Markets ETF (IEMG). VWO was up 10.8 percent in 2017's first quarter; IEMG rose 10.7 percent.

Diversify Internationally

About six months ago, we discussed how underinvested most Americans are in emerging markets. Since then, we've seen a nice total return in the Vanguard FTSE Emerging Markets ETF (VWO) of 3.5 percent. (The past three months haven't been as kind, as noted in the ETF performance figures below.)

But it is not only the emerging markets that Americans tend to be underexposed to, but the developed international markets as well.

Blame home country bias. People are more comfortable in the companies and corporate management they are most familiar with. That tends to be the companies of their home country. This leads to significant overexposure to Canada or the United Kingdom or the United States, or wherever.

The problem with this is that it’s a big world. The U.S. accounts for about half of the world’s stock market capitalization and about 25 percent of its economic activity. Investing primarily in U.S. stocks dramatically reduces the benefits of diversification.

Not only that, but U.S. markets have been outperforming international markets for more than a decade. This outperformance is one of the reasons that stocks in the U.S. have a higher valuation than international or emerging-markets companies. Across five of the broadest metrics—CAPE ratio, price to earnings, price to cash flow, price to sales, and dividend yield—U.S. stocks currently have an average premium of more than 60 percent over European, Asian, and emerging-market stocks. Higher valuations and lower dividend yields means that U.S. stocks should have lower expected future returns than foreign stocks.

Note: This is not a “sell America” call. The U.S. economy remains strong; there are no signs of a recession anywhere. If anything, the recent gains in wages and corporate profits suggest that the U.S. expansion still has a ways to go.

But that doesn’t mean we can avoid mean reversion forever. Given that the typical portfolio is underexposed internationally, as well as those valuation differences, trimming a few percent off of U.S. equity exposure and rotating into international equities is prudent long-term planning.

So cut a little off your U.S. exposure and add a little to overseas. Your grandkids will thank you.

Way to play it with ETFs: The Vanguard FTSE Emerging Markets ETF (VWO)  and the iShares Core MSCI Emerging Markets ETF (IEMG)  are two low-cost, popular ways to get emerging-markets exposure. They both charge around 0.15 percent in fees but differ a bit in exposure. IEMG includes South Korea at a 15 percent weight; VWO doesn't. Ritholtz notes that he likes VWO, too, as well as the Vanguard FTSE Developed Markets ETF (VEA) , which has an expense ratio of 0.09 percent.

Performance of last quarter’s ETF plays: The ETFs Balchunas chose to track Ritholtz’s advice were the Vanguard FTSE Emerging Markets ETF (VWO)  and the Vanguard Emerging Markets Stock Index Fund (VEMAX) . Both lost 4.5 percent for the three months ended Dec 31. Emerging markets experienced a post-election selloff stemming from a quick rise in Treasury yields and concern over President-Elect Trump's ‘America first’ trade policy. They have recovered a bit since that initial selloff.

Stick With ‘Ugly Ducklings’

Three months ago, we looked at where to invest $10,000. My suggestion, assuming your portfolio was already well diversified in low-cost global indices, was to look at inexpensive, underperforming asset classes that were “ripe for a reversion towards their historic average returns.” I suggested two emerging market indices, with the caveat that “ugly duckling investments” like these often need years to blossom.

I was way too pessimistic, as these two funds have rallied about 12 percent since then.

Rather than cash out, I am going to suggest you stay with this investment for longer. Not just a little longer, but a whole lot longer.

Why? There are at least four compelling reasons:

First, and most obvious, emerging markets remain the cheapest broad equity markets in the world. The U.S. is fully valued; the developed world ex-U.S. is also pricey. Europe, despite all of its woes, isn’t much cheaper. EM, on the other hand, remains attractively priced. If you want to see how well this thesis is playing out, look at a chart of the ratio between the S&P 500 index (SPY) versus the MSCI Emerging Markets Index (EEM). When the line is rising, U.S. markets are outperforming emerging markets; when it is falling, EM is outperforming U.S.

Second, as we noted last time, the U.S. has been outperforming EM for about seven years. These cycles can run anywhere from five to 10 years, and given the valuation differential we could be in the very early innings of a long bull market for emerging economies.

Third, emerging markets are affected by the strength of the U.S. dollar and pricing of commodities. Today, the dollar is at multi-year highs while commodities are the cheapest they've been in many years. I have no idea how long this condition will persist, but eventually mean reversion will rear its head. The dollar will weaken, commodities will see price increases, and both of those benefit the EM economies and their stock markets.

The same two inexpensive investments—DFA Emerging Markets Core Equity (DFCEX, purchased through advisers) and the Vanguard Emerging Markets Stock Index Fund Admiral Shares (VEMAX)—remain my choices. [DFCEX rose 7.4 percent for the three months ended Sept. 30; VEMAX gained 6.5 percent.]

Fourth and last is a trading rule I developed a long time ago: So long as the underlying reasons for owning something are still in place, you hold on to that position. Never make excuses for not selling once your thesis is disproved. Conversely, until your underlying reasons for ownership are no longer valid, don’t sell merely because of a little price appreciation. Cutting your losers and letting your winners run is much better investing strategy.

Way to play it with ETFs: The Vanguard FTSE Emerging Markets ETF (VWO)  holds 36,000 emerging-market stocks, with its heaviest weightings in China, Taiwan, and India. VWO is the ETF version of Vanguard Emerging Markets Stock Index Fund (VEMAX) and costs the same. Either will do.

Performance of last quarter’s ETF plays: The ETFs Balchunas chose to track Ritholtz’s advice were the iShares Core MSCI Emerging Markets ETF (IEMG)  and the iShares Edge MSCI Minimum Volatility Emerging Markets ETF (EEMV) . They rose 9 percent and 5 percent, respectively, for the three months ended Sept. 30.

Think Cheap

Assuming your portfolio is global, diverse, and mainly in low-cost indexes, we'd look at investment options that have underperformed over the past five years or so and are ripe for a reversion towards their historic average returns. Unlike cheap stocks, inexpensive asset classes have a lower chance of big drawdowns (broad asset classes don’t go to zero) and a higher probability of average or better returns.

Over the past five years, the U.S. stock market, using the exchange-traded fund SPY as a proxy, have gained 77 percent. The Emerging Markets Index (EEM), which includes almost 850 companies, is down 21.8 percent. That almost 100 percent spread is only the first part of our calculus. When we look at the longer-term cyclically adjusted price-earnings ratio (CAPE), a broad measure of how expensive or cheap a stock is, the U.S. is the most expensive, with a CAPE of 24.6. You have to go to the emerging markets to find a CAPE of 13.7.

Two inexpensive investments are DFA Emerging Markets Core Equity (DFCEX, purchased through advisers) and the Vanguard Emerging Markets Stock Index Fund Admiral Shares (VEMAX). The DFA fund costs 0.62 percentage point of assets invested, about half of the average emerging market fund. Vanguard's fund costs 0.15 percentage point. Over five years, the DFA fund is down 3.7 percent and the Vanguard fund is down 4.2 percent. Over 10 years, the DFA fund is up 4.5 percent and Vanguard's fund is up 3 percent.

A caveat: This ugly duckling investment will likely need time—quarters, or even years—to blossom into a beautiful swan.

Ways to play it with ETFs: Bloomberg ETF analyst Eric Balchunas points to the iShares Core MSCI Emerging Markets ETF (IEMG) , which holds 2,000 emerging market stocks and charges 0.16 percent of assets. For an ETF with a smoother ride, he likes the iShares Edge MSCI Minimum Volatility Emerging Markets ETF (EEMV).  It charges 0.25 percent of assets.

Russ Koesterich

Portfolio manager, BlackRock Global Allocation Fund

Don’t Give Up on Value 

After a stellar back half of 2016, U.S. value names have largely disappointed in 2017. As the post-election euphoria faded and everyone faced up to the reality of still modest growth, most investors reverted to old habits: a focus on yield and growth at the expense of value. 

Still, value’s relative performance may once again be inflecting. Value stocks outperformed their flashier growth cousins in September, and there are several reasons to believe that trend can continue.

First, value is cheap. While value stocks are by definition cheaper than growth, today they are much, much cheaper. Since 1995 the average ratio between the Russell 1000 Value and Russell 1000 Growth Indices (based on price-to-book) has been 0.45; i.e., value typically trades at a 55 percent discount to growth. Currently the ratio is 0.30. Value has not been this cheap relative to growth since early 2000.

In addition to being cheap, for the first time this year value may once again have a catalyst. It normally outperforms when economic expectations are improving. In contrast, when economic growth is modest, investors are more likely to put a premium on companies that can generate organic earning growth, regardless of the economic climate. This dynamic helps explain the strong year-to-date rally in technology and other growth stocks. 

Recent economic data, however, have been modestly stronger, and investors are, once again, entertaining visions of tax cuts. Granted, the economic impact of temporary tax cuts is more a sugar high than structural reform, but you take what you can get. At this point, even a modest boost in near-term growth expectations is arguably enough to shift investor preferences.

This creates an opportunity for value. In an environment in which investors are more sanguine about economic growth, they are more likely to notice that value stocks are not only cheap but also offer better leverage to any economic acceleration. Value is not dead yet.

Way to play it with ETFs: When it comes to picking a value ETF, the question is how bargain basement you want to go. The Vanguard Value ETF (VTV) is the most popular but has only a slight tilt toward value. The iShares Edge MSCI USA Value Weighted Index Fund (VLUE) is much more exposed to value stocks. For hard-core value seekers, the ValueShares US Quantitative Value ETF (QVAL) goes very deep to “buy stocks everyone else hates,” as its manager puts it.

Performance of last quarter’s ETF plays: Balchunas pointed to the iShares U.S. Preferred Stock ETF (PFF) as a way to play Koesterich’s preference for preferred stock in last quarter’s writeup. It was down 0.8 percent for the quarter.

Seek Yields With Protection

There are times to stretch and take more risk, and there are times when discretion is the better part of valor. Following a bull market that turned eight years old in March and countless trillions of dollars of central bank asset purchases, few asset classes are obviously cheap. Still, in a world in which interest rates are barely 1 percent, investors can be forgiven for not wanting to stick their spare cash under the mattress.

This suggests to me a compromise: finding assets with a respectable yield that will provide downside protection if markets turn south.

U.S. preferred stock is currently yielding about 5.50 percent. This compares favorably with most of the other alternatives, including high-yield, investment-grade and emerging-market debt, and a basket of U.S. common dividend-paying stocks. [Preferred shares are sort of a stock and bond hybrid; they generally pay a fixed dividend and put you ahead of common-stock holders in cashing in shares if the company's assets are liquidated.]

More to the point, following a disastrous period during the financial crisis, preferred stock has become a much less volatile asset class, currently offering the most attractive ratio of yield to volatility of the yield-oriented plays. Comparing the yield to the three-month trailing volatility of the asset class, you get a ratio of more than 1.3. In other words, investors are receiving 1.3 percentage points of income for every percentage point of annualized volatility. This is significantly higher than any of the alternatives.

Some will recall that preferred stocks did not live up to their reputation for low volatility during the financial crisis. At that time, an index of U.S. preferred, dominated by financial issuers, fell approximately 70 percent, worse than the broader market.

I see much less downside risk today. It is not clear that U.S. financials will be at the epicenter of the next crisis, as was the case in 2007-09. The sector is much better capitalized and run more conservatively than it was 10 years ago.

While preferred stocks aren't likely to send anyone’s heart racing, a yield of 5 percent-plus in a world still characterized by low rates, high valuations, and uncomfortably low volatility is worth a look.

Way to play it with ETFs:The iShares U.S. Preferred Stock ETF (PFF) currently yields 5.6 percent and has great liquidity. Its 0.47 percent fee is high for an ETF but below average for an ETF specializing in preferred stocks.

Performance of last quarter’s ETF plays: To follow Koesterich’s strategy of focusing on Asian equities, Balchunas pointed to the iShares MSCI Japan ETF (EWJ), which gained 5.2 percent, and the iShares MSCI Emerging Markets Asia ETF (EEMA), which returned 8.5 percent.

Look to Japan

We see the best opportunities within Asian equities, with an emphasis on Japan.

We’re now in the eighth year of the bull market in U.S. equities, and it's increasingly difficult to find bargains. U.S. stocks have done exceptionally well, but investors have been pushing valuations to somewhat extreme levels. Large-cap U.S. equities are trading at approximately 22 times trailing earnings, the highest multiple since 2010 and at more than 30 times the CAPE ratio, a level last seen near the peak of the tech bubble. Making matters worse, U.S. Treasury bond prices look extremely rich after several years of buying by central banks.

In this environment, Asian equities stand out as a relative bargain. In recent years, Japanese stocks have traded at a discount to the U.S., and that discount is particularly large today. The Topix index is trading at approximately 1.3 times book value, vs. more than 3 times for the S&P 500.

Japanese profitability has been improving since 2012, thanks to better corporate governance and share buybacks. In addition, Japanese equities offer accounting standards that are strict relative to the U.S., low leverage and the continuing tailwind of monetary accommodation. Finally, to the extent the global economy is likely to modestly accelerate in 2017, Japanese exporters are well positioned to benefit from improving global growth and a firmer economy.

We also see select opportunities in other parts of Asia, including emerging markets. In particular, Indian companies offer an interesting take on emerging markets. [Click on last quarter's tab for Sarah Ketterer's take on India.] India is a large, domestically oriented economy that is relatively insulated from many of the more macro risks that often derail other segments of the emerging-market universe.

Ways to play it with ETFs: Investors can use the iShares MSCI Japan ETF (EWJ)  for Japan exposure. It is by far the most popular Japan ETF and charges 0.48 percent, about average for a single-country ETF. For Asia emerging markets, the iShares MSCI Emerging Markets Asia ETF (EEMA)  tracks many Asian countries such as China and Taiwan, as well as India, which has a 12 percent weighting in the ETF. EEMA charges a fee of 0.48 percent.

Joe Brennan

Principal and global head of Vanguard’s Equity Index Group

Beware Market Timing

Figuring out where to invest this year has been quite a challenge. Equity and fixed-income valuations are stretched, with major stock indexes at all-time highs and bond yields barely outpacing inflation. Still, we caution investors against the folly of market timing. Our long-term models forecast equity returns in the 6 percent to 8 percent range and fixed-income returns in the 1 percent to 3 percent range annually over the next decade. 

To be sure, I emphasize the importance of sticking with a savings plan to remain on track with your financial goals. Given relative valuations in today’s market, however, it makes sense to step back and take a holistic look at your financial situation and options for deploying capital. 

Assuming your savings plans are on track, $10,000 might be better spent paying down debt. Extremely low interest rates made it easy for individuals to refinance high-interest-rate debt, but the future interest-expense savings from paying down even reasonably priced debt could potentially outweigh investment returns. 

Another option is investing in a good cause by donating some of the money to charity. This serves a dual benefit: helping others and earning a tax write-off. There is certainly no shortage of worthwhile charities in need, especially with the recent spate of natural disasters. The resulting tax benefit will largely depend on your tax bracket. And remember to check with your employer to see if they’ll match a portion of the gift.

As always, make sure you consult a financial adviser or tax professional to fully understand how these strategies might affect your financial plan.

Way to play it with ETFs: There used to be an ETF that donated a chunk of its fee to charity, called the AdvisorShares Global Echo ETF (GIVE), but it liquidated this May as investors shunned its 1.5 percent fee. Vanguard, along with many other financial services firms, has a nonprofit arm specializing in donor-advised funds, which are a sort of long-term charitable savings account and a way to make the most of the tax advantages of charitable giving. 

Performance of last quarter’s ETF plays: The Vanguard Total World Stock ETF (VT) , which represents more than 7,700 stocks in 60 countries, rose 4.7 percent.

Avoid Taking On More Risk  

Investors who have $10,000 to put to work may well be experiencing the anxiety caused by what I call the asset allocator’s dilemma. After several years of strong equity market returns and interest rates at historic lows, the major asset classes don’t look all that spectacular from a valuation standpoint.

Equity valuations, while not in bubble territory, are a bit stretched, leaving many investors sitting on their hands waiting for a correction or searching for a shiny, undervalued opportunity. And while fixed income can still play a diversification role in a portfolio, yields remain historically low, providing very little income. Hence the dilemma. 

Faced with this dilemma, behavioral biases can lead investors to consider alternative asset classes or taking on additional risk. Perish the thought! You may be tempted to aim for the sky in a bid for stellar returns, but like Icarus, whose wax wings melted when hubris caused him to fly too close to the sun, so too will you risk a portion of your $10,000 investment melting away. 

It’s tempting at times, and the current market is one of those times, to chase a narrow “opportunity” that hubris says will outperform. Resist this temptation and do exactly the opposite. If you're an equity investor, consider investing in a broad market capitalization-weighted index fund that covers the global stock market. The best equity investment opportunities may not be obvious in this environment, but I can guarantee they’re contained in such a portfolio. 

Now is the time to double down on strategies that are tried, true and lasting, such as low cost, diversification, low turnover and tax efficiency—all things you can put to work in your favor, and all things that an index fund offers.

Boring? Maybe. But they’ll keep you from flying too close to the sun.

Way to play it with ETFs: The Vanguard Total World Stock ETF (VT) covers the entire world in one shot, Balchunas notes. It represents more than 7,700 stocks in 60 countries; half of its holdings are in the U.S. It has a fee of 0.11 percent.

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