ETF buyers had two choices in the U.S. in 2018: play defense or run.
Amid rising volatility and interest rate uncertainty, investors in exchange-traded funds have been desperate for places to hide that also generate returns.
In the U.S. equity market, that’s meant sussing out areas that are domestically focused and don’t carry the risks of trade tensions, and also offer decent dividend payouts. Otherwise, investors have headed overseas, with emerging markets looking particularly attractive.
Health care is often seen as a domestic haven for the trade-weary. It has outperformed all groups in the S&P 500 Index in 2018, with momentum coming from strong clinical data and waning concerns about disruptive changes in drug pricing. In addition, pharmaceutical companies typically pay high dividends. Naturally investors have responded. Through Dec. 17, U.S.-listed health-care funds had taken in a record $8.4 billion, the second-most among all S&P 500 sectors and more than six times 2017’s tally.
“Their businesses are less cyclical,” said Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors. “Health care and medicine continue to be ongoing needs for a society.”
With pharmaceuticals breaking to new highs this month, investors continued to shift into the sector. The largest ETF for the group, the $18.7 billion Health Care Select Sector SPDR Fund, or XLV, took in $786 million on Dec. 12, the biggest daily inflow since November 2016.
Meanwhile, flows into consumer staples funds, another classic defensive play, haven’t been as strong, only generating about $2.4 billion of assets.
“With health care you’re defensive, but you’re not going all the way to consumer staples,” said Omar Aguilar, chief investment officer for equities at Charles Schwab Investment Management. “You can have the benefit of growth names without going into the most speculative part of the growth market.”
For investors who want more value, the place to look is developing nations, Aguilar said. The valuation of emerging markets relative to other parts of the globe is so attractive that investors are itching to get some of that potential upside, he said.
Buyers have added more than $707 million into the biggest U.S.-listed emerging-markets ETF, the $55 billion Vanguard FTSE Emerging Markets ETF, ticker VWO, in December. The fund is on track for its best month of inflows since January.
“It’s a head-scratcher because volatility is so high that normally people would escape those risky assets,” Aguilar said. “They may think that the emerging markets drought is over and are positioning themselves for an up market next year.”
Investors appear to be going global regardless of the region this month, simply to avoid buying into the U.S. The $4.5 billion iShares MSCI ACWI ex U.S. ETF, or ACWX, took in a record $358 million last week. It hasn’t seen a day of outflows in more than two months.
Lance Humphrey, a money manager in the global multi-assets at USAA Asset Management, said his team’s $12 billion portfolio is currently overweight international markets, particularly emerging markets. The $1.2 billion Invesco FTSE RAFI Emerging Markets ETF, ticker PXH, is one of his largest holdings, because of its fundamentally-weighted nature.
“We find that the valuation discount there offers just incredible upside for long-term investors, since you’re getting more than a 50 percent discount on those emerging-market value names,” Humphrey said.
Looking ahead to 2019, another potential bright spot for international funds may be those focused on small-capitalization companies that are more closely tied to their domestic home markets. This means their products stand to benefit from an uptick in local demand as populist governments attempt to spur growth, said State Street’s Bartolini. They’re also more likely to be shielded from broader geopolitical tensions and protectionism.
“The U.S. may still be the best house on a bad block, but governments outside the U.S. will have neighbor envy,” he said. “So they’ll try to generate growth and appease their constituents.”
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