From the June 2014 issue of Investment Advisor • Subscribe!

Beware of ETFs That Are Vulnerable to the End of QE

As the Fed winds down asset purchases, we could see a rotation from domestic to foreign markets

If there isn't a rotation from domestic to foreign markets happening now, there soon will be. (Photo: © Sung-Il Kim/Corbis) If there isn't a rotation from domestic to foreign markets happening now, there soon will be. (Photo: © Sung-Il Kim/Corbis)

Over the last two years, foreign markets have lagged far behind U.S. domestic markets. For the trailing 24 months (through April 30), the S&P 500 was up 34% compared to a 15% gain for the MSCI All-World ex-U.S. Index and about a 1% increase for the MSCI Emerging Markets Index.

After experiencing years of being outperformed by foreign markets, domestic markets have of course rotated back into favor. David Garff, president and chief investment officer of Accuvest Global Advisors, specializes in global portfolios and recently noted that the top performing countries have also received the most economic stimulus from their respective central banks.

This creates visibility for when foreign markets will again take the lead—at the end of large-scale bond purchases better known as quantitative easing (QE). Since the U.S. Federal Reserve Bank began to reduce its monthly asset purchases, its effects are starting to reflect in ETF asset flows.

Year-to-date (through April 30), three of the top six leaders in ETF fund flows track foreign equities indexes: the Vanguard FTSE Europe ETF (VGK), the Vanguard FTSE Developed Markets ETF (VEA) and the iShares MSCI EMU ETF (EZU).

The flows could be isolating a rotation from domestic back to foreign, or the data could simply be capturing a rebalancing effect because the performance dispersion has likely caused portfolio imbalances, or perhaps a combination of the two.

Whether or not there is currently a rotation occurring from domestic to foreign is certainly debatable, but if not now, there will be one at some point. It is the nature of foreign versus domestic—one outperforms for a time and then the other, and then it repeats.

The largest foreign equity ETF tracks the MSCI EAFE Index and, like most broad-based market-cap-weighted international index funds, has a large weighting to Japan at the country level as well as its financial stocks at the sector level. Such international funds also tend to have substantial exposure to Europe as well.

Like the United States, Japan and many western European nations have equity markets that benefitted from QE or other significant economic policies after the financial crisis. There is no playbook as to what happens after years of very low interest rates, asset purchases or both. Consequently, there can be no expectation as to what comes for equity prices after these policies end.

However, when these policies do end, there will be international ETFs still heavy in Japan and western Europe with considerable weightings in their financial stocks. It will be those countries and sectors that will be most at risk when QE ends.

There is no way to know whether the QE that has helped in the interim will then go on to hurt these markets. It is a simple thesis to construct, and advisors who prefer to avoid this risk have ETF choices beyond broad market-cap-weighted funds in the form of specialty funds that use alternative or rules-based index weightings, funds that focus on themes or sectors, individual country funds and actively managed ETFs that are able to avoid potential trouble spots.

These specialty funds carry their own risks but, for example, a fund that invests in Mexico will not own European banks. Rules-based funds and actively managed funds offer the opportunity to allocate into areas of the market with better risk-reward characteristics based on current market conditions while possibly avoiding the least favorable segments of the market.

At the end of the day, it remains imperative to know what resides underneath an ETF's hood.

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