Beware of ETFs That Are Vulnerable to the End of QE

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.