The European ETF market continues to grow. It has also seen a continued proliferation of vehicles available to investors, both institutional, wholesale and retail.
This includes active ETFs, which are attracting increased attention in the current market situation characterised by inflation and global crises.
In fact, active ETFs could be among the winners, as they can offer the best of two worlds:
The ease of use, clearly defined market exposure and attractive price point of index
The potential for alpha, research-driven investment decisions, and active engagement with
investee companies of active mutual funds.
Of course, active ETFs cannot eliminate the underlying risk of equity or bond markets. But they may allow investors to find solutions that better fit their personal preferences when investing in capital markets – both in equities and fixed income.
Which trends could be particularly important for ETF investors in 2023? Three areas may be worth a closer look: thematic investments, dividends and bonds.
1. The strength of themes
Technological innovations can generate strong growth and therefore attractive returns. Thematic ETFs seek to profit from this. At the same time, however, the concept also harbours particular risks including industry and sector-specific issues, such as the future regulation of new technologies or research methods, the taxation of energy or the global supply situation for important raw materials and intermediate products. Such risks can accumulate particularly strongly in the case of an investment in a narrow subject area.
Therefore, such investments are generally less suitable as a basic investment. They are more suitable as a supplement and tactical allocation in a broadly diversified investment portfolio.
While most thematic ETFs are tilted towards growth sectors, one key differentiator is the variety of themes they cover. Some thematic ETFs have been built to capture very specific niches of future developments such as hydrogen or solar.
Others have built their thematic ETFs around broader themes such as clean energy. These products do not simply cover special industries or sectors. Rather, their focus is on precisely those visionary and trend-setting areas of the economy that can benefit from the sea changes in our economy and society.
These could be, for example, areas such as renewable energy, the emerging metaverse, cloud computing or future mobility. Developments in digital health are another such field (see example below). Thematic investments via ETFs therefore offer the opportunity to benefit directly from the dynamics of technological innovation.
Another key differentiator is the potential development of those themes over time. The Moorgate Benchmarks Index Committee responsible for the underlying indices of Fidelity’s thematic ETFs may send out periodic consultations to key internal and external stakeholders to ensure the indices still capture the most relevant business activities used to select investee companies.
If the consultation comes to the conclusion that they do not, this might lead to business activities being redefined. This aims to ensure that the ETFs capture the most relevant companies for a given trend as the trend evolves over time.
Decarbonisation, cloud computing, alternative mobility concepts, metaverse and digital technologies in healthcare: the major changes of the coming years have the potential to trigger substantial leaps forward.
They will likely shape and change our society and economy over the long term. Innovative companies operating in these high-growth areas are among the potential winners of a new era: An era that will be shaped by the dynamism of technological innovations and other modernisation drivers.
Thematic investment example: The healthcare sector
The healthcare sector is the second-largest sector allocation in the S&P 500. It significantly outperformed the broader market in the downturn of 2022. That relative defensiveness/stability has made some market observers optimistic about the sector’s 2023 prospects. After all, history, and recent history at that, indicates healthcare stocks can be resilient in the face of macroeconomic headwinds. Why did it do so well? Because people still need to pay for health insurance, drugs and vaccines, even when they are having to watch how much they spend. Profits in the sector tend to be stable when hard times crimp earnings elsewhere. The current environment is a chance for those shares to shine.
As 2023 unfolds, healthcare investors could discover multiple factors working in their favour.
For example, ETFs with healthcare holdings, focused on quality stocks with strong balance sheets and, in many cases, storied histories of dividend growth might be the winners for next year. The good news is some healthcare stocks still appear relatively cheap. This especially applies to those of biopharma companies. Another issue that could work in favour of healthcare investments this year is coronavirus vaccine fatigue.
This does not imply diminished importance or relevance of the vaccine. Rather, investors are likely to demand more from pharmaceutical and biotech companies than COVID-19 treatments. That means many healthcare companies need to be more diversified. Others have the benefit of long-running patent protection before generic producers can bring competing products to market.
2. The power of dividends
When inflation is high and many stocks are down, dividend-paying stocks may offer investors some unique benefits. Dividends have accounted for 40% of stock market returns since 1930 and 54% during decades when inflation has been high1.
In times of high inflation, the stocks that have increased their dividends the most have outperformed the overall market. Dividend payments may help make a stock’s total return less volatile.
History shows that owning stocks in general has helped protect investors against inflation. The main reason is that stock prices have often gone up along with consumer prices as companies were able to increase their prices accordingly.
But looking back at 2022, inflation is up, and the overall stock market is down. That does not mean that stocks no longer work as hedges against inflation. But it does suggest that not all stocks may perform equally well when consumer prices are rising.
Many bonds and other investments pay a pre-determined rate of interest to investors who own them. Dividend payments, on the other hand, are variable, but can rise with inflation. Companies typically pay dividends each quarter and they often adjust them based on a variety of factors.
During periods of high inflation, stocks that increased their dividends the most outperformed the broad market, on average2.
Where can the best-performing dividend stocks be found today? Not necessarily in the same industries or sectors as in the past. Market leadership often shifts among dividend-paying stocks, as do expectations for dividend cuts and suspensions.
Just before the onset of the pandemic, financials generated the fastest dividend growth. Now, energy may sit in the pole position. Many of these stocks are those of companies that are able to raise the prices they charge their customers to offset their own rising costs of doing business.
Active ETF strategies can be an interesting way to invest cost-efficiently in high-dividend stocks – while avoiding the “dividend trap”: That is, an overweighting of sectors with low structural growth opportunities. The basis for this can be appropriately weighted indices.
3. The comeback of bonds
Bond yields are likely to remain relatively high at least through the first half of 2023. Higher yields enable bonds to become sources of reliable, low-risk income for buy-and-hold investors once again.
Bond prices typically fall when yields rise. As the Federal Reserve raised interest rates quickly and sharply to combat inflation, investors who feared falling prices sold bonds.
However, as 2023 begins, bonds look poised to deliver reliable income, capital appreciation and relatively low volatility. For the first time in decades, bond yields are high enough that income-seeking retirees can use them to help support a 4% withdrawal rate from their portfolios3. What is more, bond funds could also have a comeback: propelled by higher yields, and possibly higher prices, if the Fed has to cut rates to help the economy come out of a potential recession later in the year.
At the same time, the Fed’s rate hikes have ended the bull market in bond prices that had run for almost 40 years. However, a new bull may be ready to charge. This year could potentially shape up to be a high total return environment for bonds. Interest rates are now back to almost 30-year norms.
With US Treasury, municipal, investment-grade corporate or high-yield bonds, it looks as if investors could get respectable yields and could do very well if interest rates head back down again.
The end of Fed rate increases might matter most for bond prices in 2023 with more than worries about rising credit delinquencies, the inversion of yield curves (when short-term bonds pay more interest than long-term ones) or the possibility that foreign governments will stop buying US government bonds.
The price is nice
And if bond prices do not rise much in 2023? In this case, bonds will still pay a decent amount of interest given the current yield environment. They will also still have a face value (“par”) that the bondholder will receive when the bond matures, resulting in capital gains driven by the “pull to par” effect.
These facets of bond returns are especially meaningful for investors who are in or near retirement and are more interested in predictable income than in potential capital appreciation.
That means concerns about how interest rate movements might affect bond prices should not obscure a key fact: The return of rates to historically normal levels may present a long-awaited opportunity in bonds for those who seek a steady income combined with principal protection. Higher rates mean that retirees and savers may be able to earn attractive returns without taking much risk in 2023 and beyond.
Not only are yields up, prices of many high-quality bonds are down as a result of the 2022 sell-off.
That means opportunities exist for those with cash to buy relatively low-risk assets at bargain prices – even as they pay yields that are higher than they have been in decades. The Fed might continue to raise the federal funds rate further until it has an impact on inflation.
And if inflation comes down closer to the 2.5% range where the Fed wants and expects it to be in 2023, then real rates, which are bond yields minus the rate of inflation, could rise further into positive territory.
How long will this go on?
The opportunities provided by higher rates could be short-lived. Of course, getting inflation under control is the focus of Fed policy in the months ahead. But the central bank also wants to make sure it has room to cut rates if the economy goes into recession, potentially in 2023. Cutting rates is a powerful tool the Fed has to stimulate economic growth. Therefore, the central bank wants to be able to make impactful cuts when necessary.
That could mean that there is a window of opportunity to add low-risk, high-yielding bonds to income strategies.
While 2023 may be a great time to buy, hold and ladder bonds, the outlook is also bright for investors in funds that manage bonds with an eye to making money as prices rise. This may also lead to investors buying more bonds with longer maturities than in 2022. Here, too, active bond ETFs can open up interesting opportunities to invest efficiently and cost-effectively, be it globally or in emerging markets, where yields look quite compelling in some pockets of the market.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.
1 Source: Bloomberg Financial L.P., Morningstar, and Fidelity Investments, as of 7/31/22.2 Source: Fidelity Investments, as of 09.07.2022.3 Source: Fidelity Investments, as of 21.12.2022.
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