Core ETFs in 2014

Shared by my friend David Kotok.

Core ETFs in 2014
January 3, 2014

Happy New Year. As 2014 commences, we are looking forward and also looking back. In this commentary we will examine our “core” ETF strategy for the US stock market.

2013 witnessed a dramatic stock market year. Everyone in the market knows it, and those who retreated to the sidelines are kicking themselves for missing out on stellar returns. Stock portfolios that were invested in 2013 and that maintained their positions and diversified distributions have added about 30% in market value. Investors achieved this without needing to pick single “hot” stocks and without having to concentrate risk.

At Cumberland Advisors, we only use ETFs (exchange-traded funds) in the management of stock portfolios worldwide. In the US, we have a basic core position that selects broad-based ETFs. We add satellite positions in sectors and specific industries. In the modern era there are 1,500 ETFs to choose from; therefore, investors may construct ETF portfolios in almost any fashion they desire.

At the end of 2013, Cumberland’s core position comprised five ETFs. Those five ETFs expose the portfolio to approximately 3,000 different stocks in a weighting system that is derived from the contents of the ETFs. During the course of 2013, those weights changed as occasional substitutions were made in the ETF portfolios’ core section. We will not elaborate on the details of those changes since this is a proprietary technique used in our management system.

On January 1, 2014, the five different ETFs in our ETF core portfolio ranged in weight from a high of 30% to a low of 10%. While our portfolio composition and weights varied through last year, our main objective for this core investment style is to offer a low turnover with very broad diversification. Among the core five, PowerShares Dynamic Market Portfolio ETF (PWC) produced a 41% total return in 2013 and outperformed SPY by about 9%. The next two ETFs, Guggenheim S&P 500 Equal Weight (RSP) and iShares Russell 2000 Growth ETF (IWO) are each larger positions, and both outperformed SPY last year, by 3% and 11% respectively. Our last two positions, Guggenheim S&P 500 Pure Value (RPV) and RevenueShares Small Cap ETF (RWJ), are assigned smaller weights in our model. Each has outperformed the benchmark SPY in 2013, RPV by 15% and RWJ by 13%.

We start the year with these proven and promising core positions. They may change at any time. We will discuss industry and sector selections in other commentaries.

At Cumberland, the bottom line is that portfolio managers face strategic decisions daily. Managers get up each morning and have to buy, sell, or hold. That is the first and foremost action we undertake each day. Later we can write, talk, or tell someone else what we think about it all. The difference between managing a portfolio and not managing a portfolio is simple: a manager is on the firing line for what is done, not what is said.

Transition is ahead in 2014.

This year starts out with the same low interest rates at the short end of the yield curve as we saw in January 2013. The bond market is already up in terms of longer-term interest rates. The yield curve is steepening, which suggests economic growth rates will be improving. The Federal Reserve has finally commenced “tapering.”

The bond market seems to be ignoring the current low inflation statistics. In a longer-run scheme, bonds are negatively impacted by inflation that erodes the real value of the bond’s payment stream. Either the current bond market is anticipating a rise in inflation, or bond investors are shunning the bond market for the stock market and may be making a mistake in doing so. We think that is the case with tax-free municipal bonds: they still remain cheap. We do not own intermediate Treasury notes. They are not cheap.

Back to the US stock market. On the heels of 2013, 2014 is unlikely to see such stellar gains. Stocks cannot go up 30% per year for years and years. It simply does not happen.

Stock market history shows that after surges similar to the one in 2013, the subsequent year usually has a positive result. We expect that to be the case in 2014, for several reasons: the economy will continue to recover at a measured pace; inflation will continue to be subdued; interest rates in the shorter- term maturities will remain very low; and bond interest rates will not immediately spike significantly higher than present levels. The current 30-year Treasury bond yield is about 4% and the 10-year about 3%; high-grade muni yield remains over 4%, while a money market fund still pays next to zero %. Bonds can hold at near-present levels during 2014, but they are not yielding enough to steal the show from the stock market.

Thus the mix could lead to a positive stock market return in the high single digits for 2014. That would put a 2014 year-end close on the S&P 500 at 1950 or so. At the moment such a result is possible. But there are risks, and the outlook could easily deteriorate. Politics top the risk list.

2014 is an election year in the US. The Republicans have a narrow majority in the House of Representatives. The Democrats have a narrowing majority in the US Senate. As a country, we have a dysfunctional and divided government. Both Houses of Congress are in for a massive fight. Incumbents face primary threats from the extremes of their respective parties. Neither party nor chamber wants to be blamed for something going wrong. Each seeks power while being risk-averse when it comes to blame.

Despite the sharp divisions, since blame avoidance is now the word in Washington, political risk in the US due to some policy impasse has apparently eased. But that also means the penalty for failure is very high. Markets seem to be pricing in a docile political environment, one unperturbed by a government shutdown, a debt-ceiling fight, or an external shock from some geopolitical event (North Korea? Iran?) or some other politically induced catastrophe.

Such an assumption of sustained calm and stability sometimes flies in the face of history. The world is still a dangerous place. Washington, DC, is still a dangerous city from the perspective of the rest of us Americans, who have to put up with the shenanigans of the people we elect to govern us. Risk in the political arena remains high in 2014.

Looking back, we just had a terrific year. As of January 1, 2014, we remain nearly fully invested in our US ETF managed portfolios. But we must look forward with caution and navigate the year’s opportunities with a close eye on winds, weather, and the seaworthiness of our investment strategy. At Cumberland, that’s our first priority every day.

David R. Kotok, Chairman and Chief Investment Officer

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