This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Chuck Self, chief investment officer and chief operating officer at iSectors, an investment manager.
The financial markets performed well in 2016, reaching record highs throughout the year despite U.S. political uncertainty and ongoing geopolitical tensions. The ETF universe also continued to expand, growing to $2.5 trillion in assets as of Oct. 31, 2016, up from $2.1 trillion at the end of 2015.
However, despite attracting assets at a rapid pace, various ETFs vastly outperformed and underperformed others throughout the year. Below, we take a deeper dive into last year’s hits and misses, along with some recommendations for investors.
3 Strong Performers
Small-Cap Precious Metals
Precious metals ETFs, particularly those focused on small miners, more than doubled in share price last year. This remarkable outperformance can be attributed to a flurry of tail winds, including low interest rates, low dividend income and high demand for bullion that outpaced supply. These same factors led to strong returns for those holding reserves of the underlying metal commodity.
For example, gold bullion’s price rose 30% in the first half of 2016, and silver nearly doubled in the same period. Although precious metal prices have dropped since then, the miners have taken the opportunity to hedge their production and reduce costs.
Looking ahead, investors can find opportunity in junior silver producers, which have the most leverage to drive prices higher. Investors can look to the PureFunds ISE Junior Silver ETF (SILJ) for a pure play on silver. Early-stage gold miners also benefited from recent trends, as higher gold prices have given these companies the opportunity to increase exploration spending. The VanEck Vectors Junior Gold Miners ETF (GDXJ) is a good option for interested investors.
Diversified metals and pure-play steel ETFs more than doubled in price last year. They benefited from a 25% rise in the price of standard hot-rolled coil, a 68% increase in the demand for steel across the globe and fewer foreign imports resulting from favorable anti-dumping trade cases.
Investors are wise to consider steel producers in 2017, as Moody’s recently raised its industry outlook from “negative” to “stable.” Prices will continue to rise and capacity utilization will increase. The VanEck Vectors Steel ETF (SLX) is a pure play on the sector.
For those investors seeking a more diversified exposure, they can consider the SPDR S&P Metals & Mining ETF (XME), which invests in steel and a mix of other industrial and precious metal mining and production companies.
Political forces drove a lot of the success, as the market rallied around then-President Dilma Rousseff’s removal from office and expectations of an improving economy. Further, the Brazilian central bank decreased interest rates, which kept the Brazilian real weak and helped exporters.
Investors can expect to see continued ups and downs in Brazil as a direct result of the volatile nature of its political and economic landscape. As such, they are wise to not invest directly in Brazil, but there is opportunity via diversified ETFs, such as the iShares MSCI Brazil Capped ETF (EWZ). For those investors seeking greater exposure to the Brazilian consumer and less exposure to the energy portion of its economy, the iShares MSCI Brazil Small-Cap ETF (EWZS) is a solid option.
3 Areas That Missed The Mark
Solar stocks took it on the chin in 2016, marking an average decline of 40-45% for the year. Solar stocks were hurt by declining solar panel prices, which were largely oversupplied and crashed by more than 30%.
Solar power plant construction also dropped after industry leader SunEdison declared bankruptcy. Further, the new Republican administration is mulling a reduction or elimination of solar investment tax credits, which would undermine some of the industry’s economics.
These fundamental problems in the sector will persist into next year. Although solar stocks are relatively inexpensive compared to other areas of the market, inventory overhang and political uncertainty will continue to weigh on these names. Investors are wise to avoid the Guggenheim Solar ETF (TAN) and the VanEck Vectors Solar Energy ETF (KWT) to steer clear of the pulldown.
Strong performance in the emerging markets did not extend to all African markets, which declined more than 30% for the year, plagued by weak currencies. Egypt is especially problematic, as the value of the Egyptian currency dropped by more than 50% in early November. Because of this, the free-floating currency has attracted greater foreign investment and an International Monetary Fund loan to support economic reforms.
In Nigeria, the local currency is down almost 60% over the past year. Overall, the country is suffering from low hard currency reserves due to declining oil exports. Nigeria will benefit from higher oil prices and the ability to export greater energy volumes, but the political situation is too tenuous for most investors.
Health care was the weakest U.S.-based broad market sector in 2016. While the total sector is down only 4%, specialized biotechnology and pharmaceutical funds have declined up to 35%—a huge blow to the overall sector. Both biotech and pharma stocks were hurt by concerns that a new presidential administration would make decreasing drug prices a priority.
As the new administration and Congress takes hold, increased concerns over cuts or the outright elimination of government-run health programs, including Medicare and the Affordable Care Act, are also damaging the sector.
Amid the political uncertainty, consumers and medical professionals will seek new ways to manage pharmaceutical, medical supply and medical equipment spending. We do not recommend investors buy into health care sector stocks in 2017; however, investors seeking a diversified fund might consider the Vanguard Health Care ETF (VHT). If an investor feels that concerns about drug price caps are overdone, the SPDR S&P Pharmaceuticals ETF (XPH) is a solid option.
The new administration in the White House will likely be the largest driver of market performance in 2017. However, we expect markets to be flat next year considering we are in the late stages of an economic recovery. We are not forecasting a recession, but the many risks to economic growth are clear, and investors must carefully manage risk into the New Year when selecting ETFs.
At the time of writing, the author did not hold any of the securities mentioned, but his firm holds a position in GDXJ for client portfolios. Chuck Self, MBA, CFA, is chief investment officer and chief operating officer at iSectors, an investment manager that provides advisors access to their proprietary asset allocation models based on low-cost, index ETFs designed with various risk tolerances. He has over 35 years of experience in the investment management industry.