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In the Know: An ETF Blueprint for Q4 and Beyond

This article was originally published on ETFTrends.com.

When the smoke cleared from the previous month's volatility, October 2018 was one to forget for U.S. equities thanks to the fire sale in the technology sector, in particular, as declines in FANG (Facebook, Amazon, Netflix, Google-Alphabet) stocks roiled the major indexes. The Nasdaq Composite, in particular, stumbled by 9.2% in October, making it its second largest decline since it fell 10.8% back in November 2008.

After 10 years of market recovery from the Great Recession followed by a historical bull market run, October left investors scratching their heads and wondering whether to sit on the sidelines or stay invested. In the latest update of "In The Know," three experts provided a blueprint that could serve investors in the final quarter of 2018 and beyond--–Yasmin Dahya, Head of Americas Beta Specialists at JP Morgan Asset Management; Samantha Azzarello, Global Market Strategist at JP Morgan ETFs; and Douglas Yones, Head of Exchange Traded Products at NYSE.

Be Resilient and Stay Invested

Investors who were resilient during the Great Recession were treated to the S&P 500 becoming the longest bull market in history. It underscores the old adage of "good things come to those who wait," but in terms of investments, "returns come to those who stay invested."

After October's volatility, fear-riddled investors might be hesitant to jump into the capital markets due to being late to the extended bull run party. However, Azzarello prognosticates that there’s still time to capitalize on opportunities.

“We think growth continues, earnings growth continues–mind you, it comes down in 2019, but still positive” said Azarello. “So we still want exposure to U.S. equities, but in a way that I would say is a little bit more cautious, a little bit more quality-based.”

Rising interest rates may also be fueling investor fear of the capital markets as last month, the Federal Reserve raised the federal funds rate by 25 basis points–the third rate hike this year on the tailwinds of strong economic data. The latest sell-offs in October have been partly blamed on rising rates, causing investors to fret over whether they should stay on the sidelines.

While investors typically shift from U.S. equities to the safer confines of government debt, rising rates could also be worrying investors in conjunction with inflation that could tamp down returns from fixed-income assets. However, Azzarello views this as a blessing in disguise.

“Rates going up is a good thing,” Azzarello said. “I know it doesn’t feel that way when fixed-income returns are going negative. However, at some point, we are going to benefit from some more income in the fixed-income market and it’s something that just has to happen.”

While the temptation to stay in cash is alluring with factors at play affecting both stocks and bonds, Azzarello recommends that investors tell their clients to stay invested.

“They key thing would be we want to always continually get and stay invested,” said Azzarello. “And there’s ways to do that which make sense after a 10-year bull (market) so this doesn’t have to be cash on the sidelines or all into the market.”

Hop Back on the Value Train

Everybody loves a comeback and though the FANG (Facebook, Amazon, Netflix, Google) stocks have been largely attributed to helping fuel the decade-long bull run, the growth and momentum strategies they’ve been associated with may be falling out of favor amid October’s sell-off. However, one factor may be experiencing a resurgence—value.

Dahya points out that value is especially attractive given their deep discounts while growth and momentum were soaking up the limelight of the bull run.

“I think there’s one factor right that I think is quite attractive to us, which is the value factor,” said Dahya. “If you think about value, it’s going through its second worst underperformance since 1990—it’s been very painful for value investors, but what that has meant is two standard deviations cheap and that level of cheapness has historically been associated with 14% return for the next 12 months.”

To Dahya, being invested in value right now will allow investors to capture the upswings that can come hard and fast.

“The way it (value) performs is like a coil spring,” cited Dahya. “The returns in value come in very short periods of time. What that means is you really want to be in the factor even though it’s down to catch that upswing.”

“One of the most interesting things to me in the ETF market is that there are now products coming to the market where you can take advantage of themes like that,” Dahya added.

In fact, JP Morgan has the  JPMorgan Event Driven ETF (JPED) that exposes investors to specific events, such as mergers, acquisitions and share buybacks. JPED seeks to achieve its investment objective by employing an event-driven investment strategy, primarily investing in companies that the firm believes will be impacted by pending or anticipated corporate or special situation events based on a systematic investment process.

Get Exposed to the International Markets

The U.S. stock market has been the default play for investors even as the bull market heads out of the latter stages of its market cycle, but when the well runs dry, it could be opportunities abroad that could get the lion’s share of investor capital. Emerging markets, in particular, have been marred by the trade wars between the U.S and China, causing a negative ripple effect into emerging market ETFs.

While the majority of investors might be driven away by the red prices in emerging markets, they should see them as substantial markdowns, especially if trade negotiations between the U.S. and China result into something materially positive.

“Trade wars and a strengthening dollar have caused havoc in international markets this year,” said Azzarello. “I think short-term it’s actually a buying opportunity because we still believe in the longer-term story. They key is you want to dampen volatility in the international markets and you want to hold them.”

Before an investor looks to deep dive into the EM space, he or she must be still selective and exercise due diligence. Simply selecting a country-specific ETF in emerging markets without the proper research could be akin to catching a falling knife so investors must approach EM with caution.

“It’s still an attractive place to be,” said Dahya. “It’s still a good source of diversification in your equity bucket. Valuations are still attractive. I would argue that similar to the U.S., maybe try something non-market cap weighted, something that is a little more balanced, something that can weather that volatility.”

Dahya references the JPMorgan Diversified Return International Equity ETF (JPIN) , which has been a success story for the firm since it has been able to demonstrate downside capture.  JPIN seeks investment results that closely correspond to the performance of the JP Morgan Diversified Factor International Equity Index, which is comprised of equity securities across developed global markets (excluding North America) selected to represent a diversified set of factor characteristics: value, price momentum and quality.

Opt for Short Duration in Fixed Income

The month of September saw a hawkish Federal Reserve raise the federal funds rate another 25 basis points with hints that a fourth and final rate hike to cap off 2018 is likely given a tailwind of more positive economic data. This has presented challenges for fixed-income investors who are also seeing rising yields in benchmark Treasury notes.

“Fixed income is a very hard place for investors right now because of this fear they have of rising rates,” said Dahya. “I want investors to know there are solutions for you to help get the most out of your fixed income allocations.”

According to Dahya, one area where investors can seek opportunities is shorter duration strategies to limit prolonged exposure to the bond markets. This addresses two main fear factors in the fixed income markets—rising interest rates and a flattening yield curve.

“What investors are looking for is strategies that can help protect against rising rates, but still preserve their yield,” said Dahya.

Dahya mentioned JP Morgan’s strategy of giving investors broad market exposure to bonds via the Bloomberg Barclays U.S. Aggregate Bond Index (Barclays AGG), but with shorter duration. In fact, Dahya mentioned that the firm’s strategies have provided investors with 80% of the yield from the Barclays AGG, but with 8% of the duration—a value proposition worth considering in the bond markets.

Use ETF Adaptability to Your Advantage

Because of their adaptability as an investment product, ETFs have experienced exponential growth with respect to capital flows. With over $120 billion in assets coming in domestically, that growth is expected to only continue as more ETFs enter the marketplace.

The proliferation of ETFs has allowed them to corner specific areas around the globe like emerging markets, and while EM was decimated in 2018, Yones is still seeing an influx of capital. The investor behavior speaks to the popularity of ETFs and investors willing to flock towards these products despite the underlying economic conditions in these areas of investment.

Whether an ETF is being used as a short-term tool for lightning-quick plays by day traders or as value plays by buy-and-hold strategists, the adaptability of the product is readily apparent.

“It says people are still leaving traditional investment funds and buying ETFs regardless of market conditions,” said Yones. “They’re using them not to just say, ‘Hey, short-term, here’s my strategy,’ they’re using them for long-term core holdings and it shows the growth of the ETF investment across everyone’s portfolio.”

Embrace Change

With ETFs growing at a rampant pace, innovation has been a byproduct and companies are finding new ways to accommodate the growth in this space. However, this accelerated growth means that more regulation may be necessary to maintain the ETF industry’s attribute of transparency.

New rules are in the making by the Securities and Exchange Commission (SEC), which will allow for easier, more accessible ETF creation. Rule 6c-11, known throughout the industry as “The ETF Rule,” would permit prospective ETF issuers to organize and operate without the expense or delay associated with obtaining an exemptive order from the SEC.

“This proposal would basically streamline launching ETFs,” said Yones. “If you’re an asset manager, or say even a small manager of funds for your portfolios of clients, but yet you think, ‘Hey, I can make some efficiency here by putting it in an ETF wrapper,’ today that could cost a lot of money.”

With the new SEC law, ETF creators can bypass much of the bureaucratic red tape by following a proposed set of rules without the typical costs associated with a fund’s creation. According to Yones, this would allow for lesser fees to the investor, more product offerings and tax advantages.

To watch the entire set of "In the Know" segments, click here.