The Ultimate ETF Playbook for 2012

David Sterman's picture

Tuesday, January 17, 2012 - 11:00am

by David Sterman

Judging by the first few weeks of trading in 2012, investors may assume that recent dominant themes remain in force. If so, then you'd simply hold to what you've been holding and avoid what you've been avoiding. But in many respects, 2012 is likely to play out quite differently than 2011, so course corrections to your portfolio are essential.

Taking the top-down view, let's assess where the money flowed in the exchange-traded fund (ETF) sector in 2011 and anticipate where those funds will flow in 2012.

What worked
We surely know what succeeded in 2011. ETFs that focused on dividends, U.S. Treasuries and crude oil posted stellar gains. The first two groups, dividends and Treasuries, have a lot in common. They both represent safety in stressful economic times.

The appeal of dividend-focused ETFs is self-evident. There are a number of companies offering dividends that are far higher than the relative offering of fixed-income instruments. And they typically hold stable, established companies that have a history of repeatedly boosting their payouts. Considering the U.S. Federal Reserve is unlikely to raise rates any time soon, and corporate profits remain at robust levels, these dividend-focused ETFs should continue to appeal -- assuming the U.S. economy doesn't suddenly shift into higher gear. If that happens, then investors are likely to pivot toward growth-oriented stocks and ETFs because they would represent less risk and potentially robust upside.

If you expect the U.S. economy to simply muddle along, growing less than 3% in 2012, then Morningstar suggests you check out these dividend ETFs:

The Vanguard High Dividend Yield Index ETF (NYSE: VYM) focuses on large-cap value companies.

The Vanguard Dividend Appreciation ETF (NYSE: VIG) owns a basket of stocks that have a history of rising payouts.

The case for continued outperformance of Treasury-focused ETFs is not nearly as strong. Treasuries have rallied and rallied some more as the European crisis sent investors scurrying for the safety of U.S.-backed Bonds and Bills. Consider that the PIMCO 25+ Year Zero Coupon U.S. Treasury (NYSE: ZROZ), the Vanguard Extended Duration Treasury (NYSE: EDV) and the iPath U.S. Treasury 10-year Bull (NYSE: DTYL) all rose more than 30% in 2011.

With rates now at stunningly low levels, it's hard to envision a scenario where yields would fall much further (and bond prices rise), so you should probably forget about further robust gains for this group in 2012.

In a worst-case scenario, these treasury-focused ETFs could get pummeled. Until now, the U.S. government has had no problem lining up demand for its newly-issued securities. Many expect that to be the case in 2012 as the U.S. government issues hundreds of billions more in bonds. Trouble is, other countries have their own problems, and it's unclear if they really want much more exposure to our Bonds and Bills than they already have. If Uncle Sam needs to hike the payout to retain the interest of buyers, then Treasury-focused ETFs would give back much of the gains seen in 2011.

If rates do indeed rise in 2012, then be especially wary of the highly-leveraged Treasury ETFs such as the PowerShares DB 3X Long 25+ Treasury Bond ETN (NYSE: LBND) and Direxion Daily 20 Year Plus Treasury Bull 3x Shares (NYSE: TMF). They doubled in 2011, but would get crushed in 2012 if long rates start to tick up.

Focusing on ETF niches that finished 2011 on a high note, a number of oil-focused ETFs posted sharp recent gains. For example, the U.S. Oil Fund (NYSE: USO) has risen more than 25% since the start of October.

Some of those gains are attributable to rising tensions with Iran near the end of 2011. But the fact that oil has already doubled in value since the spring of 2009 even as major economies are in a slump tells you one thing: The oil markets are not oversupplied. And when the United States and Europe start to finally get past their current economic slowdowns, demand for oil will pick up and oil prices could hit $120 or even $140.

Of course, the U.S. economy is likely to show signs of life before the European economies, but continued growth in China, India and Brazil (which represent a combined 2.5 billion people) means the next oil "SuperSpike" can't be ruled out for 2012. If you've made money with oil-focused ETFs in 2011, then there's ample reason to stay the course.

What didn't work

Even as oil was moving up the price curve, ETFs that focus on clean energy technologies such as solar and wind stocks took a beating. High oil prices should have made these technologies comparatively more valuable, but the utter plunge in natural gas prices made life difficult for clean energy players, and also put the hurt on coal-focused ETFs.

Here's a sampling of ETFs from these niches, and how they fared in 2011:

Market Vectors Solar Energy ETF (NYSE: KWT): Began 2011 at $11 and recently traded below $5.

Market Vectors Coal ETF (NYSE: KOL):
Began 2011 around $50 and now trades below $35.

U.S. Natural Gas Fund (NYSE: UNG): Began 2011 at $12 and now trades below $6.

What does 2012 hold? Well, coal stocks are now extremely cheap on the basis of cash flow, and an ETF such as the Market Vectors Coal ETF helps mitigate company-specific risk while bringing upside if the sector rebounds.

In terms of clean energy, Deutsche Bank analysts recently issued a report suggesting that the solar energy industry has hit bottom and conditions may slowly improve. That could set the stage for a rebound in the Market Vectors Solar Energy ETF. The fund rose 15% on the day Deutsche Bank issued the report, highlighting the considerable number of investors looking for rays of hope in the industry. Still, this is a sector that is best left for those with a high degree of risk tolerance.

Looking ahead
We've recently seen a glimpse of ETF groupings that finally may be building a head of steam and could rally in 2012. For example, the SPDR S&P Bank ETF (NYSE: KBE) has spiked 20% since late November. It may be too soon to get excited about bank stocks while the European crisis remains at a boil, but as soon as some sort of fiscal solution is reached, U.S. banks stocks could surge since so many of them are trading at such low valuations on fears that the European contagion will spread.

A small but growing group of investors think we may finally start to see early signs of life in the housing sector. The iShares Dow Jones U.S. Home Construction ETF (NYSE: ITB) has risen more than 50% since the end of the third quarter (though that gain is just a snapback after the ETF plunged by a similar amount in the third quarter of 2011. And at a recent $13, it's still well below the $40 mark seen back in 2007.

Lastly, a number of emerging market ETFs took it on the chin in 2011. The iShares MSCI Brazil Index Fund (NYSE: EWZ) is off by one-third since the start of 2011. This is a fine time to read up on the emerging economies (like Brazil) that you think may have tremendous long-term potential. Chances are, the ETF representing that country is well off of its recent highs.

Risks to Consider: The year ahead is likely to throw us many surprises. This analysis is based on what we know about the incipient trends underway. So much can change, and your portfolio exposure will need to change along with the evolving outlook.

Action to Take -->
All of these potentially promising ETF groupings carry varying degrees of risk and potential upside. If you hue to a conservative path, then the dividend-focused ETFs are quite likely to deliver decent gains. Other ETF niches such as emerging markets, clean energy, banks and housing could post significant upside if the chips fall their way.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.