MONEY ETFs

Hot Money Flows into Energy and Bonds

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Sometimes it pays to follow the crowd. At other times, you'll get burned.

All too often, I see investors heading in the wrong direction en masse. They buy stocks at the top of the market or bonds when interest rates are heading up.

Occasionally, though, active investors may be heading in the right direction. A case in point has been the flow of money into certain exchange-traded funds in the first half of this year.

Reflecting most hot money trends, billions of dollars moved because of headlines. The Energy Select SPDR exchange-traded fund, which I discussed three weeks ago, gathered more than $3 billion in assets in the first half, when crude oil prices climbed and demand for hydrocarbons remained high.

The Energy SPDR, which charges 0.16% for annual management expenses and holds Exxon Mobil , Chevron , and Schlumberger , has climbed 22% in the past 12 months, with nearly one-third of that gain coming in the three months through July 18. Long-term, this may be a solid holding as developing countries such as China and India demand more oil.

“We think the Energy Select SPDR is a play of oil prices remaining high and supporting growth for integrated oil & gas and exploration and production companies,” analysts from S&P Capital IQ said in a recent MarketScope Advisor newsletter.

Headlines also favored European stocks as represented by the Vanguard FTSE Developed Markets ETF , which holds leading eurozone stocks such as Nestle, Novartis , and Roche. The fund has been the top asset gatherer thus far this year, with $4 billion in new money, according to S&P Capital IQ.

As Europe continues to recover over the next few years and the European Central Bank keeps rates low, global investors will continue to benefit from this growing optimism.

The Vanguard fund has gained nearly 16% for the 12 months through July 18. It charges 0.09% in annual expenses and is a solid holding if you have little or no European exposure in your stock portfolio.

Rate Hikes

Not all hot money trends make sense, however. As the economy accelerates and interest-rate hikes look increasingly likely, investors are still piling money into bond funds, which lose money under those circumstances.

The iShares 7-10 Year Treasury Bond ETF , which holds middle-maturity U.S. Treasury bonds, continued to rank in the top 10 funds in terms of new money in the first half. The fund, which holds nearly $5 billion, is up nearly 4% for the 12 months through July 18, compared with 4.2% for the Barclays U.S. Aggregate Total return index, a benchmark for U.S. Treasuries. The fund charges 0.15% in annual expenses.

While investors were able to squeeze a bit more out of bond returns in the first half of this year, they may be living on borrowed time.

The U.S. Federal Reserve confirmed recently that it would be ending purchases of U.S. Treasury bonds and mortgage-backed securities in October. This stimulus program, known as “QE2,” has kept interest rates artificially low as the economy has had a chance to recover.

The phasing out of QE2 could be bearish for bond funds.

Will interest rates climb to reflect growing demand for credit and possibly higher inflation down the road? How will the ending of the Fed’s cheap money program affect U.S. and emerging markets shares?

Many pundits believe public corporations may pull back from their enthusiastic stock buybacks and trigger a correction. Yet low inflation and modest employment gains may mute bond market fears.

“The Fed is on track to complete tapering in the fourth quarter, and we think there is essentially no chance that it will move the fed funds rate higher this year,” Bob Doll, chief equity strategist with Nuveen Investments in Chicago, said in a recent newsletter.

“With the 10-year Treasury ending the quarter at 2.5%, the yield portion of this forecast is more uncertain,” Doll added, “although we expect yields will end the year higher than where they began.”

While there could be any number of wild cards spoiling the party for stocks, it is wise to ignore short-term trends and prepare for the eventual climb in interest rates.

That means staying away from bond funds with long average maturities along with vehicles like preferred stocks and high-yield bonds that are highly sensitive to interest rates.

Longer-term, shares of companies in consumer discretionary, materials and information technology businesses likely to benefit from a global economic resurgence will probably be a good bet.

Just keep in mind that the hot money can be wrong, so build a long-haul diversified portfolio that protects against the downside of a torrid trend going from hot to cold.

MONEY alternative investments

Wise Up About Funds that Claim to Take “Smart” Risks

A new group of funds that claim to outperform the broad market while taking less risk are worth exploring—if you're willing to look under the hood.

Ever since the dot-com crash more than a decade ago, Wall Street and the mutual fund industry have been on a relentless push to plug what they are now calling “smart” beta strategies. These funds promise reasonable returns with lower risk through a variety of techniques.

But pursuing a smart-beta strategy isn’t as simple as just buying a fund with that name and thinking it will outperform conventional index funds. There’s always a trade-off in costs, risk and return, so you need to dig much deeper to get beyond simplistic marketing pitches.

For example, let’s say you were seeking an alternative strategy to traditional S&P 500 index funds that weight the holdings in their portfolios by market valuation.

In such traditional “cap-weighted” S&P 500 funds, the top holdings would be Apple at about 3% of the portfolio, followed by ExxonMobil at 2.6% and Microsoft at just under 2%. Every other stock in the portfolio would represent a slightly lower percentage of the total holdings.

The idea behind cap-weighting is that the biggest U.S. stocks by popularity ought to represent the largest portions of a broad-market portfolio. This is what economist John Maynard Keynes called a “beauty contest,” with investors bidding up the prices of the most glamorous stocks. The downside is that these companies may be overpriced and may not have as much room to grow as other, bargain-priced stocks.

One alternative in the smart beta fund category is a so-called equal-weighted stock index fund such as the Guggenheim S&P 500 Equal-weight ETF , which holds the same stocks as the S&P Index, only in equal proportions. This design somewhat side-steps the overpricing issue because it’s less exposed to beauty contestants, especially when they falter a bit.

To date, both the long- and short-term performance of the equal-weighted strategy has been better than cap-weighted index funds. The Guggenheim fund has beaten the S&P 500 index over the past three, five and 10 years. With an annualized return of 9.7% over the past decade through June 6, it’s topped the S&P index by more than two percentage points over that period. But it costs 0.40% in annual expenses, compared with 0.09% for the SPDR S&P 500 Index ETF.

Once you start to ignore the beauty pageant for stocks, is there an even “smarter beta” strategy?

What if you picked the best stocks based on a combination of value, sales, cash flow and dividends? You might find even more bargains in this pool of companies. They’d have strong fundamentals and might be more consistently profitable over time.

One leading “fundamentally weighted” portfolio, which also resides under the smart beta umbrella, is the PowerShares FTSE RAFI US 1000 ETF , which also has outperformed the S&P 500 by about two percentage points over the past five years with an annualized return of 20 percent through June 6. It costs 0.39% annually for management expenses.

The PowerShares fund owns some of the most-popular S&P Index stocks like Exxon Mobil, Chevron and AT&T , only in much different proportions relative to the cap-weighted indexes. The RAFI approach focuses more on cash, dividends and finding undervalued companies, so it’s not necessarily looking for the most-popular stocks.

Although looking at the rear-view mirror for index-beating returns seems to make equal- and fundamental-weighted strategies appear promising long term, you also have to look at internal expenses to see which strategy might have the edge.

Turnover, or the percentage of the portfolio that’s bought and sold in a year, is worth gauging in both funds. Generally, the higher the turnover, the more costly the fund is to run. That eats into your total return. The PowerShares fund has the advantage here with an annual turnover of 13%, compared to 37% for the Guggenheim fund.

Over the long term, “fundamentally weighted smart beta strategies are likely to outperform the equal weighted approach,” note Engin Kose and Max Moroz with Research Affiliates, a financial research company based in Newport Beach, California, which largely developed the concept of fundamental weighting and is behind RAFI-named indexes.

But just considering costs doesn’t end the debate on equal- and fundamentally weighted funds. While they may be higher-performing than most U.S. stock index funds over time, they are not immune from downturns. Both lost more than the S&P 500 in 2008 and 2011.

While it may be difficult to predict how these funds will perform in a flat economy or a sell-off, they are worth considering to replace your core stock holdings, and may be the wisest choices among the smarter strategies.

MONEY Emerging Markets

Why India’s Stock Market is Soaring

While equities in Brazil, Russia, and China continue to sink like BRICS, India's market and economy are on the road to recovery.

Although the world’s largest democracy has been hobbled by inflation, a declining currency, sub-par growth and difficult business environment, the pro-business Bharatiya Janata Party that just won an epic election in India has engendered optimism that the country can turn around its sagging economic scenario.

It’s time to increase your exposure to India’s stock market.

India’s equity market has been perking up of late, something that can’t be said for the other so-called “BRIC” economies of Brazil, Russia and China, which collectively make up nearly half of the market value of the emerging markets.

^SINU Chart

^SINU data by YCharts

The $1.3 billion WisdomTree India Earnings ETF , the largest exchange-traded fund investing in Indian stocks, has climbed 22% over the past 12 months through May 29 and is up 26% year-to-date. The fund holds large companies such as Reliance Industries and Tata Motors. It charges annual expenses of 0.83% of assets.

For a play on smaller Indian companies, consider the Market Vectors India Small-Cap ETF , up nearly 31% over the past 12 months and nearly 46% year-to-date. It spots an expense ratio of 0.93% holds stocks such as Ramco Cements and Hexaware Technologies.

Before digging in too deeply, be aware of the risks of investing in India.

* The bureaucratic business environment is tough to navigate, as well as corrupt.

* Stocks listed on Indian exchanges are volatile and will continue to be. The WisdomTree fund’s returns, for example, have been all over the board. After climbing 95% and 20% in 2009 and 2010, respectively, the fund lost 40% in 2011 and 9% last year. This is a reason India shouldn’t dominate your global stock holdings, but represent a “satellite” position that includes other emerging economies.

* The Indian economy is still sluggish relative to its historic standards. In the last fiscal year, economic growth slowed to a 10-year low of 4.5% from a high of 10.4% in 2010, according to The World Bank. If new Prime Minister Narendra Modi can pull off a turnaround, demand will increase for banking services and credit, construction, consumer goods, and vehicles. The Modi-led BJP government may also ramp up trade with China and other growing Asian economies.

* Inflation, hovering around 10%, continues to hamper the Indian economy. The central bank has raised interest rates three times since September 2013. Along with a pronounced drop in the rupee against the U.S. dollar, the country has been stung by the U.S. Federal Reserve’s pullback on its bond-buying stimulus, which had pumped billions into developing nations like India.

Neena Mishra, director of ETF Research for Zacks Investments in Chicago, sees India as a good long-term investment since renowned economist Raghuram Rajan took over as the governor of the central bank of India.

“The central bank has taken a number of positive steps in the past few months, towards bringing down inflation, liberalizing financial markets and strengthening the monetary policy framework,” Mishra says.

Although tangible economic progress seems slow to investors in the West, India’s development and social progress is largely a success story that will accelerate if economic growth picks up.

Growth is expected to increase to nearly 5% in the most recent fiscal year; to almost 6% in the 2014-2015 fiscal year; and 6.5% the following year. If those forecasts prove true, India would trail only China as the largest and fastest-growing developing country.

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