Refresh and Refocus

Investors were likely happy to see the month of October end. Besides the increasing rancor of a historically bitter election, there was a lackluster response to third quarter corporate earnings reports and rising bond yields.


The S&P 500 fell 1.8% in October – its worst month since January – while bond yields have risen substantially from their summer lows, hurting bond returns for the month.

All in all, investors should feel relatively good about the year so far with returns of 5.0% or higher for most stock categories as well as the broad U.S. bond market. In fact, almost every major asset class is in positive territory, including real estate (after a rough October) and commodities. There are still challenges ahead, with central bank meetings in the U.S. and Europe and an OPEC gathering in Vienna. Any of those could result in surprises and increased market volatility.

The U.S. Federal Reserve is leaving interest rates unchanged this month. It is, however, on track to raise rates again in December. A ¼ point increase is priced into the financial markets and should not be a cause for concern. A larger increase or a significant change in guidance could change the market’s tone significantly.

And of course, there is the election, the end of which will hopefully bring a much-needed refresh to the news cycle, and optimistically, a focus important issues. In the meantime, the prospect of a Brexit-like outcome is weighing on the markets. The CBOE VIX index, a measure of expected volatility known as the market’s “fear gauge,” has risen to its highest close since the June UK vote to leave the Eurozone. If the unexpected happens, look for a sharp, and hopefully temporary, sell-off in stocks. We could see a flight to safety in U.S. Treasury securities and a weaker U.S. dollar. The Fed could also balk on a rate increase in response to the increased volatility.

Looking Past the Rhetoric

Why, given the relatively good returns this year, is investor angst so high? Certainly, the unusual election rhetoric could be part of the answer. Also, many financial commentators continue to see the years of low interest rates and accommodative Fed policies as market distortions that will eventually result in economic contraction and a market downturn. It is now difficult for those who predicted doom and gloom to admit that in most of the world’s economies, fundamentals are improving, albeit slowly. The most recent U.S. GDP report showed the U.S. economy growing at 2.9% in Q3, clearly better than the 0.8% and 1.4% numbers for the first two quarters. China, the world’s second largest economy, also surprised on the upside. Income growth is finally in evidence in the U.S. and there are incremental signs of higher inflation, both indicating improving economic fundamentals.

It was not so long ago that gold bugs worried that Federal Reserve policies – often referred to as money printing – would decimate the currency and wreak economic havoc. Now, the U.S. dollar has strengthened and stands at $1.10 to the Euro, versus its 10-year monthly average value of $1.21. A stronger dollar is not necessarily positive, as it makes U.S. goods more expensive for foreigners to buy our products, creating a trade imbalance that could impair future economic growth.

What’s Working

With equities, the highest yielding sectors – telecom and utility stocks – were the worst performers in October, reversing the earlier trend toward high dividend paying firms. We expect more pressure on high yield stocks as the Fed focuses on higher rates in the coming months. Banks and other financial stocks registered market-leading returns in October, performance we expect to continue as interest rates rise. We also favor large high-quality technology firms with low debt, many of which are selling at attractive valuations relative to future growth. We are closely watching large internet-based retailers whose share prices have recently declined.

In fixed income, we allocate 10% to Treasury Inflation Protected Securities, or TIPS. While yields on TIPS are not great, inflation indicators are showing signs of life again and the best time to buy inflation insurance is when it is cheap.

The Big Shift

Last year, exchange-traded funds, also known as ETFs, received new investor funds of $150.6 billion, while traditional mutual funds had outflows of roughly the same amount. Traditional funds still dwarf ETFs in total size, with $11.5 trillion invested in mutual funds and roughly $2.1 trillion in ETFs. Nonetheless, the trend toward ETFs and away from traditional funds continues to gain speed. What is so special about ETFs versus mutual funds and what is driving the ETF inflows? Several factors favor ETFs:

Better Performance – First, and most important, is the recognition that while it is always difficult for active managers of stocks and bonds to outperform indices, it is particularly difficult when those securities are inside an expensive mutual fund wrapper. ETF securities are by nature designed to track an index, or predetermined group of securities. The indexes can be very narrow, such as one that tracks companies in the cyber security industry, or very broad, like the Vanguard Total U.S. Stock Market ETF that tracks all publicly traded U.S. based companies.

Lower Cost – The average U.S. equity mutual fund charges 1.42% in annual fees and other expenses, while the average equity ETF charges 0.53%. The average ETF expense ratio includes specialty ETFs that focus on unusual – and frankly questionable use – products that short the market (inverse funds) or track volatility (the VIX index). Investors can track the U.S. S&P 500 through the SPDR S&P 500 Trust ETF with annual costs of 0.09%. Taking out the specialty funds, the average annual ETF expense drops to 0.18%, a significant cost advantage over traditional funds in a lower return world.

More Transparent – Existing regulations require mutual funds to report holdings only quarterly, while ETFs disclose holdings daily. Between reporting periods, fund managers can stray away from stated investment objectives, hampering an investor’s ability to manage diversification and control risk.

Better Liquidity – ETFs trade throughout the day just like individual stocks. Through a creation/redemption process, ETFs trade very close to their net asset value, or NAV. The creation/redemption process allows for authorized participants (usually large institutional investors) to step in and arbitrage away any price discrepancy from the underlying securities, creating a tight spread between an ETF’s price and its NAV.* We also note that exchange-traded funds are only as liquid as their underlying securities and can be impacted by unusual volatility that can create a discrepancy between the price and NAV. The U.S. SEC is reviewing the potential market impact of a liquidity squeeze and the role of ETFs, particularly in certain fixed income securities with potential liquidity issues, such as high-yield bonds.

Higher Tax Efficiency – Index-based ETFs allow for lower portfolio turnover and therefore, lower internal capital gains. Through the creation/redemption process previously mentioned, ETFs can create and redeem shares “in-kind” by exchanging shares in the ETF for the underlying securities. This allows for the fund provider to pick the cost basis to be passed to the authorized participant, limiting any capital gains that are generated through reconstitution and rebalancing. The availability of many ETFs that are similar, but different enough for tax purposes, allows for easy harvesting of tax losses. This creates a strategic opportunity for ETF investors to capture a loss, but maintain exposure.

How We Use ETFs

In the equity markets, Proffitt & Goodson utilizes a core-satellite approach to implement investment and diversification strategies and manage risk. The core allocation targets specific and broad ETFs that provide low-cost, diversified exposure to large, mid, and small-cap U.S. stocks, as well as international developed and emerging markets. Depending on account size and objectives, a carefully structured portfolio of individual stocks can be substituted for a portion of the U.S. allocation. We continue to evaluate alternative equity strategies using liquid ETFs that could potentially enhance diversification.

In the fixed income markets, ETFs allow for targeted investing in specific slices of the bond market where diversification can be difficult and expensive to achieve, or too illiquid. Prior to the 2008/09 credit crisis, we built portfolios of individual corporate bonds for many clients. Post crisis, regulation changes have made such bonds less liquid and costlier to trade. ETFs allow us to target specific duration and quality segments more precisely and at lower cost than with individual securities. The exception is municipal bonds, where our knowledge of individual issuers, particularly in Tennessee, allows us to better control risk using individual bonds.

What It All Means

The markets have been better this year than the heightened level of anxiety suggests. This election cycle is unlike most in memory, and the nature of today’s economy remains difficult to fully understand. At times, change seems to be accelerating out of control, hence the anxiety. But the reality is more stable, and for now, broad diversification strategies are working well. We continue to focus on quality stocks and bonds that can survive the next downturn and carry on. We also remember that the best markets have always been known to climb a “wall of worry.”
Please contact us directly with any specific questions or concerns. As always, we appreciate the opportunity of working with you.

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The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.

*When rising demand causes the ETF price to trade at a premium to the underlying securities, authorized participants purchase the underlying securities in the secondary market, redeem them for shares of the ETF and sell those shares into the secondary market. The reverse process occurs when the ETF price trades at a discount to NAV.