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Two ETF portfolios for capital growth: one year on

Our exchange traded fund (ETF) portfolios for capital growth are profiting from an emerging markets equity renaissance
September 8, 2016

What a difference a year (and Brexit) makes. In April 2015, we launched two model exchange traded fund (ETF) portfolios for capital growth, and one year on from our last update both are storming ahead. The portfolios were constructed by Christopher Aldous, managing director at Charles Stanley Pan Asset, and David Liddell, ‎chief executive officer at online investment adviser IpsoFacto Investor. Over one year to 1 September 2016, Mr Liddell's portfolio has grown 13.4 per cent and Mr Aldous' portfolio is up 9.5 per cent, easily beating the targets they set in April 2015.

The performance is a marked turnaround on this time last year, when both portfolios were down since launch. When we last checked them in September 2015, both were suffering due to a China-led market crash, with Mr Aldous' portfolio hit by its 17 per cent allocation to Chinese equities. One year and one vote to leave the European Union (EU) later, however, both portfolios have profited from a dramatic snapback in sentiment towards emerging markets and China, which have delivered some of the best growth over the year.

The top-performing investment is iShares Asia Property Yield UCITS ETF (IASP). This invests in an index of real-estate companies and real-estate investment trusts (Reits) from developed Asian countries with a one-year forecast dividend yield of 2 per cent or more. It has returned 44.9 per cent over one year and yields a healthy 5.3 per cent.

 

Emerging markets rise from the ashes

Emerging market equities and bonds have been the star performers in 2016 following a turnaround after five years of underperformance. June 2016 was a turning point for ETFs invested in emerging market equities, which pulled away from their developed world counterparts to deliver some of the best returns across both Mr Liddell's and Mr Aldous' portfolios between 1 September 2015 and 1 September 2016.

Mr Aldous took large single-country bets on China and India in his portfolio, and opted for a small-cap emerging markets ETF and Far East ETF, instead of a broader-based ETF. HSBC MSCI EM Far East UCITS ETF (HMFE) tracks an index of giant and large-cap stocks from China, Indonesia, Malaysia and other emerging economies and delivered a return of 34.9 per cent over the year. SPDR MSCI Emerging Markets Small Cap UCTIS ETF (EMSD) also returned more than 30 per cent over the year, a turnaround on its previous spell of poor performance. Small-caps are often considered a good bet for high long-term growth, and over the long term the MSCI Emerging Markets Small-Cap index has outperformed MSCI Emerging Markets Index. Over 10 years the index has returned 163.3 per cent, compared with 111.6 per cent. SPDR MSCI Emerging Markets Small Cap is invested in small-caps from 21 emerging markets, including Brazil, China, Colombia and South Africa.

Although both of those holdings have delivered some of the best returns over one year, they have been highly volatile. In the four months to September 2015, when we last checked in with this portfolio, HSBC MSCI EM Far East UCITS ETF had lost more than 28 per cent and SPDR MSCI Emerging Markets Small Cap was down by more than 20 per cent following a global stock market rout triggered by fears over a Chinese slowdown.

One year on, markets are reeling from another shock in the form of the UK's vote to leave the EU. But instead of falling, emerging markets have risen to the top of the pile. Commentators say that is not a result of Brexit, but rather the effect of a low-rate environment pushing yield-hungry investors towards emerging economies, a lower-than-anticipated rate hiking cycle in the US and slowly strengthening domestic economies.

Mr Liddell says a reversal in the gloomy attitude towards emerging markets was long due, which is why he allocated to them in 2015 with his ETF portfolio. "We expected emerging markets would recover," he says. "In April I was thinking that emerging markets had underperformed and I am always looking for the assets that have underperformed, where the market might have overdone a correction and this is exactly what that looked like."

"Part of the outperformance of emerging markets over the year has to do with currency and part of it has to do with China. The Chinese market has been all over the place, but at one point last year investors were fearful that it would fall apart altogether, but in fact the situation has not been as bad as many expected, which led to a stock market bounce."

Mr Liddell holds Vanguard FTSE Emerging Markets UCITS ETF (VFEM), which returned 30.8 per cent over the year. He says he likes the index it tracks, which differs from the MSCI Emerging Markets Index. FTSE Emerging Index has a larger number of country constituents, with 972 holdings as opposed to MSCI Emerging Market's 836. FTSE Emerging Index also does not include South Korea as FTSE categorises this as a developed country. South Korea makes up 14.6 per cent of the MSCI Emerging Markets Index.

 

Hedged share classes prove a bad bet

A less successful strategy was betting on weakening currency in Europe and Japan. Mr Aldous' hedged ETFs were set to profit if the yen and the euro weakened against sterling, but work against investors if the opposite took place. Although both regions continued to plough ahead with monetary easing programmes, that failed to send the currencies in one clear direction and the ETFs hedged back to sterling lost money as markets appeared to lose faith in central bank tools.

In 2013 and 2014, hedged share classes starkly outperformed unhedged share classes in Japanese funds, and in 2015 the same was true of European equities. Mr Aldous chose to bank on continued pressure on those currencies as a result of central bank liquidity injections.

In Japan, he selected UBS MSCI Japan Hedged to GBP UCITS ETF (UC61) to bank on the continued fall in the yen against sterling as a result of Prime Minister Shinzo Abe's 'three arrows' of monetary reforms - a combination of monetary easing, fiscal stimulus and structural reform. But over the year to 1 September, the ETF lost more than 17 per cent.

In the immediate wake of Mr Abe's 2012 election victory, the yen weakened and equities soared. Mr Abe now commands an overwhelming majority, having swept to victory again in elections in 2016. However, recent policy moves aimed at shoring up Abenomics have failed to keep equities afloat. In January 2016, a move to negative interest rates sent the yen soaring up rather than down.

Mr Liddell opted for an unhedged Japanese ETF and his portfolio has fared better as a result. Vanguard FTSE Japan UCITS ETF (VJPN) returned 17.4 per cent over one year. The unhedged MSCI Japan index also made a positive return over that time.

Lynn Hutchinson, assistant director at Charles Stanley Pan Asset, says: "The returns in Japanese and eurozone equities have been disappointing, reflecting a perceived reduction in monetary policy traction."

But Ms Hutchinson and Mr Aldous remain convinced that Japanese equities could continue to perform, saying: "We will continue to hold this Japanese equity ETF as the Japanese authorities have shifted their focus away from monetary intervention towards supporting the domestic equity market."

Mr Aldous also chose UBS MSCI EMU Hedged to GBP UCITS ETF (UC60) to minimise the risk of falling returns from converting a weaker euro back into pounds, after more rounds of quantitative easing. But the vote for Brexit has resulted in a falling pound rather than euro, so this ETF lost 3.1 per cent over the year.

Mr Liddell's unhedged Vanguard FTSE Developed Europe ex UK UCITS ETF (VERX) performed far better, returning 14.7 per cent. This ETF differs from UBS MSCI EMU hedged to GBP UCITS ETF not only because of its lack of hedging, but also because it has exposure to European countries outside the eurozone.

 

Property - add when it hurts

You are probably well aware that a number of open-ended property funds have temporarily prevented investors from taking their money out, or are only allowing this with the payment of high exit fees, after they were inundated with a high level of redemption requests following the UK's vote to leave the EU.

Mr Aldous holds iShares UK Property UCITS ETF (IUKP), which lost 8.7 per cent over one year. ETFs do not invest in physical commercial property, but rather in the shares of property companies. This means that their returns tend to be more closely correlated with the wider equity market, and they do not fulfil the same diversification role in portfolios as bricks and mortar investments. However, they do give investors access to a healthy income stream at low cost.

Despite the poor performance, Mr Liddell wants to introduce this ETF to his portfolio. "I've added this on the basis of property having done so badly," he says. "I'm looking to replace some of the UK exposure we've taken out this time around. If we get another UK recession and it gets beaten up, it is likely that everything else in the portfolio will get beaten up with it."

Mr Liddell's main change is reducing US equity exposure by removing iShares Core MSCI World UCITS ETF (SWDA). He says: "I want to reduce my exposure to US equities on the basis that there is political risk, the US rate cycle is a little uncertain and US equities have done well."

Mr Liddell is also taking the same bet on currency hedging as Mr Aldous because he believes that Mr Abe's most recent round of stimulus could send the yen down against sterling, and is replacing Vanguard FTSE Japan UCITS ETF with UBS MSCI Japan hedged to GBP UCITS ETF.

Mr Liddell is also adding inflation protection in the form of iShares Global Inflation Linked Government Bond UCITS ETF (SGIL). He says: "One of the risks I want to protect against is inflation being higher than people are expecting."

Mr Aldous has chosen to remove HSBC MSCI EM Far East UCITS ETF to add more exposure to short-dated UK corporate bonds via SPDR Barclays 0-5 Year Sterling Corporate Bond UCITS ETF (SUKC) and has also added exposure to iShares Global High Yield Corporate Bond GBP Hedged UCITS ETF (GHYS). He has replaced iShares £ Index-Linked Gilts UCITS ETF (INXG) with Lyxor FTSE Actuaries UK Inflation-Linked Gilts UCITS ETF (GILI), which has a lower ongoing charge of 0.07 per cent

Mr Aldous has chosen mainly accumulating shares for his portfolio, but Mr Liddell likes to select a mixture and reinvest dividends to generate stronger capital growth. "We've been in a period of slow growth for some time and I think that is likely to continue," says Mr Liddell. "I think that is in part why I like Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYL). I like high-yielding ETFs which will generate more return out of income than growth. I would reinvest the dividends for this kind of portfolio."

 

Christopher Aldous' original and adjusted portfolio

Asset allocationFundAllocation (%)Total return 1 Sep 2015 -1 Sep 2016 (%)Total return adjusted for allocation (%)
UK gilts (10%)Vanguard UK Gilt UCITS ETF (VGOV)1018.31.8
Corporate bonds (15%)iShares £ Corporate Bond 0-5 UCITS ETF (IS15)154.90.7
NEW: iShares Global High Yield Corporate Bond GBP Hedged UCITS ETF (GHYS) 3
Index-linked gilts (10%)iShares £ Index-Linked Gilts UCITS ETF (INXG) REPLACED WITH: Lyxor FTSE Actuaries UK Inflation-Linked Gilts UCITS ETF (GILI)1025.52.6
 NEW: SPDR Barclays 0-5 year sterling corporate bond UCITs ETF (SUKC)8  
UK equities (6%)Vanguard FTSE 100 UCITS ETF (VUKE)313.50.4
 db x-trackers FTSE 100 Equal Weight ETF (XFEW)39.30.3
US equities (9%)iShares Nasdaq 100 UCITS ETF (CNX1)4.530.31.4
 UBS MSCI USA 100% hedged to GBP UCITS ETF A-acc (GBP) (UC74)4.59.90.4
Europe (ex UK) equities (15%)Wisdom Tree German Equity GBP Hedged (DXGP)53.70.2
 UBS MSCI EMU 100% Hedged to GBP (acc) (UC60)5-3.1-0.3
Japanese equities (10%)UBS MSCI Japan Hedged to GBP ETF (UC61))10-17.1-1.7
Asian equities (3%)REMOVED: HSBC MSCI EM Far East UCITS ETF (HMFE)334.91.0
Chinese equities (4%)db x-trackers Harvest CSI 300 ETF (RQFI)216.10.3
 HSBC MSCI China UCITS ETF (HMCH)226.00.5
Emerging markets equities (4%)db x-trackers MSCI India ETF (XCX5)222.70.5
 SPDR MSCI Emerging Markets Small Cap ETF (EMSD)232.40.6
UK property (6%)iShares UK Property UCITS ETF (IUKP)6-8.7-0.5
Asian property (3%)iShares Asia Property yield UCITS ETF (IASP)344.91.3
Renminbi (3%)REMOVED: Commerzbank CCBI RQFII Money Market Ucits ETF (CCMG)3????
Sterling (2%)Cash account [GBP]2n/an/a
    
Portfolio return    9.6

Source: FE Analytics, as at 1.9.16

 

David Liddell's original and adjusted portfolio

Asset allocationFundAllocation (%)Total return 1 Sep 2015 - 1 Sep 2016 (%)Total return adjusted for allocation (%)
UK equities (30%-55%)SPDR FTSE All-Share UCITS ETF (FTAL) (35%)2512.44.3
 iShares Core FTSE 100 UCITS ETF (CUKX) (20%)2013.92.8
Overseas equities (20%-45%)iShares MSCI World Value Factor UCITS ETF (IWFV) (20%)1016.91.7
 Vanguard World High Dividend Yield (VHYL)526.11.3
 REMOVED: iShares Core MSCI World (SWDA) 523.81.2
 Vanguard FTSE Emerging Markets UCITS ETF (VFEM) (5%)430.81.5
 Vanguard FTSE Developed Europe ex UK UCITS ETF (VERX)2.514.70.4
 NEW: UBS ETF - MSCI Japan hedged to GBP UCITS ETF (UC61)317.40.4
Cash/bonds/alternatives (0%-50%)db x-trackers db Hedge Fund Index UCITS ETF 3C (GBP hedged) (XHFG) (5%)5-4.0-0.2
DELISTED: iShares £ Corporate Bond Interest Rate Hedged UCITS ETF (SLXH)5
 NEW: iShares Core £ Corporate Bond UCITs ETF (SLXX)5 -
 NEW: iShares UK Property UCITS ETF (IUKP)2.5 -
 NEW: iShares Global Inflation Linked Government Bond UCITS ETF (SGIL)5 -
 NEW: db x-trackers US Dollar Cash UCITSd ETF 1C (XUSD)3  
 Cash10n/an/a
    
Portfolio return    13.4

Source: FE Analytics as at 1.9.16