Global financial markets are in a slump and the pain doesn’t look like it’s going to end any time soon. Since the explosion of Covid-19 pandemic, it has been a roller coaster ride for the global financial markets. In the latest chapter to this saga, central banks globally are reacting to the highly inflationary environment by rapidly raising interest rates. The predictable reaction to a rapidly rising interest rate scenario is falling financial markets.
How Much Is the Market Down in 2022?
The S&P500 is down 20% in the first six months of 2022 and has set a record for having the worst start to the first half of the year since 1970. Most global benchmarks have not fared much better either. Take a look at the figure below. The only exception to the global correction appears to the UK FTSE 100 and the Hang Seng. Why are the FTSE 100 (UK) and Hang Seng (Hong Kong) outperforming the S&P500? We’ll discuss a little later.
Bonds have not fared better either. The bond index consisting of US investment grade bonds is down 10% in the first half of 2022. Such moves in the investment grade bond market are very unusual! The high yield benchmark is down nearly 14% in the first half of 2022.
Quite often the reason for including bonds in a portfolio is to provide downside protection when the stock markets are correcting. However this time the correlation is relatively high and this means that there is nowhere to hide. While no doubt the bond portfolios have held up better than stocks (as they should!), the negative double-digit returns are painful – particularly to those investors with more “conservative” portfolios (typically retirees or those with low tolerance for volatility).
I am not going to spend much time discussing alternative assets like cryptocurrency, but suffice to say that the pain there is much worse. Bitcoin is down around 59% in the first half of 2022 and down 71% from its peak. Ouch!
The Market Sentiment
Investors are always looking for clues about what the stock market will do next. One popular survey is compiled by the American Association for Individual Investors. They poll their members to find out how many are bullish, bearish, or neutral on the stock market.
There are numerous other indicators compiled by the large investment advisory services that capture a broader investor base (particularly institutional and professional investors), however the AAII survey is still quite useful as an indicator of investor mood.
At the end of June 2022, the sentiment was decidedly bearish as nearly 47% of the votes are Bearish compared to only 23% in the Bullish. Of course, sentiment can change rapidly, so it’s always important to stay up-to-date on the latest readings. While the negative mood has perhaps moderated a bit from a few weeks ago, the sentiment is still quite negative. Contrast this with the bullish high in November 2021 when the market was near highs.
One popular indicator that analysts use to gauge market sentiment is the AAII Sentiment Indicator. It is calculated using the survey data discussed above using this simple subtraction:
Sentiment = # of Bullish votes – # of Bearish votes.
When the result is a negative number, it indicates the mood is mostly negative. Conversely, when it is positive, it indicates that the mood is bullish. Over the longer term, above-average returns have usually followed very bearish moods and below-average returns have usually followed very bullish moods. It therefore, quite literally, pays to be a contrarian. The image below from the AAII, though somewhat confusing, is very illustrative. The current reading is -24 which means that the market mood is negative, which implies that you should be greedy.
It is important to note that being a contrarian is not easy. By definition, you have to go against the broader mood in the market and that is not easy! Also as the broader mood does drive market returns in the very short term, you have to also be able to absorb your investments going down for some time. The indicator has been mainly bearish for the last 6 months and yet the market still goes down! If it was so easy to be a contrarian, everyone would do it (which paradoxically means that nobody would be a contrarian)!
The only one comforting factor is that when the market goes down, remind yourself, great assets are on sale and its time to buy!
What Should I Do Now?
The first rule is do not panic. The second rule is to go shopping! These are the times that give you the best opportunity to make truly excess returns, otherwise known as alpha.
Why are you so blessed to be able to generate this alpha when others are worried only about losing money? Well, you may have heard that the stock market usually discounts the future, meaning that the negative (or positive) news that people are talking about are already reflected in the stock prices. This means that the market takes down the prices of these companies even before they report any drop in earnings.
In effect, this means that bad news is already priced in to a certain extent and you have the opportunity to buy stocks that are already priced for some degree of negativity! Since your time horizon extends beyond the next 18-24 months, you have the ability to look through this bad news and buy stocks that do not reflect the subsequent economic recovery! It literally pays to be patient!
What Should I Buy?
It’s a confusing world out there, so I have done my best to provide some suggestions. Please remember the caveat that I am just offering some ideas here and ultimately it is your job to do the underlying research and confirm that these options suit your requirements. Please remember that in the financial markets your capital is always at risk.
The Passive Approach
If you feel that trying to pick between different options is too overwhelming or confusing, then your best approach is to proceed with a robo-advisory platform like Nutmeg which will do all the heavy lifting for you. If you are not familiar with them, please read our detailed review on the platform.
The Active Approach
If you are comfortable with making some investment decisions, trading ETFs, and managing your own risk profile, then this article is for you. The focus of this article is to propose ETFs which would be reasonable investment opportunities. If you are in the UK, take a look at our article which discussed how you can buy US stocks and ETFs from the UK.
My general framework for this article is to look at the areas where there has been the most pain (largest drawdowns) and where the valuations are the most reasonable. This indicates that market herd has abandoned those sectors. Some other underlying assumptions are:
- These are truly investments and not trades, where the assets are invested for the long term, so the time horizon is longer than three years. I therefore do not recommend any leveraged ETFs.
- We might still be in the midst of a correction, so investments could still go down significantly over the coming months.
If you are looking for a platform to trade on the financial markets, take a look at our detailed review of Fineco and consider signing up to get free trading commissions!
There is an endless variety of stock focused ETFs available, so I have divided them in to two categories: 1) broad market ETFs and 2) sector-specific ETFs. The goal is to find ETFs which will provide reasonable returns without getting into very niche areas where the risk might be too high.
A reasonable approach would be a core-satellite portfolio, where the core of the portfolio is in the broad market funds (say 60-70%) and the rest of the funds are allocated to sector-specific ETFs. I first discuss some broad-market ETFs here, followed by two sectors that have been really beat up in this market correction of 2022.
As we are discussing ETFs from major providers here and the holdings of these ETFs are also large companies, we do not have to worry much about the underlying fees or liquidity. In all cases, the the total expense ratio (including fees) is below 1% which is sufficient for our purpose.
Best Broad Market ETFs for 2022
As shown in the first chart in this article, amongst the major benchmark indices, the ones that have fallen the most are the Nasdaq, S&P 500, with Euro Stoxx 600 tied with the MSCI ACWI. As the Nasdaq is a tech-heavy index, I cover that separately in the sector-specific section below.
These broad market ETFs would form the core component of your core-satellite strategy, meaning that they should have a higher allocation in your portfolio compared to the other market holdings.
Let’s look at what I think are the best broad market ETFs to buy in this market correction of 2022, as they could make great long-term investments (my opinion only, not a recommendation):
The S&P 500 is probably the most famous index globally as it tracks the largest 500 companies listed in the US. The S&P 500 is down 20% in the first half of year and is currently trading at a forward price-to-earning ratio of 15.8, which is below the historical 10-year average of 17.1 and median of 16.8. It’s actually closer in line with the 20-year average and median figures. As you might guess, this means that the index is not terribly cheap, but it’s also not insanely expensive either. It therefore makes sense to allocate some capital here.
Although one might think that investing in the S&P 500 is investing only in the US, it is important to note that the largest companies in the index are all multinational: Apple, Microsoft, Amazon, Alphabet (Google), Tesla, etc.
Best ETFs to track the S&P500 ETF are shown below.
Trading in the US Markets
|iShares Core S&P 500 ETF||NYSE:IVV||0.03%||$288B|
|Vanguard S&P 500 ETF||NYSE:VOO||0.03%||N/A|
|SPDR S&P500 ETF Trust||NYSE:SPY||0.095%||$355B|
Trading in UK Markets
|Vanguard S&P 500 UCITS ETF (USD)||LSE:VUSD||0.07%||$32B|
|Vanguard S&P500 UCITS ETF (GBP)||LSE:VUSA||0.07%||$30B|
In case you are wondering what is the difference between VUSD and VUSA? The difference is just related to the trading currency. Both VUSD and VUSA represent the same underlying index and both trade on the London Stock Exchange. If you only have GBP to invest, then its easier to just buy the VUSA as you do not have to incur any currency exchange charges. If you want to transact in USD and can buy ETFs on US markets, you’re better off with IVV or VOO as the fees are every so slightly lower for those two ETFs.
The MSCI All-Country World Index is a nice global benchmark of stocks and gives investors allocation to the major global companies. The ACWI ETF holds 2,371 companies! The single largest country represented in the index is still the US with a nearly 60% weighting. This is mainly because the US stock market has outperformed the rest of the world over the last decade.
The index currently trades at a forward price-to-earnings ratio of 13.6, which is at a discount compared to its 10-year average of 15.5 and median of 15.3. It’s also lower than the 20-year average of 14.5 and median of 14.4.
I like the ACWI because it gives good exposure to global markets, where there are many excellent companies. Compared to the S&P500, the ACWI benchmark also brings in excellent companies like TSMC, Nestle, Tencent, and Alibaba. The benchmark also has a slightly lower technology sector weight compared to the S&P500, which makes it a little bit more balanced.
If you do not want to bother with figuring which specific geographies to invest in, the ACWI is a one-stop solution to achieving geographic and company level diversification.
The MSCI ACWX index, a cousin of the ACWI, is the All-Country World Index excluding the USA. It represents all the major regions in the world except for the USA. As a result of this, the countries with the largest representation in the index are Japan (13.7%), China (10.4%), the UK (9.85%), Canada (8%), France (6.9%).
The index currently trades at a forward price-to-earnings ratio of 10.9, which is at a discount compared to its 10-year average of 13.6 and median of 13.5. It’s also lower than the 20-year average of 12.9 and median of 13.1.
If you want exposure to the global markets, but not the US, then this is a good index to own. Unlike the S&P 500 and the ACWI, the financial sector has the largest representation in this index. The 5 largest holdings in this index are TSMC, Nestle, Tencent, Roche, and Alibaba – all fantastic companies in their own right.
Best Sector-Specific ETFs for 2022
The point in going after sector-specific ETFs is to take advantage of sectors that have sold off the most as the herd suddenly shifts away from the sectors due to a change in the narrative. The goal is to generate some excess returns (alpha) in comparison to simply holding the broad indices. As the fear factor from the sector starts to reduce and demand increases, these ETFs should outperform their larger peers.
When the normalization happens, you can then sell these sector ETFs and either reallocate that cash to the broader index, or alternatively, invest in the sector that is underperforming at that point in time. As you may appreciate, there is slightly more trading required with this strategy, so please judge its suitability for your skills and needs. Note though that this is not a day-trading strategy. You should expect to hold these ETFs for probably longer than a year.
These sector-specific ETFS would form the satellite component of the core-satellite strategy, meaning that they should have a lower allocation in your portfolio compared to the broader market holdings.
Coming to the present, I checked the S&P’s sectors and found that in the first half of the year, the two sectors which have underperformed the most are Consumer Discretionary and Information Technology. Naturally, these two sectors are where we can do some of our hunting.
Best Technology Sector ETFs for 2022
As interest rates go up and the market herd starts to rotate away from the “growth” areas of the market, it creates plenty of opportunities for us. Many high-quality companies are trading at reasonable valuations and this means that buying them through the ETF gives us great opportunity to generate some excess returns.
The S&P 500 Info Tech index is currently trading at a forward price-to-earnings multiple of 19 compared to 10-year average of 18.4 and median of 17.3. The 20-year average is 18.06 and median is 17.8. The Nasdaq index is currently trading at a forward price-to-earnings multiple of 21.2 compared to 10-year average of 22 and median of 20.6. The 20-year average is 21.3 and median is 21.2.
In the tech sector, some of the ETFs that can be considered for buying are:
This ETF tracks a global basket of companies in the electronics, computer software and hardware, and informational technology sub-sectors. IXN is down 29% in the first half of the year. The top 5 holdings in IXN, as of the writing of this article, are Apple, Microsoft, NVIDIA, Visa, and TSMC.
I like this ETF as it has a global basket of companies and you do not have to split hairs by trying to pick specific geographies or sub-sectors. If however you wish to get more targeted exposure to certain geographies or sub-sectors, see the other ETFs listed below.
Invesco QQQ (Nasdaq:QQQ)
The QQQ, another well-known ETF, tracks the Nasdaq-100 index, which is composed of major US companies excluding certain sectors. Typically, the Nasdaq is associated with the technology sector and the top 5 holdings reflects that. They are: Apple, Microsoft, Amazon, Tesla, and Alphabet (Google). QQQ is down in line 29% in the first half of the year.
This ETF focuses on North America, but takes a broader scope and also brings in technology companies that are classified under other sectors. IGM is down 33% in the first half of the year. The top 5 holdings in IGM, as of the writing of this article, are Microsoft, Apple, Amazon, Alphabet (Google), and NVIDIA.
This ETF mirrors the holdings of the ICE Semiconductor ETF which is composed of the major US listed semiconductor companies. We have all heard of chip shortages as a consequence of Covid, but now there are fears that there is a glut of new semiconductor fabrication plants under construction which could lead to an oversupply of chips. Combine this with a potential recession and rising interest rates, it makes sense that the ETF is down 35% so far this year!
The SOX benchmark is trading at a forward price-to-earnings ratio of 13.2 compared to the 10-year average of 16.3 and median of 15.7. The 20-year median is 16.4. In fact, the SOX is trading very close to the valuation lows of the last 10 years, which is quite astonishing, considering the high quality companies that are held here!
The top 5 companies in the SOXX ETF are Broadcom, Texas Instruments, NVIDIA, and Qualcomm.
Another ETF similar to the SOXX is SMH. I have a detailed article comparing SOXX vs SMH and further discussion on the semiconductor sector.
If you believe that software will eat the world, then this should be the ETF to choose! IGV holds a basket of North American software companies and is down 32% in the first half of the year. The top 5 companies in this ETF are Microsoft, Salesforce, Adobe, Oracle, and Intuit.
Best Consumer Discretionary ETFs for 2022
As the name implies, this sector represents companies which primarily derive their sales from selling goods and services of a discretionary (non-essential) nature to consumers. The other consumer sector – Consumer Staples – consists of companies which sell goods which are more immune to economic forces. This latter basket would include companies like Proctor & Gamble or Nestle.
The consumer discretionary stocks are inherently more volatile than the consumer staple stocks and when there are fears of recession or a reduction in consumer spending, these stocks get hit. This gives you the opportunity to pick up some shares at a discount.
The S&P500 consumer discretionary index is currently trading at a forward price-to-earnings multiple of 20.3, compared to a 10-year average of 21 and median of 19.1. The 20-year average is 18.8 and median is 17.6.
Let’s take a closer look at the two ETFs which I like in this sector.
This ETF owns a basket of global consumer discretionary stocks. As you may have guessed by now, I prefer to own ETFs that own a global basket of stocks, rather than focus on a specific region. RXI is down 28% for the year. The only thing that I don’t like about this ETF is that it has a 10% weight in Tesla, which is its largest holding. After Tesla, the other holdings in the top 5 are Amazon, Home Depot, Alibaba, and Toyota Motor.
This ETF tracks US based consumer discretionary companies. IYC is down 32% for the year. The top-5 holdings in IYC are Amazon, Tesla, Home Depot, Costco, and McDonald’s Corp. IYC also has a nearly 9% weighting in Tesla, so lower but not significantly different from RXI. There are 179 stocks in this ETF compared to 166 in the RXI, so it’s trade off in terms of higher numerical diversification, but no geographic diversification.
Bonds & Bond ETFs
Bonds are an interesting beast and an area of the market that does not get as much interest in the minds of the retail investor as they should. Part of the reason is that interest rates have been low for over a decade and it made no sense to invest in bonds. TINA was the rallying cry.
However now that interest rates are starting to go up, the yields in the bond market are starting to look somewhat appealing. Before we dive into the best bond ETFs to buy in the current context, I will quickly discuss a few basic concepts here first.
What is a Bond?
A bond is a debt security, like an IOU. When you buy a new issue bond, you are lending money to the issuer, which can be a corporation, government, or municipality. In return for your loan, the borrower promises to pay you interest (the coupon) and to repay your principal (the face value of the bond) when it matures. Bonds are normally issued with maturities of more than one year, but they can have maturities as short as a few months.
If you found that confusing, just think of a bond like a bank loan in which the borrower pays only the interest for the life of the loan. When the loan period ends (the maturity date), the borrower must return the original borrowed amount (the principal) to you.
The interest rate for the bond (known as the coupon) is set based on the risk profile of the borrower and the borrowing period. The higher the risk or longer the borrowing period, the higher the coupon the bond will have. Over the life of the bond, its actual price will fluctuate based on market conditions such as interest rates, economic cycles, changes to the borrower’s business, etc.
How to Make Money with a Bond?
Just like with stocks, with bonds you can either buy and hold (till maturity) or you can trade them. In both cases, your return is dependent on the buying and selling price + the coupons collected during your holding period.
Where things can get confusing is that bonds have some technical factors that can cause bonds issued by the same company to move differently. Some key terms to know are:
- Yield: In concept, this is similar to the dividend yield on a stock. As the actual interest payment is fixed at issue time (not for all bonds, but easiest to explain this way), the yield is basically a function of the price you pay for the bond. What you need to remember: When price of the bond goes down, yield goes up; and vice versa.
- Duration: The easiest way to think about duration is to equate it to the maturity period remaining on the bond. It’s not the perfect definition but it works for our purposes. Bonds with longer maturity periods (longer duration bonds) exhibit higher sensitivity to changes in the interest rate. What you need to remember: When the central bank increase their interest rates, bonds that have a longer duration will go down price more than bonds of a shorter duration (even when the borrower is the same).
- Risk profile: When a new bond is issued, borrowers with a poor risk profile will have to pay a higher interest rate (coupon) compared to borrowers with less risky profile. Due to variations in the economic and political cycles, a borrower’s risk profile may change over the life of a bond. What you need to know: If the market expects a bond to get a ratings downgrade, the price of the bond goes down; and bonds that expected to get a ratings upgrade, go up in price.
Just like equity markets, bond markets also discount the future, so bond prices trade on expectations of the future. Expert managers make money by carefully balancing the above factors to ensure that they can maximize the returns while minimizing risk.
Hopefully that was clear as mud!
What has the bond market done in 2022?
The backdrop of high inflation and rapidly rising interest rates (especially coming from a rock-bottom interest rate scenario during Covid) means that bonds have a tough hill to climb. The bond index consisting of US investment grade bonds is down 10% in the first half of 2022. In comparison, the index of shorter-term bonds is only down 5%.
The chart below shows that all types of bonds have been hit quite hard. The duration concept is very vividly clear in this chart – the longer the duration, the greater the fall in the bond prices. Longer-term bonds are down even more than high-yield bonds, which means that the bond market is more worried about rising interest rates than about a long drawn-out recession.
In keeping with the framework we used in the equity section, I am making my recommendation in two buckets: 1) Core bond ETFs and 2) Targeted bond ETFs. The goal remains the same here – select ETFs which provide reasonable returns without taking undue risk.
The core-satellite approach is also valid in the fixed-income component of your portfolio. The core bond ETFs should be closer to 60-70% of your fixed income portfolio, supplemented with the targeted bond ETFs in the satellite section.
The one important aspect to note is that in a rising interest rate scenario, bonds and bond funds are still susceptible to declines in price. Therefore even now investors in bond funds should be careful as there is still a risk of a loss of some capital in the medium term (next 2-3 years). Please plan your capital allocation appropriately.
Best Core Bond ETFs for 2022
This is a US-focused bond fund and provides a broad exposure to US investment grade bonds. These are bonds with a rating bucket of BBB or higher. The chart below shows the level of draw down that this fund has experienced: from the peak of $119 in late-2020, the fund is now down about 15%. This is almost equivalent to the blip that the fund experienced in 2008! If you held this fund for the last 5 years, your returns were just about 0%.
I like this fund as it does not attempt to get too fancy with its holdings. The purpose of a core bond fund is to preserve capital while providing some decent yields, and for that purpose, this bond fund is great. The objective here is not to compete with equity funds to generate a high rate of return.
The fund holds 10,258 bonds with US Treasury bonds and US government-backed mortgage bonds amounting to nearly 64% of the assets. The holdings have a yield of 3.55% with an effective duration of 6.5 years. The yield on the ETF is 3.2% with an unbelievably low management fee of 0.03%.
UK-based fixed income investors may not like to be exposed to the currency volatility of owning US bonds so it would make sense to own a more domestic-focused portfolio of bonds.
There are couple of downsides to owning this fund though:
- The yield of 0.9% is lower compared to AGG.
- The ETF pays only semi-annually, as compared to monthly on the AGG
- An effective duration of 10.5 years is higher than the 6.5 years on the AGG, which means that as interest rates continue to rise (most likely scenario for now), the fund will experience a greater move to the downside.
The shrewd reader will counter the first bullet with the interest-rate parity equation (long-term FX moves will negate the difference in interest rates between the US and the UK), and you would theoretically be correct. However in reality, FX is driven by more than just interest rates, so one cannot merely just base their decisions on the interest rate differential.
Additionally, with relatively higher commodity price pressure in the UK and Europe due to the Russia-Ukraine war, the inflationary pressures are higher here than the US. This means that ugly combination of inflation and recession will have a greater impact in UK than in the US.
As you might guess, I am not the biggest fan of owning IGLT currently, however should you want to restrict your exposure to a high-grade UK-focused bond ETF, then IGLT would be a good option.
Best Targeted Bond ETFs for 2022
The goal of owning some of these targeted bond ETFs is to get a little more creative with the bonds. Obviously this would bring with it some more commensurate risk, so please restrict these funds to the satellite category of your fixed-income allocation.
If you thought the chart for AGG was ugly, you may want to close your eyes for the chart for ILTB.
As you may recall from the discussion above, bonds with higher duration exhibit greater interest rate sensitivity. Therefore as the interest rates grind higher, ILTB will go lower much faster than the other bond ETFs listed here as it has a modified duration of nearly 23 years.
One might be tempted to chase the higher yield of 4.4% on this ETF compared to the 3.2% but the exaggerated price moves would make that a fool’s errand.
My suggestion (this is an opinion only, not a recommendation) is to only allocate a small amount of capital to this ETF for the time being. However as interest rates grind higher, it would make sense to keep buying even as the fund goes down.
I like this ETF simply because the market mood is so pessimistic currently and the market herd is worried about how high interest rates can go. However, as the impact of higher interest rates flows through the economy and GDP growth starts to slow down, or we go in to a recession, central banks will eventually be forced to stop raising or even start cutting rates. This fund will shine under that scenario as its price will increase.
Finally, a nice global bond! This ETF holds a mix of international high-yield corporate bonds. High-yield bonds are bonds issued by more riskier borrowers, which means that these borrowers must pay a higher interest rate to the lenders (such as yourself). Obviously there is no free lunch, as these higher risk borrowers also have a greater risk of defaulting on their bonds.
Typically, high-yield borrowers fall in to the BB rating bucket (in S&P terminology) and below. Nearly 58% of the holdings in the BB category compared to 0% in the AGG (AGG holds only BBB rated or higher).
ILTB offsets this higher risk (known as credit risk) by ensuring that the bonds have a shorter duration (6.5 years, the same as AGG) and also a large number of holdings.
What is TINA?
TINA is an acronym that stands for There Is No Alternative. The term is often used to describe situations in which there is no other choice or course of action available. While the phrase can be used to describe positive situations, it is more often used in negative or neutral contexts. In the context of the financial markets, TINA meant that for most of the last decade, investors piled in to the stock market as returns everywhere else were too low. Eventually, TINA also led to people investing in highly risky corners of the market, such as in companies with no earnings, cryptocurrencies, and NFTs.