Most armchair strategists started May by saying that 2016 was the year the old “sell in May and go away” adage would hold true, thanks to a laundry list of issues: Weak global economic growth, at least two Fed rate hikes, Brexit and Clinton vs. Trump, which were all supposed to knock equities down and send investors running for cover. Instead, the S&P 500 was up more than 1.5% in May, just shy of its all-time high, meaning traders who don’t want to underperform in 2016 are being forced back into the game this summer.
Reaching into the value bin might seem like a smart strategy at this point in the cycle with declining earnings and most markets trading close to all-time highs, but ETF investors using a bottom-up strategy to find funds with attractively priced stocks might find their money heading to strange places.
We decided to do a quick scan of the market with a value strategy focusing on the AAA bond yield that even Benjamin Graham could appreciate. We wanted stocks with a dividend yield close to that bond yield (around 3.7% at the start of June) and an earnings yield more than 2 times that, which translates into a price/earnings ratio of around 13.5X. To simplify things we cut the dividend yield to 3% or above and the P/E to 15x or below.
That produced a list of more than 200 names, and while there were plenty of oil trusts (but no utilities), the real surprise was the strong showing by retailers including national chains like Target (TGT), Macy’s (M) and Kohl’s (KSS.) Screening for high dividend yields isn’t likely to bring up a list of companies having a great 2016. These names are all challenged by weak to negative earnings growth as consumer spending remains low, but they could represent a chance to buy stable dividend payers whose earnings might be stable enough to keep those checks coming for the foreseeable future.
The problem is there are just three retail-oriented funds with less than $700 million in assets between them, so traders looking to play the bargain theme aren’t being overwhelmed with options. The majority (97%) of those assets are in two funds: The SPDR Retail ETF (XRT) and the VanEck Vectors Retail ETF (RTH), which have wildly different performance despite common holdings. XRT is the bigger fund and offers more diversity with close to 100 names. And with an equally weighted allocation, the fund has more than 22% of its holdings in retailers trading at a P/E below 14.
But that exposure comes at a price. Equally weighted allocations tend to produce more volatile, small-cap oriented portfolios and can miss out on the benefits of an extremely strong performer--a problem the market-cap weighted and heavily concentrated (25 holdings) RTH doesn’t have.
Instead, RTH suffers from the “original sin” of ETFs; thanks to the tremendous performance of Amazon, the stock now makes up more than 16.5% of its allocation compared to a mere 1.5% for XRT and the S&P 500 (see “Benchmark arbitrage”). No one is complaining as Amazon is up more than 30% in the three months ending May 31, which also explains why RTH is up more than 4.5% during that period while XRT is down 2%. Amazon delivered more than 100% of RTH’s return in those three months, which is all well and good until, just like Apple and tech funds, the party stops and the strong performer becomes a drag on performance.
With options like this, investors might be better off putting retail funds on layaway for the future.