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Finding The Best Places To Invest Among Tough Global Markets

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These are exhilarating times and trying times to be an ETF investor. It's easy to get carried away by the headlines that the major averages are making all-time highs. Until the fine print reminds you they're basically back to where they were a year ago.

"It's been an unprecedented equity market roller coaster," Omar Aguilar, chief investment officer of equities at Charles Schwab Investment Management, said on a July 12 media call. While Aguilar was speaking after the stock boomerang following Britons' vote to leave the European Union, he was referring more generally to the sharp bouts of volatility that have accompanied U.S. stocks' slow and relentless grind sideways over the past year.

Exchange traded funds allow Americans to invest in far-flung international markets with one tap on a touch screen. Even better, they allow investors to make opportunistic trades depending on their outlook for the asset class and the global macroeconomy.

But this investment vehicle's flexibility can seem double-edged when the stock market outlook changes as often it has lately. For Aguilar, Brexit reinforces the uncertainties that ETF investors are already grappling with. Will a potential loss of confidence spill over to our shores? Which emerging markets are likely to face collateral damage? What could further weakening of the British pound mean for the dollar and U.S. portfolios?

These are important issues to investors. More than ever before, they understand the importance of allocating to international as well as domestic markets to diversify portfolios and reduce risk. However, they're feeling stuck between a rock and a hard place. Earnings are on a downswing in corporate America. The profit outlook is equally or more bleak in Europe, Japan and many emerging markets.

The performance of two ETFs tells this painful story clearly: iShares MSCI ACWI ( ACWI ), which provides access to the global stock market in a single fund, has given up 2% in the past year through July 13.

[ibdchart symbol="ACWI" type="daily" size="full" position="leftchart" ]

If that sounds depressing, consider this: iShares MSCI ACWI ex US ( ACWX ), which also invests in the global stock market but shuts out the United States, has slumped more than 8% over the same period.

[ibdchart symbol="acwx" type="daily" size="full" position="leftchart" ]

Not all international markets are hurting though. As oil rallied, iShares MSCI Brazil Capped ( EWZ ) jumped 53% to become one of the best-performing ETFs of 2016 so far.

All told, investing experts largely agree upon these grim facts: Global volatility is here to stay in the near term, and portfolio returns are unlikely to creep above the single digits. That has some investing experts asking: Does it still make sense to invest internationally in the current market scenario? At BlackRock, the world's largest asset manager and the firm behind iShares ETFs, strategists are optimistic that U.S. earnings will improve in the second half. However, they caution investors and financial advisors that the rebound may not be as big as many expect.

"U.S. equities are the least dirty shirt of global equity markets, although high valuations keep our return expectations in check," Richard Turnill, BlackRock's global chief investment strategist, wrote in a July 11 research note. In this decidedly mixed climate, he favors quality stocks and dividend growers.

That preference for domestic stocks is, by and large, shared by the ETF investing pros who spoke to IBD about how they're constructing portfolios for the months ahead. In a recent interview, they offered unique perspectives on rate hikes, currency volatility, Brexit contagion and more.

'Stay Close To Home As Europe And Japan Face Unique Challenges'

Susanne Alexandor is vice president and client portfolio manager at Cougar Global Investments, a Toronto-based tactical ETF strategist that seeks to achieve high portfolio returns primarily by managing downside risk; assets under advisement: $1.23 billion.

Our message and positioning for our global unconstrained portfolios remain "stay close to home" in the United States. Cougar Global's strictly macro-focused approach continues to view the U.S. economy as in relatively better shape than its global peers. The flexible U.S. labor market has played a role. Proactive policymaking by the Federal Reserve under Ben Bernanke and now Janet Yellen has also helped. While it is difficult to isolate the effects of quantitative easing on the economy, we now know the economy eventually recovered from the Great Recession and remains on track to grow modestly. Confidence is up. The American consumer accounts for over 70% of gross domestic product, and has been spending, comforted by the continuing creation of jobs that has seen the unemployment rate drop back under 5%. The most recent employment report confirmed yet again that the labor market is healthy.

The outlook for the path of rate hikes is very cautious, so as to not derail the expansion and exert further upward pressure on the U.S. dollar. We therefore hold our exposure almost evenly split between the cap-weighted S&P 500 and S&P Midcap 400 ETFs. We remain mindful of the effects of currency volatility, and midcaps tend to have less earnings exposure outside the United States than large caps.

We have avoided the United Kingdom, Europe and Japan. All three have unique challenges. Japan's inability to escape 20 years of stagnation and deflation is concerning. We foresee little change within our 12-month horizon.

In Europe, Brexit contagion has us concerned. The economic impact for the U.K. and Europe is sure to be negative in the short term, and its magnitude will depend on what the U.K. eventually negotiates. More important, the stability of the European Union and the euro are at risk. Euro-skeptical populist parties are gaining in polls across the continent. With several elections over the next year, the political landscape in Europe could change dramatically. Austria will be rerunning its election on Oct. 2. The anti-immigration, anti-EU candidate Norbert Hofer has another chance to become the first far-right leader of an EU country.

Combined with the weak banking sector, high unemployment, tight fiscal policy and lack of structural reforms, the European macro outlook is not promising -- as evidenced by the negative yields offered across a large segment of the bond universe.

Emerging markets have recovered this year as the U.S. dollar rally faded. However, we remain unconvinced that the fundamentals in many of these markets will result in a sustained growth trend. China's continuing moderation will also present challenges.

With geopolitical and macro concerns escalating, we have become more defensively positioned by allocating more to gold and bonds at the expense of equities.

Loose central bank policies continue to underpin market sentiment, collectively doing "whatever it takes" as European Central Bank President Mario Draghi famously said. For the time being, that may be enough to support markets. Despite our caution, we are still allocating a healthy portion of our mandates to the most promising opportunity: staying close to home in U.S. equities.

(Editor's note: Cougar Global strategies include SPDR S&P 500 ( SPY ), SPDR S&P Midcap 400 ( MDY ), iShares Core S&P Small-Cap (IJR), iShares Core US Aggregate Bond (AGG) and iShares Gold Trust (IAU).)

'Don't Abandon Investing Overseas And Look For Opportunity'

Jeff Raupp is senior vice president at Brinker Capital, an investment management firm in Berwyn, Pa., that emphasizes a multiasset approach to portfolio construction while actively managing market opportunities and downside risks; assets under management: $18 billion.

We've had a strong bias within our equity portfolio toward the United States, and continue to maintain that bias going forward. Within the U.S., our focus has been on large-cap stocks, believing those have more attractive valuations than smaller-cap stocks. We also have had a bias toward higher dividend stocks , although we have been reducing that bias as those stocks have rallied sharply. While developed international markets are priced cheaper than the U.S., we think slower growth and political uncertainty warrants their lower valuations.

Europe and Japan have fully engaged central banks, which will utilize any tools at their disposal to stimulate their economies. However, both have to contend with already low interest rates and large balance sheets, which will likely limit their effectiveness.

The outcome of the Brexit referendum creates an added level of uncertainty for Europe and the United Kingdom that will likely dampen future business investment to some extent. In spite of central bank stimulus, I wouldn't expect demand to pick up substantially until we get some clarity on the future U.K.-eurozone relationship. It appears that could play out over the next several years.

Longer term, Europe continues to work through structural issues created by a common currency without integrating more fully. And Europe as well as Japan will suffer from poor demographics in the coming decades. This creates a longer-term headwind for investment in both of those regions.

While we are underweight developed markets, we think the benefits of a multiasset class approach are too powerful to abandon investing overseas altogether. While the U.S. appears to be the strongest economy, that could quickly change with a Fed policy mistake or headwinds from a political standpoint.

Emerging markets are more attractive to us than developed markets. Generally, the long-term fundamentals are good -- much better demographics and higher GDP growth -- although that can vary greatly country to country. Emerging markets have been unloved over the last four to five years because of their association with commodities and, with commodity prices appearing more stable, we think emerging markets present some attractive valuations. Our focus within emerging markets has been on consumer-based economies as they've tended to provide more diversification from the developed markets and were less affected by the downdraft in commodity prices. Now that commodity prices have stabilized, we've been increasing our exposure to the broader emerging market universe. After multiple years of underperformance, emerging markets are an area where I think many investors are underinvested, and we should start seeing a shift in that direction.

Frontier markets are also an area we like. These markets, such as Kuwait, Argentina and Pakistan, tend to be less global in nature, and driven more by their own fundamentals. Similar to emerging markets, you have a demographic tailwind, and investors are really just starting to discover the space.

'The Currency View Cannot Be Divorced From The Market View'

Benjamin Lavine is chief investment officer at 3D Asset Management, an independent Connecticut firm that has $750 million in AUM and works with fee-based financial advisors to bring low-cost, ETF-based solutions to individual clients.

We would be more inclined to invest internationally despite the risks surrounding Brexit and China slowdown. The United States remains the top choice among global investors, but the S&P 500 trades at 17.9 times earnings based on next-12-month consensus estimates. A lot of things need to go right for the U.S. markets to maintain or expand these valuation levels. We believe valuations are more attractive internationally, although our preference is for emerging markets over foreign developed markets given the growth challenges in major blocs such as Japan and Europe. We think that Europe, including the United Kingdom, will continue to face further fallout from the vote to leave the European Union ("Brexit"), but much of the near-term demand will be driven by liquidity-driven repositioning. The long-term arrangement between the U.K. and Europe has yet to be determined.

We believe that investors cannot divorce the currency view from the market view when deciding whether to invest in foreign markets vs. the home market. In other words, investors should generally not allocate capital to foreign assets if they are uncomfortable with the underlying currency used to value those assets. Currencies are very difficult to time. In general, we view currency hedging more as an insurance policy against the underlying market exposures rather than as a tactical, alpha-seeking trade.

If we are concerned about short-term volatility in the foreign currencies, we seek an insurance policy (hedging) for our longer-term allocation. We may hedge our asset class views through the adoption of a currency hedged ETF. The embedded costs include the trading expenses to implement the hedge as well as the cost-of-carry or the interest-rate differential between the home currency vs. foreign currency. Additional costs include trading expertise embedded in some of the more actively managed ETFs such as dynamic currency-hedged ETFs.

Currently, we are invested in FlexShares Currency Hedged Morningstar EM Factor Tilt (TLEH) as a way to hedge some of our emerging market exposure. In the past, we used WisdomTree Europe Hedged Equity (HEDJ) as a way to hedge our European equity exposure from a falling euro. We estimate the cost-of-carry for emerging-market hedging at around 2.5%, which may seem high (due to interest-rate differentials), but we harbor ongoing concerns about China's currency policies and the spillover of further devaluations on the broader markets.

With respect to the Brexit vote, we did not position our ETF portfolios in anticipation of a specific outcome. Polls had the vote neck-and-neck, and markets, in hindsight, had aggressively priced in a "remain" outcome more than what was warranted based on the polling. Although the British pound continues to weaken vs. the other major developed currencies, both the euro and the yen continue to hold their value vs. the U.S. dollar. Given that the bond market does not expect any Fed tightening for the remainder of the year, we do not anticipate further strengthening of the dollar vs. the yen and the euro.

Investors interested in currency hedged ETFs should first determine the desired level of hedging. The large ETF providers such as iShares, WisdomTree, and Deutsche X-trackers offer dollar-hedged versions of mainstream equity indices. IndexIQ offers 50% hedged ETFs as well. Finally, iShares offers dynamic-hedged ETFs based on MSCI's Adaptive Hedge Indices, and WisdomTree also offers their own line of dynamically hedged indices. Dynamic hedging incorporates valuation and technical signals to determine the appropriate hedge ratio.

(Editor's note: 3D Asset's views should not be relied upon as investment advice or a forecast of the future. It is for informational purposes only.)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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