The Year of the Dynamic ETF
With the world digesting the surprising results of the 2016 U.S. Presidential Election, the team at IndexIQ has turned their thoughts to next year and their top five ETF-focused trends and insights for 2017.

1. Volatility is likely to rise.
A significant equity valuation gap has emerged since the Global Financial Crisis, captured in the fact that earnings per share in the S&P 500 have increased by approximately 129% since April 2009, while the total return of the S&P 500 Index over that same time period has been 190%. Stock buybacks have been falling sharply (Q3 2016 saw a 44% decrease in the number of buybacks from Q3 2015),¹ removing synthetic share buying from the markets. The U.S. election and other geopolitical trends seem to be favoring populist movements, not just in the U.S. but in Europe, which is still dealing with the fallout from the Brexit vote; and in South America, which saw the defeat of the FARC² referendum in Colombia. All of these factors and more set the stage for what we believe will be an increase in volatility in 2017, making it important for investors to diversify across investment strategies and consider approaches designed to provide downside protection.

2. Divergent central bank policies will introduce even more uncertainty around currency moves.
The U.S. Federal Reserve is clearly about to embark on a tightening path, while at the same time the European Central Bank, Bank of England, and Bank of Japan are still pursuing their easing policies. The conventional wisdom seems to be for U.S. dollar strength in the New Year, but we did not see dollar strength in 2016, despite that being the same conventional wisdom at the start of this year. Predicting currency moves will continue to be a losing game for investors in 2017, and maintaining at least a partial currency hedge in an international equity portfolio could help mitigate some volatility and risk.

3. Growth of ETF industry assets will continue.
ETFs saw an approximately 14% growth rate in their overall assets this year through mid-August,³ which was roughly the same rate of growth experienced by the industry over the previous 12 months. That trend is likely to continue as ETFs have displayed competitive performance. Further, there is increasing pressure on fees that make ETFs attractive. And there are questions about how a Trump presidency will impact new Department of Labor rules. If enacted as announced, the rules appear likely to cause many advisors to favor the lower cost structure of ETFs over active mutual funds. Estimates as to just how much this will increase the migration of assets from active to passive vehicles vary widely, but it seems clear that these new rules are likely to speed the pace of ETF adoption across the advisor channel.

4. “Smart beta” bond exposures will continue to gain investor acceptance.
A flurry of “smart beta” and factor-driven approaches to equity investing has been one of the biggest stories in the world of ETFs over the past several years, and many of these approaches have found wide acceptance, with investors and advisors looking to add potential opportunities for outperformance to their portfolios. However, of the 783 ETFs that ETF.com currently classifies as “smart beta” only 24 come from the fixed income segment. In a low yield, low growth environment, we believe strategies that allow investors to add additional opportunities for growth and income to their portfolios could prove attractive. As with any new category, the key will be education and understanding how various approaches work.

5. Investors will continue to shift assets back into commodities.
A weaker dollar has helped drive strong commodity returns so far in 2016, with gold up approximately 6.3% for the year and oil up more than 37.4%.⁴ Oil, however, is likely to remain range-bound for the foreseeable future due to Organization of Petroleum Exporting Countries’ production caps, which set a floor, and oncoming supply from U.S. shale operations. Still, commodities, gold in particular, have been exhibiting high degrees of negative correlation to the equity market, which will likely draw investors back to the space that has been on the sidelines during the commodity downturn of the past several years. Importantly, a diversified approach to commodities should be considered, much the same way an entire portfolio is viewed through the lens of diversification. Over-concentrating in gold and oil— while ignoring other major commodity sub-sectors such as livestock, grains/food/fiber, industrial metals, timber, water, and coal—could mean that investors miss out on potential opportunities for growth and additional non-correlated sources of return.

1 Source: Morningstar, 10/31/16.
2 The Revolutionary Armed Forces of Colombia-People’s Army (FARC).
3 Source: Morningstar, 8/15/16.
4 Source: Bloomberg, 12/15/16.