There are reasons to be cautious about today's stock market. In addition to the persistent economic effects of the COVID-19 pandemic, these include:
- The S&P 500 market cap to nominal GDP ratio hovering near 140% (compared to a 60-year average of 62%).1 Moreover, the next 12 months (NTM) price-to-earnings (P/E) for every S&P 500 sector, excluding health care, is trading at double-digit premiums to their 20-year average NTM P/Es.1
- The rolling 12-month price change for the S&P 500 growth index less the S&P 500 value index (the growth value differential, considered an indicator by some investors) reaching an all-time high in Q3 2020, and has remained at levels comparable to the early months of the early 2000s bear market.1
- Margin debt at all-time highs relative to both the S&P 500 as well as nominal GDP.1
Yet the case for continued market strength remains strong, even with global markets at or near record highs. Historic levels of government and central bank support have helped backstop corporate earnings. And a robust vaccine rollout could help earnings bounce back in a big way.
If you believe in the market's long-term prospects and you are interested in exploring exchange-traded funds (ETFs) to help build or adjust the equity portion of a diversified portfolio, consider using Fidelity's ETF Screener to quickly sort through a lot of data. You can search for ETFs using a variety of characteristics like the fund's objectives, fundamentals, technicals, performance, volatility, trading characteristics, tax considerations, and analyst ratings.
Below, we feature 3 ETF screens, plus the top 10 results for each using various criteria.
In his recent market commentary, Jurrien Timmer noted that, when comparing trends in the global financial crisis to the pandemic of today, policy response compared with economic activity and stock fundamentals are exhibiting similar patterns. "The eventual recovery caused a rotation from growth to value and from large caps to small caps," Timmer states. "That happened in 2009 and it's (belatedly) happening now."
Of course, there remains a lot of uncertainty as to how these dynamics will play out. But if you are interested in exploring ETFs with at least 50% small-cap exposure that are trading at relatively attractive valuations, you can use Fidelity's ETF Screener to find opportunities.
Here are the top 10 ETFs with at least 50% exposure to small caps that hold US assets with a "low" P/E ratio (under 17x based on the weighted average of all holdings over the last twelve months), sorted by lowest P/E, as of February 25, 2021:
- iShares Russell 2000 Value ETF (IWN)
- Principal US Small-Cap Multi-Factor ETF (PSC)
- First Trust Small Cap Core AlphaDEX® Fund (FYX)
- WisdomTree US MidCap Earnings Fund (EZM)
- Avantis® US Small Cap Value ETF (AVUV)
- Vanguard Russell 2000 Value Fund ETF Shares (VTWV)
- iShares Morningstar Small-Cap ETF (JKL)
- First Trust Small Cap Value AlphaDEX® Fund (FYT)
- Invesco S&P Midcap Value with Momentum ETF (XMVM)
- First Trust Nasdaq® ABA Community Bank Index Fund (QABA)
As with any screen you run, you should evaluate the quality of the list that is generated. Does it appear that the screen results match your criteria? Is there a preponderance of a particular type of ETF? The results above do not appear to be concentrated in a particular sector or industry. But you can dig deeper into any of these ETFs to get a better sense of their composition and exposures.
Returns relative to risk
P/E by itself may not be a sufficient screening criterion if you want a more robust assessment of an ETF's risk relative to its return. You might consider using an ETF's Sharpe Ratio, which is a measure of historical risk-adjusted performance. It is calculated by dividing the ETF's excess returns by the standard deviation of the fund's returns. The higher the ratio, the better the fund's return per unit of risk.
The top 10 results for large-cap ETFs with the highest Sharpe Ratio (month-end, 3 year), as of February 25, 2021 (sorted by highest Sharpe ratio), are:
- Invesco Wilderhill Clean Energy ETF (PBW)
- Ark Next Generation Internet ETF (ARKW)
- iShares Global Energy ETF (ICLN)
- First Trust Nasdaq® Clean Edge® Green Energy Index Fund (QCLN)
- Invesco Solar ETF (TAN)
- Ark Genomic Revolution ETF (ARKG)
- SPDR® FactSet Innovative Technology ETF (XITK)
- Ark Innovation ETF (ARKK)
- Invesco Dynamic Software (PSJ)
- Invesco DWA Technology Momentum ETF (PTF)
Unlike the previous screen, these results are concentrated almost entirely in alternative energy and technology ETFs. You would want to do your due diligence to understand the characteristics and risks of ETFs in these industries/sectors. Another factor to consider is that several results of this screen are ETFs with relatively limited track records (i.e., several years). An ETF with a relatively limited track record, compared with established funds with longer tenures, may be more difficult to evaluate.
Interest rates have risen substantially over the past several months. For example, the 10-year US Treasury yield has climbed nearly 1% since the near-term nadir in August 2020. Yet rates remain relatively low after coming off historically low levels.
A misconception that some have regarding ETFs is that they do not pay dividends. On the contrary. If a stock is held in an ETF and that stock pays a dividend, then so does the ETF. While some ETFs pay dividends as soon as they are received from each company that is held in the fund, most distribute dividends quarterly. Some ETFs hold the individual dividends in cash until the ETF's payout date. Others reinvest the dividends back into the fund as they are received, and then distribute them as cash on the ETF's payout date.
Investors seeking income from stocks need to be comfortable with the additional risks compared to bonds (particularly US government bonds). With that said, if you are looking for ETFs that pay dividends, here are the top 10 results for ETFs with large-cap exposure featuring the highest SEC yield, as of February 25, 2021:
- JPMorgan Equity Premium Income ETF (JEPI)
- Invesco CEF Income Composite ETF (PCEF)
- First Trust CEF Income Opportunity ETF (FCEF)
- Energy Select Sector SPDR® Fund (XLE)
- Invesco International Dividend Achievers ETF (PID)
- Global X MSCI SuperDividend® EAE ETF (EFAS)
- First Trust Stoxx® European Select Dividend Index Fund (FDD)
- Invesco S&P International Developed High Dividend Low Volatility ETF (IDHD)
- VictoryShares Emerging Market High Div Volatility WTD ETF (CEY)
- First Trust S&P International Dividend Aristocrats ETF (FID)
If you think one or more of the ETFs identified by a screen is worth considering to help manage the risk in your portfolio or achieve your objectives, your next step should be to research it further. And always remember to evaluate a fund's costs, including the following:
- Expense ratio2: Look for low expense ratios to help reduce your overall costs.
- Bid-ask spread: Look for small bid-ask spreads to help reduce costs of investing.
- Tracking error: Look for a low tracking error to find ETFs that indicate a better job of replicating their benchmark indexes.
If you find ETFs with similar objectives, you could compare their expense ratios, bid-ask spreads, and/or tracking error to find the better deal. You can filter for all of these factors using the ETF Screener.
Knowing the individual components of an ETF can also give you a better sense of what you are buying or selling. You can find an ETF's components on its ETF snapshot page on Fidelity.com, under Portfolio Composition. On that page, you can find the ETF's style (value, growth, or blend) and size (large, mid, or small), as well as ratings and key statistics.
Finally, you should fully understand the risks involved in any investment strategy. Any investing opportunity should be considered within the context of a well-diversified investment strategy that conforms to your specific time horizon, objectives, and risk parameters.