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Where ETF Investors Should Look outside the US

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Where ETF Investors Should Look outside the US

Large U.S. company stocks are beginning to look pricey relative to their historical trends as the ongoing bull market rally pushes into its ninth year. Consequently, investors may consider potential exchange traded fund opportunities outside of U.S. large-caps.

On the recent webcast (available On Demand for CE Credit), Opportunities Outside of U.S. Large Cap Companies, Salvatore Bruno, Chief Investment Officer and Managing Director of IndexIQ, pointed out that the global economic outlook is improving, with forecasts showing growth around the world is improving and broadening, especially in Southeast Asia.

“Growth is steady and improving in key areas outside the U.S.,” Bruno said.

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Along with the growth prospects, investors may also find better value in global markets. Looking at 12-month forward price-to-earning ratios, the S&P 500 is relatively pricey compared to international benchmarks. The S&P 500 was trading at a 17.7 P/E as of the end of June, compared to its 15.4 30-year average. In contrast, the MSCI Europe was trading at a 14.8 P/E, compared to its 14.0 P/E 30-year average. The MSCI Japan was hovering around a 14.4 P/E, compared to its 27.8 P/E 30-year average. The FTSE World ex U.S. showed a 14.2 P/E, compared to its 16.2 P/E 30-year average.

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Earnings growth will also further support market prices in global markets. For instance, trailing earnings have rebounded on the Euro Stoxx 50 Index while forward earnings push higher.

“Growing earnings may continue to provide a tailwind for European equities,” Bruno said.

However, as more look to global opportunities, investors should keep in mind potential currency risks that come with international investing.

“Currency valuations tend to revert to the mean over long periods of time, but fluctuate dramatically during shorter periods — increasing the impact of currency movements,” Bruno said.

Due to the currency fluctuations and the predictable nature of the foreign exchange market, it is difficult to pinpoint the best times to use a completely hedged or unhedged investment approach. Bruno warned that missed opportunities due to sharp currency swings have historically led investors to chase after performance through either fully hedged or nonhedged strategies. Alternatively, investors may consider a 50% hedged investment strategy as a way to still keep their feet in the water without worrying too much about risks.

“Based on historical statistics over nearly the past two years, a 50% hedged approach consistently provided a competitive return compared to a fully hedged or unhedged portfolio,” Bruno said.

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ETF investors may consider alternative options that take a more neutral view on foreign currency movements through a handful of 50% hedged/50% unhedged options, including the IQ 50 Percent Hedged FTSE International ETF (NYSEArca: HFXI)IQ 50 Percent Hedged FTSE Europe ETF (NYSEArca: HFXE) and IQ 50 Percent Hedged FTSE Japan ETF (NYS Arca: HFXJ). All three funds have approximately half their currency exposure of the securities in the underlying index hedged against the U.S. dollar on a monthly basis.

Along with the neutral hedged international ETFs to diversify away from large-cap U.S. stocks, investors may also consider multi-factor small-cap investments to capture potential opportunities at home.

A factor can describe any characteristic relating to a group of securities that can help explain their risk and return. Some of the most common factors that have been historically outperformed include size, value, quality, momentum, and volatility. The various factors can be combined to form a multi-factor, smart-beta ETF strategy.

“Single factors have been highly cyclical from year to year, and timing can be a difficult endeavor,” Bruno said. “Combining multiple factors creates a more diversified solution to potentially enhance returns over time.”

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Investors may also focus on the small-cap segment as smaller stocks have historically outperformed large-cap stocks over time and recovered faster from downturns. Small-caps may also outperform ahead as the segment have historically done better than large-caps in periods of rising rates.

When looking beyond U.S. large-caps, investors can also consider something like the IQ Chaikin U.S. Small Cap ETF (NasdaqGM: CSML), which tries to reflect the performance of the Nasdaq Chaikin Power US Small Cap Index, which applies a shareholder yield screen and the so-called Chaikin Power Gauge, a quantitative multi-factor model that identifies securities expected to outperform their peers, to select components from the Nasdaq US 1500 Index. The target focus will include small capitalization stocks.

“The Chaikin Power Gauge is a factor-based model which combines four primary factors, including value, growth, technical, and sentiment to select stocks with the potential to provide enhanced returns over time,” Tom Psarofagis, Director of ETF Product Management at IndexIQ, said.

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