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Will Large Cap ETFs Outshine Small Caps in Q4?

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 As we have moved into the fourth quarter of 2016, investors’ are having a tough time taking a call on whether they should take positions in large cap ETFs. Historically, since 1926, large market-cap stocks have inevitably outperformed their smaller counterparts in the fourth quarter. Data compiled by University of Chicago professors Eugene Fama and Dartmouth’s Kenneth French have proved this trend. However, small cap stocks beat their large cap peers during the rest of the year since 1926. 

Research scholars have identified three general reasons for this reverse trend. These are: tax-loss selling (selling of losing positions to take shelter from taxes that the profits may have realized earlier in the year), window-dressing (fund managers sell their loss making assets to avoid holding them in their year-end reports) and money managers’ compensation incentives trade-off (money managers’ risk tolerance likely to be greatest in January and least in December).

All three factors have a negative impact on small-cap stocks which are more susceptible to volatility than their large-cap peers.

Will history repeat itself in 2016? We believe it will. Apart from the above mentioned findings, we will now discuss a few more reasons which are likely to affect the investment scenario in Q4. (Read: Will Low Volatility ETFs Regain Their Mojo?)

Advantages of Large-Cap ETFs

Large cap stocks have three unique features. These stocks are very stable and less prone to market volatility and therefore they stabilize the entire portfolio. Such investments generally offers high dividend yields providing a regular income scheme to investors. Also their long business tenure and established brand of products provides clarity on valuations. As a result, large cap ETFs are highly desirable by investors for capital appreciation purpose.

Key U.S. Events

The U.S. is gearing up to witness a string of important events, the first one being the impending presidential election. Who will be the next president and whether there occur any change in policy making under the new administration will be followed closely by the market. Unexpected electoral results or any major change in government policy may generate market volatility at least in the short term.

Secondly, the market is still uncertain about Fed’s decision of an impending interest rate hike in December. Fed-funds futures, a popular tool for betting on central-bank policy, showed Monday (10/17/2016) that investors assigned a 69% likelihood of a rate increase in December, according to CME Group data. Once again, a hike in interest rate may also generate market volatility.

Tepid Global Economic Growth

According to a study by FocusEconomics, global economic growth has been lukewarm in the first half of 2016. According to the projection, economic activity around the world has been decelerating since Q1 2015. The primary reasons being the slowdown in emerging markets, particularly in China and in commodity-dependent economies of Latin America, the Middle East and North Africa, together with Sub-Saharan Africa. FocusEconomics also forecasted that the global economy is expected to grow at a slower pace in 2016 than in 2015, with a modest uptick projected for 2017.

Geo-Political Conflicts in Europe, Middle East, South Asia

Uncertainty stemming from the Brexit vote will continue to deter investments in the U.K. and Eurozone. The Eurozone saw a slowdown in the second quarter of 2016 as weakness in domestic demand (probably due to Brexit induced panic) outweighed strong external growth. Uncertainty stemming from the Brexit vote may continue to deter investment in this region.

Meanwhile, political conflict has heightened in South Asia owing to strained ties between India and Pakistan. Also, the ongoing political conflicts in the Middle East region raise concerns. These conflicts may also adversely impact investors’ sentiments going forward.  (Read: Quality ETFs and Stocks for a Market Beating Portfolio)

ETFs in Focus

Under such scenarios, large-cap ETFs are the safest bets when compared to small or mid- cap ETFs. Below we highlight a few large-cap ETFs which we believe will perform well in the fourth quarter.

SPDR S&P 500 ETF (SPY): This fund generally corresponds, before expenses, to the price and yield performance of the S&P 500 Index. The fund manages an asset size of nearly $192,762.28 million and an average daily trading volume of 92,097,500 shares. The fund charges an expense ratio of 11 basis points (bps) a year. SPY has gained 5.8% so far this year (as of October 17, 2016).

iShares Core S&P 500 ETF (IVV): The fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of U.S. large-cap stocks, as represented by the S&P 500 Index. The fund manages assets worth $79,090.75 million and an average daily trading volume of 3,469,357 shares. The fund charges an expense ratio of 4 bps a year. IVV has rallied 5.3% so far in 2016 (as of October 17, 2016).

Vanguard S&P 500 ETF (VOO): The Vanguard S&P 500 ETF invests in stocks in the S&P 500 Index, representing 500 of the largest U.S. companies. It manages an asset size valued more than $260,500 million and an average daily trading volume of 2,114,766 shares. The fund charges an expense ratio of 5 bps a year. VOO is up 5.9% so far this year (as of October 17, 2016).

PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV): This fund is based on the S&P 500 Low Volatility Index. It invests at least 90% of its assets in stocks comprising the Index. The index is compiled, maintained & calculated by Standard & Poor's and consists of 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. The fund manages an asset size of almost $6,581.3 million and an average daily trading volume of 2,535,554 shares. The fund charges an expense ratio of 25 bps a year. The fund has rallied 6.8% so far this year (as of October 17, 2016).

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