Three ETF Ideas For The Third Quarter

by on July 1, 2010 | Updated July 8, 2010 | ETFs Mentioned:

The first half of 2010 is officially in the books, but few of the questions on investors’ minds at the start of the year have been answered. When 2009 drew to a close, few expected the remarkable rally to continue into the new year. The consensus was that the easy gains had been made since the bear market lows last March, and that markets would demand more concrete evidence of improving economic fundamentals if the bull run were to continue.

The first six months of the year have given investors several reasons to be optimistic; the emerging markets of the world continue to expand at impressive rates, while many advanced economies–including some of those hit hardest by the recent downturn–have halted contraction and begun growing again. Factories are coming back on line, and demand for raw materials has jumped considerably from 2009 lows.

But signs of trouble are abundant as well. Unemployment remains elevated not only in the U.S. but throughout much of Europe as well. The recent G-20 summit in Toronto revealed major divisions among the governments of the world; the U.S. is advocating continued borrowing and stimulus spending, while Europe is preparing to impose harsh austerity measures to combat worries of a sovereign debt crisis. And many of the largest emerging markets, which not so long ago seems to be unstoppable drivers of growth, are showing signs of slowing down.

In short, the outlook for the remainder of 2010 is clouded with uncertainty. Against this complex and often contradictory backdrop, many investors are unsure of exactly how to proceed. Many of those with the appetite for a little risk are turning to long/short investment pairs that have the potential to generate positive returns regardless of the general direction of the markets. For investors uncertain of what the future holds, we outline three all-ETF long/short investment ideas for the second half of 2010 [for more actionable ETF ideas, sign up for our free ETF newsletter]:

1. Long EEO, Short XLE

One of the dominant stories of 2010 has been the ongoing drama playing out in the Gulf of Mexico. When a BP platform collapsed in late April, few could have anticipated that the resulting leak would pump oil into ocean waters for several months, repeatedly frustrating teams of engineers, government officials, and members of the Coast Guard working around the clock. The fallout from one of the worst environmental disasters in U.S. history has weighed heavily on shares of British oil giant BP, which has seen more than $100 billion of market cap losses [see Seven ETFs For Investors Mourning The Death Of BP's Dividend]. But it has also cast a shadow over the entire U.S. oil industry, which faces rising public outrage and the prospect of unprecedented government interaction.

The knock on emerging markets historically has been the significant risk associated with investments, including political risk. Stories of nationalized copper mines in Chile or oil rigs in Venezuela are held out as cautionary tales of the risk inherent in emerging markets. But in the wake of the Deepwater Horizon oil spill, it is the domestic oil industry that is drenched in risk. A moratorium on new deep-water drilling projects is a very real possibility, and further regulation in some form is a virtual certainty. Considering that the current administration has already indicated that it won’t hesitate to impose a “windfall profits tax,” a return to the days or record profits seems highly unlikely.

No one is sure if oil prices are headed towards $30 or $100, but we believe that there is a great opportunity in the energy sector. In the current environment, it’s hard to argue with the notion that emerging markets offer significantly better growth potential compared to the U.S. and other advanced economies. Historically, this enhanced return potential has been balanced out by greater risk and volatility. But in the current environment–at least in the energy sector–the greater risk is found in the U.S. market.

The Energy Select Sector SPDR (XLE) offers exposure to Big Oil, including major weighting is Exxon, Chevron, and ConocoPhillips. The Dow Jones Emerging Markets Energy Titans Index Fund (EEO) from Emerging Global Advisors offers exposure to energy firms in developing economies, including China’s CNOOC, India’s Reliance Industries, and Brazil’s PetroBras. The return potential from going short XLE and long EEO seems attractive in the second half of 2010, regardless of crude’s direction.

2. Long XLF, Short EUFN

Over the past few years, few sectors of the global economy have exhibited the volatility that has become characteristic of the financial industry. Although many institutions have repaid the emergency government funds borrowed during the depths of the recession, concerns about stubbornly high unemployment, a potential commercial real estate bust, and over-leveraged households have weighed on the financial sector. Public mistrust of big banks remains high, and it seems unlikely that the glory days of Wall Street will return any time in the near future.

With comprehensive regulatory overhauls seemingly coming down the pipeline, investors would hard-pressed to make a compelling bull case for the U.S. financial sector. But next to their European peers, U.S. banks come across as a sterling example or responsible lending and prudent risk management. The balance sheets of European banks have been battered by exposure to rapidly-depreciating sovereign debt, as well as an abundance of commercial loans gone bad in one of the continent’s numerous property busts.

Even if European governments are successful in drawing up and implementing austerity plans, the cloud of uncertainty seems poised to linger over the euro zone for the foreseeable future. Upcoming stress tests seemingly bear major downside risks for European financial institutions with relatively upside potential; skepticism to any encouraging results would run high among investors.

The holdings of the Financial Select Sector SPDR (XLF) include the usual suspects; Bank of America, JP Morgan, Citigroup, and Goldman Sachs are all given big weightings. On the other hand, the iShares MSCI Europe Financials Sector Index Fund (EUFN) offers exposure to major financial institutions in Europe, including HSBC, Banco Santander, and Credit Suisse.

The outlook for the global financial sector is about as cloudy as it gets. But if the storm continues, it seems like a fairly safe bet that the worst damage will occur near its center, making a long XLF/short EUFN position intriguing.

3. Long HAO, Short FXI

One of the biggest stories of the year so far in the investment world came perhaps when it was least expected. As government officials around the world were preparing for a showdown with China over its currency policy at the G-20 meetings in Toronto, Beijing announced that it would allow the yuan increased flexibility against the U.S. dollar. Officials around the world cheered the move; a more flexible yuan eliminates what many saw as an unfair advantage for Chinese exporters. That translates into good news for the export-dependent economies of Germany and Japan (along with countless others).

The outlook for the Chinese economy also brightened on the news of a shift in currency policy. While manufacturers will feel an immediate pinch as the cost of their goods rises for foreign buyers, any adverse impact was expected to be more than offset by the long term advantages. Economists anticipate that the move will speed China’s transition from an export-driven economy to one more dependent on local consumers. “China is now speeding up the restructuring of the economy and transforming its growth model, a task that has been made even more important and urgent by the international financial crisis,” said the central bank in a statement.

The iShares FTSE/Xinhua China 25 Index Fund (FXI) is the largest ETF in the China Equities ETFdb Category. Like many international ETFs, this fund is dominated by mega cap stocks, and maintains a heavy tilt towards the financials and energy sectors (in aggregate, these industries account for almost 70% of assets). Meanwhile, exposure to consumer stocks that could benefit from a boost in buying power is almost non-existent.

The Claymore/AlphaShares China Small Cap ETF (HAO) also offers exposure to Chinese equities, but is a very different fund from FXI. As its name suggests, HAO invests in small cap stocks. This fund is light on energy exposure and much heavier on consumer-driven corners of China’s economy; consumer goods account for about 19% of assets while business services (16%) and consumer services (7%) also make up significant slugs.

Again, it’s unclear whether China’s impressive growth will continue throughout the second half of the year. But as the soon-to-be second largest economy begins “transforming its growth model,” exposure to stocks that could benefit from an increasingly wealthy population seems preferable to mega cap equities. That makes a long HAO/short FXI position intriguing as the third quarter dawns.

Disclosure: No positions at time of writing.