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Stock and bond ETFs reverse recent trends

Economic data on the rising unemployment rate and corporate missed earnings appear to have contributed to the recent reverse of the upward trend in stock ETFs. This post explores this and other recent trends by highlighting selected ETFs that passively track major stock and bond indices.

NASDAQ market correction

As this WSJ article recently highlighted, the NASDAQ (ticker: QQQ) is officially in “correction” territory now. We define a correction as when prices drop by more than 10% from a recent high. Missed expectations from major investments in Artificial Intelligence by tech leaders Microsoft and Alphabet may have contributed. Nevertheless, the S&P 500 index ETF (ticker: IVV) is still up over 12% year to date, as the chart below illustrates. While returns for these two stock ETFs are lower than their mid-year peak, they are still good relative to other markets, like bonds.

Recent trends in stock and bonds ETFs.
Stock ETFs recently started a downward trend, but bond ETFs started an upward trend.

Recent trends in Bond ETFs

Investors appear to be quickly moving away from stock ETFs and into bond ETFs. This so-called “flight to safety” is clear in the image above in the recent upward trends in bond ETFs. The intermediate-term bond ETF, iShares Core U.S. Aggregate Bond ETF(ticker: AGG), shows some of this new trend. This trend is amplified when a longer-term bond ETF, like iShares 20+ Year Treasury Bond ETF (ticker: TLT), is viewed.

What is next?

The Fed left short-term interest rates unchanged after meeting this past week. But, a rate cut is looking more likely, as inflation is down to 2.5% now, edging closer to the Fed’s target of 2%. The Fed’s next meeting is in September, so investors will be eagerly awaiting the outcome of this important meeting. In the meantime, investors may continue to invest in bond ETFs to potentially hedge any additional losses in stock ETFs.

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2024 Mid-Year Review of Stock-Based ETFs

Welcome to our 2024 mid-year review of stock-based ETFs. Like our previous mid-year reviews, we will discuss here how various sectors of the market performed in the last six months using ETFs. Consequently, we will show a significant performance difference between various sectors of the S&P 500.

Review of the 11 Sectors of the S&P 500

To review, recall that there are 11 sectors in the S&P 500 as shown below. So, while some of these sectors have several ETFs tracking them, we choose the ETFs in parentheses due to their long history in the markets.

  • Information Technology (XLK)
  • Health Care (XLV)
  • Financials (XLF)
  • Consumer Discretionary (XLY)
  • Communication Services (XTL)
  • Industrials (XLI)
  • Consumer Staples (XLP)
  • Energy (XLE)
  • Utilities (XLU)
  • Real Estate (IYR)
  • Materials (XLB)

Then, using this list and reinvesting dividends, we see that some sectors had total returns that did very well in the first half of 2024. However, a couple sectors, such as the Real Estate and Communication Services, lost value in the first six months of 2024.

2024 Mid-year review of S&P 500 sector ETFs. Total Returns. Source: https://www.etfreplay.com/charts.aspx
2024 Mid-year review of S&P 500 sector ETFs. Total Returns. Source: https://www.etfreplay.com/charts.aspx

Best ETF investment performers of 2024

As the chart above shows, the technology sector continues to outperform the broader index. As our favorite WSJ writer recently described, the three largest stocks in the S&P 500 (Microsoft, Apple, and Nvidia) contributed more than 20% of the total market value of the index. In fact, eight of the top ten stocks in the S&P 500 index are technology stocks. This outperformance still appears to be attributable to the substantial investor interest in artificial intelligence (AI) and how this interest is impacting other sectors, like utilities.

Outlook

While we won’t try to estimate where markets will go from here, it does seem reasonable that stock-picking to beat the S&P 500 will continue to be challenging. Thus, the high concentration of technology stocks in this index continues to propel the performance of this market cap weighted index. As a result, if the technology sector does falter, the diversification of this index may help reduce volatility.

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Utility ETFs outperforming

Returns of utility ETFs have been particularly strong over the past three months, exceeding the returns of the S&P 500 index ETF by over 10%. Our favorite WSJ writer mentioned this situation recently, along with some explanations. In this post, we explore other aspects worth considering with utility ETFs.

What is in a utility ETF?

Several ETFs focus their holdings on utility companies. The largest is the Utilities Select Sector SPDR Fund (ticker: XLU), which is over twice as large as the next largest utility ETF, the Vanguard Utilities ETF (ticker: VPU). But, these ETFs track two different indices. XLU tracks the S&P Utilities Select Sector Index, while VPU tracks the MSCI US Investable Market Utilities 25/50 Index. Consequently, XLU has 31 holdings, less than half of the 67 in VPU. However, examining the top ten holdings in each ETF reveals they are very similar. So, not surprisingly, the year-to-date returns for both of these ETFs are identical, at 12.25%.

Top Ten Holdings of the two largest Utility ETFs, as of May 31, 2024. Source: etf.com

What is driving energy demand?

As Jason Zweig’s noted in his recent article, Artificial Intelligence (AI) may be playing a role. Training AI models are very energy-intensive. And, as we’ve written about before, the largest companies in the S&P 500 are actively involved in AI development. But, Maria Pope, CEO of Portland General Electric, believes there are three big drivers increasing electricity demand in the U.S.

  • Manufacturing returning to the U.S.
  • Government support of semiconductor production.
  • Data centers and their need to train and run AI models.

Will this demand remain elevated for the foreseeable future? And, how will the markets respond? ETF investors should consider these points when evaluating sector ETFs like those focused on utilities.

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Bond funds continue to challenge investors

Bond funds continue to challenge investors seeking less risk from the stock market, but also retaining buying power. My favorite writer Jason Zweig also wrote about this recently, along with many of his readers’ opinions. In this post, we illustrate what’s been happening over the last year since we last wrote about bond ETFs.

Bond funds and their time to maturity

Bond fund performance over the last year appears to still be heavily dependent on their time to maturity. As the image below shows, the total return of the shortest-term U.S. treasury bill ETF (ticker: BIL) was gradual and positive. The intermediate-term bond fund (ticker: AGG) nearly broke even for the last 12 months. The long-term bond fund (ticker: TLT) was most sensitive to rising interest rates and had the largest loss and most volatility over the past 12 months.

Shorter-term bond ETFs continue to perform well with low volatility. Source: etfreplay.com
Shorter-term bond ETFs continue to perform well with low volatility. Source: etfreplay.com

Bond ETFs with shorter terms to maturity

Staying with shorter-term ETFs has become much easier with several options for investors to consider. Here is a short list to consider:

  • SPDR Bloomberg 1-3 Month T-Bill ETF (ticker: BIL)
  • iShares Short Treasury Bond ETF (ticker: SHV)
  • Goldman Sachs Access Treasury 0-1 Year ETF (ticker: GBIL)
  • iShares 0-3 Month Treasury Bond ETF (ticker: SGOV)

Referring to the image above, we see that the SPDR Bloomberg 1-3 Month T-bill ETF returned 5.3%. And, as we have written about previously, this return is exempt from state taxes. This exemption is significant for states like California and Hawaii, but irrelevant for states like Texas and Florida that have no state income tax. In any case, with current inflation around 3%, these short-term investments are helping ETF investors to maintain and slightly grow their buying power.

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AI and the S&P 500

Artificial intelligence (AI) continues to impact markets like the S&P 500 in 2024. If you are already invested in broad-based ETFs, you may be invested in AI, whether you realize it or not. In this post, we discuss how AI companies are influencing cap-weighted indices.

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Fear of Missing Out

Jason Zweig at The Wall Street Journal recently wrote an article about one of the leading AI companies Nvidia. In his article, he noted how this company was now more than 4% of the S&P 500 index, thanks to its recent rise in share price.

And, other companies working in the AI space are also seeing very positive share price increases, like Microsoft. In fact, according to this page on ETF.com, Microsoft and Nvidia now account for about 11.5% of the S&P 500 index. This weighting of AI in the S&P 500 is due to the S&P 500 being a “cap-weighted” index.

A stock market index wherein each component is weighted relative to its total market capitalization

What is a Capitalization-Weighted Index? source: Corporate Finance Institute (CFI)

So, even if an investor thinks they may have “missed out”, they have not if they owned an S&P 500 ETF or some other cap-weighted index fund.

Other firms in the S&P 500

Because the S&P 500 is cap-weighted, the firms in this index become more (or less) significant as their market capitalization increases (or decreases). The image below shows the current top-10 holdings in the S&P 500 ETF (ticker: IVV). Note that over half of those in this list are tech firms that are at the forefront of AI. In fact, for investors in Apple, there may not be enough investment in AI.

Top 10 holdings in the S&P 500 ETF IVV. Source: etf.com
Top 10 holdings in the S&P 500 ETF IVV. Source: etf.com

ETF investor options to embrace or avoid AI

Hopefully, ETF investors realize that they may already have AI investments, if they are invested in one of the ETFs tracking the S&P 500, like VOO, IVV, or the oldest ETF SPY. Alternatively, ETF investors wishing to embrace AI more may seek tech-centric ETFs, like XLK. Or, by seeking dividend-paying stocks not seeking growth from AI, an ETF investor may seek funds like DVY or VTV. Investor preference for growth in the AI space will likely affect investments for many years to come.

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2023 ETF Year in Review and 2024 Outlook

The 2023 year was generally good for the stock market. We wrote previously about the possible market performance during the 3rd year of a presidential term, and 2023 didn’t disappoint. The total return, including dividends, for the S&P 500 ETF (ticker: IVV) was 26.3%, according to ETFReplay.com. However, 2023 ETF equity returns varied significantly across the eleven S&P 500 sectors. We will dive into these sectors in this post.

2023 ETF Returns by Sector

The chart below shows the total returns in 2023 for the 11 sectors in the S&P 500. As we can see, two sectors beat the S&P 500. These were the technology and consumer discretionary sectors. Artificial intelligence was a big theme in 2023 thanks in part to ChatGPT, which explains why the technology sector did so well. Consumer discretionary returns could be explained by continued pent-up demand as the impact of the global pandemic diminishes.

2023 ETF returns
2023 S&P 500 Index and Sector Total Returns.
Source: etfreplay.com

Unfortunaltely, nine sectors of the S&P 500 performed worse than the overall index. Industrials, materials, financials, and real estate did produce double-digit returns, but still underperformed the index. Also, health care, energy, consumer staples, and communication services all were nearly flat for the year. The worst-performing sector was utilities, likely due to the high levels of debt many utilities carry and how refinancing this debt in 2023 likely became much more expensive.

2024 ETF Outlook

So, where will markets go from here? Referring back to the presidential cycle analysis quoted above, the 4th year of a presidency is the second best for total returns of the S&P 500. The political uncertainty associated with year four of a presidential cycle is likely to blame. Many investors may want to see how elections this fall turn out before making larger investment decisions. And, investors may also be looking for indications from the Federal Reserve on future decisions on interest rates. Regardless of what happens on these fronts, 2024 is looking to be a very exciting year for ETF investors.

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Tax Loss Harvesting

As 2023 heads to a close, many investors are considering whether to sell investments at a loss, often referred to as tax loss harvesting. In this post, we explain this tax opportunity and the financial benefit possible from it. We also describe a pitfall that investors should avoid to achieve the benefit of tax loss harvesting.

notebook and calculator on green surface
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Short-term or long-term?

Why is tax loss harvesting important? To begin, ETF investors must understand the difference between short-term and long-term gains or losses. An investor realizes a short-term loss when they sell an ETF held for less than one year. In general, taxes on losses on short-term investments in securities like ETFs occur at a higher rate than those gains realized from short-term investments. For taxpayers at the highest rates, the short-term rate is 37%, and the long-term rate is 20%.

So, if an investment is below its purchase price within one year of holding it, an investor can sell it and realize a short-term loss. This short-term loss can be deducted from any short-term gains, like those from bond or money market investments. Consequently, an investor’s income tax may be reduced.

Pitfalls

The most obvious pitfall is the wash sale rule. Investors may not obtain a tax benefit if they sell an ETF for a loss within 30 days, and then rebuy it. Consequently, such a violation eliminates the opportunity for tax-loss harvesting. Investors wishing to stay invested in the markets can opt to buy a different ETF that is not “substantially identical” and not wait 30 days.

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The Federal Funds Rate and ETFs

In early 2022, the U.S. Federal Reserve began raising the federal funds rate in an effort to reduce inflation. According to TradingEconomics.com, this effective rate grew from near 0% to over 5% in the past seven quarters, reaching a 22-year high. In this post, we examine ETF returns during this period of rate increases.

Stock and Bonds ETFs

The chart below shows the last seven quarters of ETF total returns, which includes price appreciation and short-term capital gains. This time frame corresponds to the increase in the federal funds rate. Investors saw positive returns in only two ETFs during this period of increasing rates.

Stock, Bond, and Cash ETF total returns during the recent period of increasing federal funds rate.
Stock, Bond, and Cash ETF total returns during the recent period of increasing federal funds rate.
Source: ETFreplay.com

Stock ETF returns during this period were mixed. As shown in black, the iShares S&P 500 Value ETF (ticker: IVE) was the best-performing stock ETF. During this time, the iShares Core S&P 500 ETF (ticker: IVV) in green and the iShares S&P 500 Growth ETF (ticker: IVW) in red lost 7% and 17%, respectively. Clearly, investors preferred value over growth during this period. Investors may have had concerns about the increasing cost of financing a firm’s growth opportunities. Alternatively, investors may have preferred dividend-producing firms commonly found with value stocks.

Intermediate and short-term Bond ETFs returns and increasing federal funds rate

The iShares Core U.S. Aggregate Bond ETF (ticker: AGG) also had a negative return during this period, consistent with how rising bond yields generally reduce bond prices. However, for short-term treasury bond ETFs like the iShares Short Treasury Bond ETF (ticker: SHV), investors saw a slow and steady climb. As we’ve written before, the increasing federal funds rate contributed to this growth. And, this short-term bond fund also has tax-efficient benefits when compared to money market funds and short-term certificates of deposit.

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Bond ETFs amid rising interest rates

Interest rates continue to rise, with the Federal Reserve recently raising its benchmark rate to a range of 5.25% to 5.5%. While borrowers may face higher costs, new investors in short-term Treasurys now realize these higher annual rates. However, investors in certain bond ETFs could also realize this rate with added liquidity, and convenience, while potentially avoiding state and local taxes.

US Treasury Bills are backed by the full faith and credit of the U.S. Government

Short-term investment options

There are several common approaches for investing in the short term, which we characterize as less than one year. Thankfully, these investments have zero default risk because the full faith and credit of the US Government backs them.

These investments include bank CDs, direct purchases of US short-term Treasury bills, money market funds, and certain Bond ETFs. Firstly, bank CDs and money market funds may be the most convenient for individual investors. Short-term bank CDs are currently yielding over 5%, and money market funds provide similar returns within most brokerage accounts. Unfortunately, both of these short-term investments are often subject to both state and federal income taxes. For residents of California, Hawaii, and New Jersey, the top state income tax rate exceeds 10%.

Bond ETFs for Tax-efficient investing in the short term

Alternatively, similar returns are possible if an investor chooses to purchase short-term Treasury bills from the U.S. Department of the Treasury. Or, an investor may purchase US Government Bonds ETFs. Both of these options are exempt from state taxes. However, treasury bills have maturity dates of 4, 8, 13, 26, or 52 weeks. So, at maturity, the investor receives back their investment plus interest. That means that an investor would need to regularly re-invest in treasuries at TreasuryDirect.gov.

To avoid the need to continually re-invest, and likely avoid state taxes, there are several short-term Bond ETFs to choose from. Here are just a few, that with reinvested dividends have returned 2.5-2.8% so far this year (e.g. from December 30, 2022, to July 28, 2023).

  • SPDR Bloomberg 1-3 Month T-Bill ETF (ticker: BIL)
  • iShares Short Treasury Bond ETF (ticker: SHV)
  • Goldman Sachs Access Treasury 0-1 Year ETF (ticker: GBIL)
  • iShares 0-3 Month Treasury Bond ETF (ticker: SGOV)
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2023 Mid-Year Review of Stock-Based ETFs

With the first half of 2023 now past, we devote this post to a mid-year review of ETFs in a variety of stock sectors within the S&P 500. As we will see, while this broad market index of large-cap stocks did well, there was significant variation in returns across the sectors of the S&P 500.

Sectors of the S&P 500

There are 11 sectors in the S&P 500 as shown below. While some of these sectors have several ETFs tracking them, we choose the ETFs in parentheses due to their long history in the markets.

  • Information Technology (XLK)
  • Health Care (XLV)
  • Financials (XLF)
  • Consumer Discretionary (XLY)
  • Communication Services (XTL)
  • Industrials (XLI)
  • Consumer Staples (XLP)
  • Energy (XLE)
  • Utilities (XLU)
  • Real Estate (IYR)
  • Materials (XLB)

Using this list and reinvesting dividends, we see that some sectors had total returns that did very well in the first half of 2023, and several did not.

2023 mid-year review of S&P 500 sector ETFs
2023 Mid-year review of S&P 500 sector ETFs. Total Returns. Source: https://www.etfreplay.com/charts.aspx

2023 mid-year sector winners

As the figure shows, the technology and consumer discretionary sectors had the highest total return so far in 2023. In retrospect, the technology sector gains were possibly fueled by sector layoffs that didn’t appear to hurt the investor’s view of the future profitability of this sector. Similarly, future expected consumer discretionary spending gave investors significant confidence in this sector. And, overall, the S&P 500 gained nearly 17% in the first half of 2023. At this rate, the effect of the 3rd year in a presidential cycle on stocks may remain true in 2023.

Losses in the first half of 2023

The energy and utility sectors were the worst-performing sectors of the S&P 500 in the first half of 2023. With increasing interest rates, long-term investments by these sector participants are becoming increasingly expensive. So, it appears that investors don’t see strong prospects for profitability in these sectors.

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