XLV Health Care Select Sector

As we start 2012, the economic outlook for the year remains clouded across the globe. European woes continue to dominate the headlines while concerns over a slowdown in China and the U.S. are likely to weigh on the markets unless more positive data hits the wires. Beyond these issues, politics are also looking to play a key role in 2012 as elections in the U.S. and Russia, as well as tensions with Iran, could spook the markets at any time.

Despite these worries, some are cautiously optimistic about the New Year and the market going forward. These predictions could be accurate if inflation remains under control in emerging markets, there aren’t any geopolitical flare ups, and if the U.S. economy can continue to grow at its modest pace, helping to buoy the global economy. In fact, the ISM in the U.S. has risen to a six-month high in the most recent reading, suggesting that European concerns are still not really being felt by many U.S. businesses and that we could skirt a double dip recession (see Three Outperforming Active ETFs).

In light of the uncertainty, more ‘tactical’ as opposed to ‘broad based’ picks may be the way to go in this environment as they could help investors to be more nimble in this rocky year. Furthermore, these tactical choices could be better targeted at the true growth corners of the economy or sections that may have lower levels of risk in this volatile atmosphere. With this in mind, we have selected five surgical allocations that investors may want to make in 2012 over their more broad based counterparts, especially if the status quo in the market continues throughout the year:

MSCI Malaysia Index Fund (EWM) over MSCI Emerging Markets ETF (VWO)

With broad emerging markets facing a host of issues to start the year, many investors are worried about putting large amounts of capital to work in these surging nations. This could be especially true if the Chinese real estate bubble bursts, tensions heat up in Korea, or a slump in commodity prices hurts Brazil. All three of these issues could heavily impact VWO in 2012 as the fund allocates close to 50% of its assets to these three countries suggesting that it could be particularly impacted by these concerns (see Top Three BRIC ETFs)..

Instead, investors may be better off considering a smaller nation such as Malaysia and its main ETF EWM which continues to fly under the radar. In addition to being a major export market for a variety of goods both basic and high tech, the country is a major center for Islamic banking as well. This sector could continue to grow and help the Malaysian economy as oil rich Arab states push more capital into the nation as a safe way to diversify portfolios into another Islamic nation. EWM has close to 30% of its assets in financials, and the next three biggest sectors are industrials, consumer staples and consumer discretionary, suggesting that the fund is pretty well diversified and could be a solid pick no matter what happens this year in the other emerging Asian markets.

S&P Oil & Gas Exploration & Production Fund (XOP) over Energy Select Sector SPDR (XLE)

The energy market certainly picked up steam in the final few months of the year helping to push XLE to a gain of 3.1% in 2011 on a 25.4% surge in the fourth quarter. This run could continue in 2012 especially if there is more turmoil in the Arab world or if tensions with Iran continue to remain high. Unfortunately, many large Western oil companies are frozen out of emerging markets thanks to the rise of state owned or state backed oil firms such as Petrobras, Petronas and Sinopec. Thanks to this, extra supplies in growing markets could be hard to come by for ‘big oil’ this year (read Time To Consider The Small Cap Oil ETF).

As a result, many investors may want to consider looking at firms that are engaged in exploration activities instead as these firms could play a very crucial role for firms looking to boost production in the face of high crude prices. In fact, this has already been the case over the past few months as XOP has outperformed XLE in the fourth quarter, gaining 35.7% in the period. Should oil prices remain high this segment could continue to outperform this year and be a solid pick for investors seeking more exposure to crude oil in equity form.

Intermediate Corporate Bond Index Fund (VCIT) over Extended Duration Treasury Index ETF (EDV)

Long-term bonds had an incredible run over the course of 2011 as one of the longest duration ETFs, EDV, gained nearly 45.6% on the year with virtually all of the gains coming between August and September. Yet after that period, EDV slumped heavily as the fund lost about 7.8% over the last three months of the year as investors sought higher yielding bonds or equities. Given that Treasury bonds are still approaching all-time lows and that a 30 year bond only offers a 3% yield, one has to believe that this trend out of Treasury bonds could continue this year as well (also read Do You Need A Floating Rate Bond ETF?).

If one believes this to be the case, a closer look at VCIT could be warranted. Not only does the fund pay out a higher yield than its Treasury counterpart—3.8% to 3.0%-- but the fund has a far lower level of duration risk. In fact, the average duration is just 6.2 years for VCIT while it is close to four times that figure for EDV. This suggests that if interest rates trend higher, VCIT will be far less impacted than its long-dated counterpart from a negative perspective. This means that while the fund has underperformed EDV in 2011, if interest rates trend modestly higher towards historical levels, we could see VCIT be the winner instead this year.

S&P Biotech Fund (XBI) over Health Care Select Sector SPDR (XLV)

Health care was another big winner in 2011 as investors trended into the safe haven as protection from further market turmoil. XLV gained close to 10.5% on the year thanks to these worries, including a 14.4% jump in the past quarter alone. Yet, despite these gains, there are some concerns over the industry this year. First, the political uncertainty in the U.S. could rock the broad health care market, especially if any large changes to ‘ObamaCare’ look likely to be pushed through Congress. Additionally, many large pharma firms are quickly running out of profitable drugs and their pipelines remain anemic to say the least, suggesting that it could be a rough period if there aren’t a few big discoveries in the near term (also read Three Low Beta Sector ETFs).

In order to avoid most of these worries, a closer look at the biotech sector may be the way to go for those seeking more exposure to the health care market. Biotech firms generally have better pipelines than their pharma counterparts and have better growth prospects as well. Additionally, as big pharma gets more desperate, a push to acquire biotech firms could be made by those flush with cash in an attempt to bolster growth prospects. Thanks to these reasons, as well as the uncertainty plaguing much of the rest of the health care space, biotech could be a star performer in the space for 2012.

China AlphaDEX Fund (FCA) over FTSE China 25 Index Fund (FXI)

Concerns over China and a slowdown in the country could be among the most important stories in the market this year. Housing is unaffordable for many and there are some concerns over the ability of the country to transition to a more consumer and internally focused nation as opposed to its current role as an export powerhouse. Thanks to these worries, speculation is beginning to build over massive losses at banks across the country, especially if the property bubble bursts in the country at some point this year.  This could be especially bad news for China ETFs such as FXI as the fund has close to 50% of its portfolio in financials and is thus heavily exposed to any broad banking crisis in the country (read Forget FXI Try These China ETFs Instead).

Instead, a look at a slightly more ‘active’ fund could be the way to go for those seeking more China exposure in this uncertain time. FCA has a much more modest allocation to financials of just under 20% of the total assets and it uses a more methodical approach to select holdings. Instead of just allocation based on market cap as many funds do, FCA ranks eligible stocks by growth and value factors, picking the best 50 for inclusion in the fund. Thanks to this more qualitative approach and the smaller level of exposure to financials, we look for the fund to outperform FXI in 2012, although it is very possible for both to see severe weakness once again on the year.

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Long EWM and VWO.

 
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