ETFs for contrarian investors

What is contrarian investing?

Contrarian investors go against the grain of market sentiment. Such an approach can prove to be successful in financial markets due to the effect of “herding” by many market participants. For example, the current market outlook is characterized by high uncertainty and negative headlines – this leads to selling pressure which feeds into more negative sentiment and further downward momentum.

Now this doesn’t mean that an investor should blindly buy everything that has sold off – for example, buying a crypto asset that has sold off 90%+ this year would not be a prudent decision unless there was some foundational research underlying that decision. However, a high quality company which has sold off 50%+ this year and still has a strong free cash flow outlook could be a prime candidate for a contrarian investor. 

Investing against the grain is very difficult and requires a high level of discipline from the investor. How does an investor avoid catching a falling knife? It is difficult to time the market and therefore contrarians must be comfortable with short-term losses in pursuit of a long-term focused gain.

Most beaten down pockets of the market this year

Of the GICS sector ETFs in the US, some of the largest drawdowns year-to-date have come from:

1. The Consumer Discretionary Select Sector SPDR Fund – XLY (-32% YTD)
2. The Real Estate Select SPDR Fund – XLRE (-23% YTD)
3. The Technology Select Sector SPDR Fund – XLK (-22% YTD)

These sectors are heavily exposed to a rising rate environment and potential recession which have dominated the news flow and headlines. 

Keep in mind, rate hiking cycles are usually short-lived, and recessions typically last around 10 months. Therefore, investors who are willing to look through a few months of underperformance could consider investing in these sectors when their sentiment is at their worst.

And of the classic factors in the US, some of the largest drawdowns year-to-date have come from:

1. iShares MSCI USA Momentum Factor ETF – MTUM (-18% YTD)
2. iShares Edge MSCI USA Quality Factor ETF – QUAL (-17% YTD)
3. iShares Edge MSCI USA Size Factor ETF – SIZE (-13% YTD)

A drawdown in momentum (MTUM) and small-cap (SIZE) makes sense in the context of the current market environment. What comes as a surprise, however, is the drawdown in the quality (QUAL) factor as these investments generally outperform in difficult economic conditions given their more stable and predictable earnings. 

Top holdings in the QUAL ETF include S&P Global Inc. (4.0% weight), Johnson & Johnson (4.0% weight), Apple Inc (3.8% weight), Eli Lilly (3.5% weight), and Nike (3.2% weight) – all of which are resilient businesses which could offer a relatively more attractive valuation right now.

It goes without saying that this strategy is not for those with weak knees. These sectors or factors could continue to sell off and it’s certainly not recommended that an investor allocates 100% of their portfolio into these pockets. Instead, bullish investors could begin systematically rebalancing their portfolio with a tilt towards these areas, slowly adding to their positions over time.

Data as of December 14, 2022.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.