3 ETFs for a Strong Economic Recovery From the Pandemic

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it. A version of this article previously appeared in the September 2020 issue of Morningstar ETFInvestor. Click here to download a complementary copy.

It’s staggering how quickly the market recovered from the novel coronavirus-driven sell-off earlier this year. The U.S. economy shrank by nearly a third in the second quarter compared with the previous year, its worst contraction ever recorded, and unemployment remains high (though it is falling). Yet, by the end of July, the U.S. stock market clawed back all its losses from earlier in the year. Few would have predicted such a quick recovery given the plunge in economic activity and consumer confidence resulting from the pandemic. This underscores the challenges of making successful tactical investments based on current market conditions. Things can change quickly in ways that are hard to predict.

While the future is unknowable, there are some areas of the market that might be worth overweighting for those who believe the economic recovery will be swifter than anticipated and are comfortable with the risks.

ETFs for a Swift Recovery The speed of the market recovery suggests investors expect the economic pain caused by the coronavirus to be temporary. There are currently several vaccine candidates for COVID-19 in phase 3 trials, and some of those could be on the market early next year. Even if an effective vaccine were approved tomorrow, it would still take time for consumer confidence and spending to return to pre-pandemic levels. That's because it would take time for a critical mass of the world's population to get vaccinated, employers to ramp up hiring, and anxiety about health and economic security to subside.

Yet, the market is forward-looking, and some segments will likely bounce back stronger than others as the economy moves further along the road to recovery. Vanguard Small-Cap Value ETF VBR (which has a Morningstar Analyst Rating of Gold), Invesco S&P SmallCap Consumer Discretionary ETF PSCD, and U.S. Global Jets ETF JETS are well-positioned to benefit as the economy gets back on its feet.

In this environment, these are all risky investments, particularly PSCD and JETS. They all lost considerably more than the market during the sell-off and experienced sharp increases in market risk between the first and second halves of the trailing 52 weeks through Aug. 28, 2020, as shown in Exhibit 1. That said, the same dynamics that hurt them when the market was grappling with the pandemic should help them as the economy recovers.

Vanguard Small-Cap Value ETF Small-value stocks' fundamentals are often among the market's weakest. These firms tend to be less profitable and are less likely to enjoy durable competitive advantages than their larger and faster-growing counterparts. They also tend to be more heavily indebted than growth stocks and often have higher fixed costs and less flexibility. As such, small-value stocks have tended to be highly cyclical--much more so than large-cap stocks.

Small-value’s sector tilts contribute to this cyclicality. VBR has greater exposure to the cyclical basic materials, financial services, and industrials sectors than its growth counterpart and Vanguard Total Stock Market ETF VTI. It also has less exposure to healthcare, communication, and technology stocks, which fared better than most during the Feb. 19-March 23, 2020, sell-off.

Why favor cyclical firms with weak fundamentals? They should bounce back more than their better advantaged counterparts as the economy strengthens. Small-value stocks are also currently one of the cheapest segments of the U.S. market, based on Morningstar’s price/fair value estimates. So, there is a good short- and long-term case for favoring small-value stocks.

Small-value stocks are especially cheap relative to their growth counterparts. At the end of July 2020, VBR was trading at its largest discount to Vanguard Small-Cap Growth ETF VBK since that data was first available in February 2004, and it’s still close to that level, as shown in Exhibit 2.

Valuations matter over the long term. The larger the price/fair value gap between these value and growth funds has been, the better VBR has tended to do over the next five years relative to VBK, as Exhibit 3 illustrates. Now, this isn’t a tidy relationship. There are many other things that influence how these two funds perform relative to each other and relative to the broader U.S. market. But attractive valuations are certainly a plus.

VBR is one of the better options for exposure to small-value stocks. It targets stocks representing the cheaper half of the U.S. small-cap market and weights them by market cap. This approach is simple, but effective. It mitigates turnover, diversifies risk, and harnesses the market’s collective wisdom to size its positions. This has been one of the better-performing funds in the small-value Morningstar Category over the past decade, largely because it is one of the cheapest. It should continue to serve investors well.

Invesco S&P SmallCap Consumer Discretionary ETF Consumer discretionary stocks offer a more direct way to profit from a recovery. Consumer spending plummeted as the virus spread and businesses shuttered to flatten the curve. Even after things started to reopen, spending didn't return to normal. The U.S. personal saving rate spiked in March and April this year and is still well above average, as Exhibit 4 shows.

This decline in spending is understandable. Many consumers are worried about the health risks of going out and so have been doing it less. Job security has also become a bigger worry for many during the pandemic, and this has also depressed spending.

Given the impact of the coronavirus on consumer spending, it’s no surprise small-cap consumer discretionary stocks were particularly hard-hit during the sell-off earlier this year. What is surprising is how quickly that sector rebounded, recovering all its losses by mid-August. Yet, these businesses are still feeling the impact of consumers’ newfound frugality. PSCD’s holdings experienced an average 12.4% year-over-year decline in revenue, based on the most recent quarterly data available through August 2020.

The hit could have been worse--and it was among many of the firm’s smaller holdings. However, the fund’s strong rebound despite this challenging environment suggests the market expects business to improve in the near term. This fund has strong momentum and likely more room to run if consumer spending increases as the economy recovers from the pandemic.

However, the fund isn’t for the faint of heart. There’s a risk that consumer spending may be slow to return to pre-pandemic levels, which could hurt its performance and even threaten the viability of some its holdings. These include brick-and-mortar retailers, which are facing stiff competition from Amazon.com AMZN and other online retailers; restaurant chains; and small consumer product firms. As is often the case, these small firms tend to be more cyclical than their larger counterparts and less likely to enjoy durable competitive advantages, creating greater risk and upside potential.

U.S. Global Jets ETF JETS is the riskiest of the bunch. Warren Buffett recently dumped all his airline holdings, largely because of coronavirus uncertainty. Airline passenger traffic has dropped significantly during the pandemic, as businesses have shunned in-person meetings that require travel and many potential vacationers are afraid of the health risks of hopping on a plane. TSA checkpoint data places U.S. passenger traffic in August 2020 at less than a third of what it was in August 2019.

It will likely take a long time for passenger traffic to recover, and it may never return to its pre-pandemic levels. Even when the crisis is largely over, more companies will likely allow employees to work remotely and increasingly opt for video conferences in lieu of in-person meetings that require travel. This route is cheaper and often just as effective. It will also probably take a while for the public to feel comfortable flying again. Until then, airlines will likely continue to operate at reduced capacity and discount their fares. So, the pain is far from over.

That said, the airline sector could be a good place to be as the economy recovers from the pandemic, as it is one of the industries most directly affected by the virus. JETS offers a good way to get exposure to this sector. It invests in airline companies listed in developed markets across the globe, placing greater emphasis on larger U.S. and Canadian carriers.

High Risk, High Reward These three exchange-traded funds' exposure to the novel coronavirus pandemic is precisely what makes them worth considering as tactical bets on a swift economic recovery. That exposure makes them quite risky but should also give them considerable upside as things improve.

Of the three, VBR is the only one that might be suitable as a long-term core holding. Its attractive valuation and broadly diversified market-cap-weighted portfolio should set it up for success beyond the pandemic. A fast recovery could give it a short-term boost.

The other two ETFs are riskier, owing to their narrower portfolios, but they probably have more upside in the near term. PSCD has already enjoyed a strong recovery. While there is a risk that the market may have gotten ahead of itself, this fund likely still has more room to run as the world recovers from the pandemic. A slow recovery could seriously hurt JETS, but the market has already priced in a gloomy outlook, leaving room for airline stocks to surprise on the upside.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.