Major funds among the best ETFs and mutual funds posted sharp gains in the first quarter in spite of higher yields and inflation rate concerns.
Treasury bonds ended the first quarter as one of the worst in history on spiking rates and growing fears of inflation. Equity markets, meanwhile, continued their sector rotation, with the highest returns among the value and cyclical sectors.
March and Q1 were disastrous for U.S. Treasuries as the 10-year yield jumped 30 and 81 basis points, respectively, to end the month at 1.74%. A basis point is one-hundredth of a percentage point. Both the bond market and growth stocks saw increased volatility as investors considered the risk that inflation may come sooner than expected. Nevertheless, the Federal Reserve reassured investors about its commitment to keep rates steady and that any rise in inflation may be rather temporary.
Best Bond Funds Decline in Q1
General U.S. Treasury funds sank 2.94% in March, deepening their quarterly loss to 8.27%, according to Lipper Inc. data. They were by far the worst performers within fixed income. Higher-quality debt instruments such as corporate debt A and BBB-rated funds also fell as rising yields pummeled their total returns. They shed around 1.5% and 4% during the month and the quarter, respectively.
Riskier areas of the fixed income market, such as high yield funds, were able to achieve mildly positive returns in March and Q1 thanks to their higher coupons. General municipal debt funds also rose, up an average 0.7% in March and 0.44% in Q1.
“March can be characterized as continued renewed optimism of the recovery,” said Robert Gahagan, senior vice president and senior portfolio manager for American Century Investments. He pointed to the GDP forecast getting raised, greater optimism on inflation and the labor market, as well as continued success of the Covid-19 vaccine rollout. “All of that resulted in a month that saw rising rates.”
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Gahagan also co-manages several fixed-income funds, including $2.8 billion American Century Short Duration Inflation Protection (APOIX) and $2 billion American Century Diversified Bond (ADFIX). The funds are up 1.31% and down 2.73% year to date, respectively.
Best Stock Funds Post Gains
On the equity side, U.S. diversified stock funds advanced an average 2.9% and 8% during the month and the quarter. Among stock indexes, the Dow was the big winner with a 6.62% and 7.76% jump for those periods as large industrials started recovering. The S&P 500 mostly kept pace, with a 4.4% and 6.2% gain, while the Nasdaq lagged, returning just 0.48% on the month and 3% in Q1 as growth stocks pulled back.
Value was clearly the name of the game, with large-cap value funds surging 6.24% and 11.35% in March and Q1. The best mutual funds for the quarter, however, were small-cap value funds, racking up an incredible 22.12%. Value was also the main contributor to returns of the best international equity funds.
Among the best sector funds were consumer goods, industrials and financial services funds, soaring nearly 6% in March. For the quarter, some of the best mutual funds were natural resources, commodities energy and financial services, with returns ranging from 18.4% to 25.3%.
“For the month and the quarter, the big theme has been one of dispersion,” said Cargi Chaudhuri, head of U.S. iShares markets and investment strategy at BlackRock. “Unlike last year’s rally, which was very synchronized and virtually every asset class moved up, now we’re seeing a significant dispersion.”
Best ETFs And Mutual Funds Gain On Strong Economic Recovery
She said the backdrop is one of a strong economic recovery. Chaudhuri said the Fed continues to be on hold and interest rates will probably continue to move higher. By the end of the year, 10-year yields could move closer to 2%. But “I also want to point out that interest rates are moving higher for the right reason. And I think that’s extremely meaningful. … They’re moving up in anticipation of a higher growth expectation.”
That said, she expects the markets to remain volatile, while risk assets continue to move higher, though not in the same straight line as we saw in 2020. Rate-sensitive sectors such as technology and fintech stocks have already come under some pressure. But she believes this could correct itself and that investors should not ignore the growth sectors in the market, in particular the cyclical parts such as semiconductors.
IShares PHLX Semiconductor (SOXX) holds a concentrated portfolio of some of the biggest players in the field, such as Texas Instruments (TXN), Intel (INTC), Broadcom (AVGO) and Nvidia (NVDA). The $6.7 billion fund is up 18.5% this year and charges a yearly management fee of 0.46%. Nvidia is on IBD Leaderboard list.
Financials, Banks, Insurance Poised To Benefit
Chaudhuri also likes financials, as banks are poised to benefit from a steepening yield curve, as are insurance companies. IShares U.S. Regional Banks (IAT) and iShares U.S. Insurance (IAK) offer such exposure. They are up 26.9% and 12.74% YTD, respectively. As the economy reopens, consumer, health care and homebuilders should be strong sectors as well, she said.
Other areas to benefit from global growth would be China, emerging markets, as well as infrastructure and clean energy funds.
Among the best ETFs, Invesco S&P SmallCap 600 Revenue (RWJ) and Invesco S&P SmallCap Value with Momentum (XSVM) were the top U.S. diversified stock funds. Within sector ETFs, cannabis funds still dominated the YTD performance despite their more recent declines. Other strong performers were funds focused on retail, such as SPDR S&P Retail (XRT).
On the bond side, Virtus InfraCap U.S. Preferred Stock (PFFA) and iShares International Preferred Stock (IPFF) were the best ETFs with a YTD return of 11.69% and 6.71%, respectively. Oil funds underperformed in March, but showed solid returns for the year.
Best ETF Manager Sees Healthy Wage Inflation
Invesco’s head of fixed income and alternatives ETF product strategy Jason Bloom said that the Fed actually wants healthy wage inflation. The Fed especially wants healthy wage inflation for certain demographics that have been left out of the economic recovery since the financial crisis.
“When you look at the core inflation metrics and wage inflation, they’ve been falling throughout the pandemic,” he pointed out. “All of the sensational headlines have really been focusing on inflation in pockets of the markets that are mostly generated by supply chain disruptions or sudden shifts in demand that are the result of the pandemic. And those are, by definition, temporary and transitory. But that is what the market inflation mania is focused on.”
He said that so far, the data is proving the Fed to be correct. So, he believes this “inflation mania is going to subside and the reality of what is going to be an uneven, hoping, global reopening.”
For bonds, he believes that completely avoiding longer-term bonds would be a mistake as investors would miss out on yield. “Sprinkling in some longer-duration exposure at these higher yields probably makes sense as you’re going to get a huge yield pick up,” he said.
Taxable Munis, High Yield And Preferred Could Shine
For that, he likes taxable munis, which are very high quality and provide substantial yield. Other areas of the fixed income market he favors are high yield, especially bank loans, regular municipal bonds, variable-rate preferreds and global high-yield bonds.
Funds that offer such exposure include $6 billion Invesco Senior Loan (BKLN), $2.3 billion Invesco Taxable Municipal Bond (BAB) and $2.3 billion Invesco AMT-Free Muni Bond (PZA). Other funds that offer such exposure include the $1.6 billion Invesco Variable Rate Preferred (VRP) and $233 million Invesco Global Short Term High Yield Bond (PGHY).
Bloom’s message to investors?
“Don’t get too focused on the short term. And don’t make big bets on what the rate market is going to do; stay diversified,” he concluded. “We don’t think you should completely abandon the long end of the yield curve right now. If the Federal Reserve is correct, and inflation is not a problem, you’re going to sacrifice a lot of yield by sitting in the front of the yield curve.”
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