BREAKING: Market Jumps To Cap Solid Week

Finding the best ETFs and mutual funds is tougher in this market. (Gorodenkoff — stock.adobe.com)

Despite a positive start early on, stock and bond markets ended August deep in the red. It's a reminder of how the market and even the best mutual funds face challenges.

The Federal Reserve continued pressing on with its hawkish policy, while investors grew more concerned with the prospect of a deepening recession. Except for a few select areas, most of the best mutual funds and ETFs had a hard time keeping their heads above water.

Interest rates rose sharply, with the 10-year U.S. Treasury yield adding 48 basis points to end the month at 3.15%. This all but secured a negative performance for many bond funds. On the equity side, the S&P 500 sank 4.08%, the Nasdaq 4.53% and the Dow 4.06% in August. They are down 16.14%, 24.07% and 13.29% this year.

"It's been a bit of a roller coaster," said John Porter, chief investment officer of equity at Newton, a BNY Mellon Investment Management firm. He's also lead manager of $2.7 billion BNY Mellon Small/Mid Cap Growth (DBMZX).

"The theme (in August) continued to be the theme that we've been wrestling for a good part of the year, which is the push and pull between inflation data points and Fed's responses, action and commentary, and then there's the fundamentals of the company specific data points, which have been pretty solid this year."

U.S. diversified equity funds lost an average of 3.27% in August, for a year-to-date decline of 16.49%, according to Refinitiv Lipper data. Value outperformed growth. Equity leverage funds were the worst performers. Dedicated short bias funds jumped 4.28%.

Within sector funds, the best mutual funds were those focused on energy. More specifically, commodities agriculture, natural resources and global natural resources returned between 1.9% and 4.6%. They also show solid gains for the year. U.S. and global real estate, as well as science and technology funds posted some of the worst declines.

In the diversified ETF space, only two funds posted mildly positive returns in August. First Trust Dorsey Wright Focus 5 (FV) and Pacer Trendpilot US Large Cap (PTLC) rose 0.17% and 0.13%, respectively. Year to date, the top five ETFs in the diversified fund category were dividend paying funds.

Some of the best ETFs for sector investors were, not surprisingly, oil and gas producers, as well as cannabis and uranium miners. AdvisorShares Pure US Cannabis (MSOS) soared nearly 12% in August. While Sprott Uranium Miners (URNM) jumped 11.33%, swinging its YTD gain to a positive 7.75%. So far this year, however, Invesco Dynamic Energy Exploration & Production (PXE) and First Trust Natural Gas (FCG) are the best sector ETFs, sporting over-56% returns.

Internationally, world equity funds lost an average of 3.9% in August and are down 21% on the year. But a few countries were strong outliers. India region funds rose 1.74%, trimming their losses this year so far to 8.75%. Several foreign ETFs also scored impressive returns. IShares MSCI Turkey (TUR), Franklin FTSE Brazil (FLBR) and Invesco Golden Dragon China (PGJ) jumped 16.9%, 6.5% and 6.2%, respectively, last month.

The former two ETFs together with iShares MSCI Chile (ECH) are the top three ETFs this year with 14%-plus returns.

Andrew Slimmon, managing director and U.S. equity portfolio manager at Morgan Stanley Investment Management, says that the sell-off in August shouldn't have come as a surprise to investors.

He explained that the rally that started in June "wasn't led by defensive (sectors), it was led by high risk. And that risk trade got very very overbought."

That affected the best ETFs. "Regardless of whether you're bullish or bearish on the stock market from the longer-term (perspective), I think you had to be concerned about the risk-on," he said. If the market were to decline further, Slimmon said he would sell some of the more defensive names and buy more offensive stocks.

On a positive note, the market is now less vulnerable to bad news than it was in August. Slimmon doesn't expect earnings to significantly deteriorate in the third quarter. Inflation might come down a bit and we could even possibly see mildly positive GDP growth, he said. As such, he believes we could end the year with the market higher than at current levels. Many institutional investors are underweight equity and could put their cash to work. And this could spur a year-end rally.

He's less constructive on 2023. While the stock market is telling us that inflation is coming down, the risk to inflation is not: "What happens if wage inflation turns out to be stickier? I think the market is going to get consumed with 'will the Fed need to do more?' And we don't know that now."

For the future, Slimmon says key is to anticipate trends early. This summer, consumer sentiment was at an all-time low, as measured going back 46 years.

"Consumer sentiment has never been more negative than it was in July," he said. "I find that incredible, considering that sentiment is worse today than it was in the midst of Covid when we were (locked up in) our house and worrying whether we would get sick and potentially die. The direction of change for sentiment is inevitably going to move higher because it swung so far."

Consumer discretionary names could benefit from this move. Those include home apparel, furnishing and retailing. Meanwhile, he's been selling energy stocks to free up liquidity. He still believes financials should do well as interest rates rise. He's also been underweight technology stocks, which has helped performance.

Newton's Porter believes inflation would need to keep falling and falling quickly for the Fed to stop hiking rates in the near future, "and that's a really hard prediction to make." He adds: "the odds are on the side that the Fed is going to be raising rates a little bit longer and to a greater magnitude than what the market is expecting."

Porter also has taken advantage of recent rallies to reduce portfolio volatility and risk level. "The reality is, I'm a long-only investor. My clients expect me to be fully invested and I am fully invested," he said.

Within fixed income, mostly short and ultrashort funds posted positive returns. The rest of the bond market declined. Among the best bond ETFs were those focused on rising rates. Simplify Interest Rate Hedge (PFIX) and FolioBeyond Rising Rates (RISR) soared 50.6% and 24.42%, respectively, this year.

Intermediate U.S. Treasury funds have had a good year for flows, said D.J. Tierney, managing director and senior portfolio strategist at Schwab Asset Management.

Schwab Intermediate-Term U.S. Treasury (SCHR) is Schwab's "second-largest ETF in terms of growth this year," he said. "It's had over $4.5 billion of inflows. And I've noted this also for the space of other intermediate Treasury ETFs."

Tierney said that these funds have yields over 3%, "and I think that maybe investors and advisors are getting comfort that they're reflecting the path of where the Fed is going." SCHR holds nearly $8 billion in total assets, has an SEC yield of 3% and is down 8.6% YTD. It only charges 3 basis points per year to hold the fund.

"We're a little more constructive on fixed income, and in equities we're a little more balanced," said Tierney. "We tend to be very long term in our views. … If you can put together a diversified portfolio — stay in the market, don't overreact to all this volatility we've seen. That's really our mantra."

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