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January 6, 2025

ETFs to Start HODLING in 2025 - Part II: Satellite Strategies

In the first part of our discussion on Exchange Traded Funds (ETFs), we focused on core ETFs. These are highly diversified funds that can function within a portfolio as a quasi-permanent base layer of stock market exposure.

As we continue the analysis, we focus on satellite ETFs.

Satellite ETFs offer investors more narrowly defined exposures, including asset classes other than stocks. They are complementary to core stock holdings and often have different risk characteristics.

Satellite ETFs

While core ETFs are broad-based, satellite ETFs are more concentrated and therefore should have smaller allocations within a portfolio. They can be used selectively to target specific opportunities and economic scenarios.

Selected “Satellite” ETFs

Bitcoin

Individuals who are primarily interested in Bitcoin for investment purposes may find Bitcoin ETFs, which were approved for the first time in January 2024, appealing on many levels.

Bitcoin can still be purchased directly, through platforms like Coinbase, where investors retain direct control over their holdings.

Direct Bitcoin ownership creates flexibility to change custody arrangements in the future or to use Bitcoin more like a monetary asset.

Also, as the Bitcoin economy develops, we may in the future see many more use cases for direct ownership of Bitcoin (using it as collateral for loans, for example) than are available today.

But Bitcoin ETFs also have a lot to offer.

Bitcoin ETFs can be conveniently held within standard brokerage accounts. Management fees are quite low (typically only 0.15% to 0.25% per year).

Whereas crypto exchanges may involve high commissions (we have seen 3% to 4%), the large asset managers who run Bitcoin ETFs are able to execute trades in Bitcoin very efficiently on behalf of their shareholders.

Bitcoin is a highly volatile digital commodity, but there is a plausible case for very significant upside if it continues to gain traction globally as an alternative decentralized system for storing capital.

In perhaps the most bullish scenario, Bitcoin prevails as a superior monetary technology (similar to how email replaced much of snail mail) and takes real share of global financial assets.

If this optimistic scenario were to play out, we could see a continuation of Bitcoin’s historical pattern of delivering abnormally high rates of return over long periods of time.

Of course, there is also significant downside risk in Bitcoin.

Because of the high volatility and much greater potential for a total or near total loss of principal (versus diversified stock funds, for example), any investment in Bitcoin should be sized judiciously.

Bitcoin should be viewed as a promising but highly speculative investment. Investors in Bitcoin ETFs should truly embrace the HODL mindset to avoid panic selling if the price of Bitcoin declines sharply, which it often does.

Gold

Gold ETFs provide investors with exposure to another commodity with monetary properties, albeit a physical one.

Like Bitcoin, there are multiple platforms that support direct gold ownership, but gold can also be owned indirectly through relatively low fee ETFs.

Gold has performed quite well over time, delivering close to 12% annualized returns over the past 20 years.

Gold is therefore interesting in and of itself as an investment because of its demonstrated potential to deliver strong returns as a supply-constrained real asset.

Among other drivers, emerging market central banks continue to accumulate gold reserves as they transition away from U.S. Treasuries for multiple reasons.

But gold is also interesting in a portfolio context. In market crises, gold often holds its value or even rises as stocks decline.

Gold ETFs are especially useful as a way of storing capital that can be deployed in periods of stock market weakness, when stock ETFs or individual stocks can be purchased at reduced prices.

Short-term bonds

Another good use case for ETFs is as an alternative to bank accounts and Certificates of Deposit to hold cash.

Investors can buy short-dated government bond ETFs. These ETFs own T-bills that typically mature within 0 to 3 months, which limits interest rate risk.

These ETFs also tend to offer yields that are somewhat higher than those available from banks.

Government bond interest income is also normally exempt from state taxes on investment income, if applicable, whereas as bank account interest is not.

Similar to gold ETFs, short-term government bond ETFs can be used to store capital that may ultimately be used to buy stocks, whether in response to a specific opportunity (such as a sharp market decline) or as part of a long-term allocation plan.

Country-specific

While debate may rage over whether international stocks as a whole are attractive investments, country ETFs give investors the opportunity to establish positions in particular international stock markets where they might have more long-term conviction.

Two international market opportunities we find intriguing at this time, for different reasons, are India and Japan, which have each been relatively strong performers over the past two years.

Total International vs. India vs. Japan - 2 years

The most populous country on the planet, India has favorable demographic trends. Under Prime Minister Modi, a close Trump ally, India is also undertaking crucial economic reforms.

India has become the second largest country within the MSCI Emerging Market Index with a weighting of approximately 20% (versus China at approximately 27%).

A prominent ETF that offers passive exposure to Indian stocks is the iShares MSCI India ETF (INDA).

Japan has weak demographics but has pockets of strength in many important industrial markets as well as deep pools of capital.

Japan is the largest foreign developed market country and represents approximately 23% of the MSCI EAFE Developed Market Index.

The long-term upside story in Japan is largely based on the potential for corporate restructurings that unlock value.

A prominent ETF that offers passive exposure to Japanese stocks is the iShares MSCI Japan ETF (EWJ).

We may provide a fuller discussion the long-term case for Indian and Japanese stocks in the future. Our main purpose here is to highlight these as examples of using country-specific ETFs to achieve international exposure in a selective way.

Sector-specific

ETFs also come in handy for investors looking to play long-term opportunities in attractive industry sectors.

Investors should be aware that as ETFs become more focused on specific areas, fees tend to get higher and the products start to resemble actively managed funds.

Sector ETFs have the advantage of providing exposure to promising areas without making a commitment to any particular company or companies.

For example, an investor who has conviction in the favorable long-term supply-demand scenario for copper, as we do, may find an ETF like the Global X Copper Miners ETF (COPX) interesting.

Semiconductors are another interesting industry niche with a compelling long-term outlook.

Two prominent ETFs that give exposure to the semiconductor space include VanEck Semiconductor (SMH) and iShares Semiconductor (SOXX).

With regard to technology and growth opportunities, there are many ETFs, operating at low fees, that skew in this direction.

The largest and perhaps most famous is the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100 and houses more than $300 billion of assets.

Alternatively, there are growth ETFs like the Vanguard Growth ETF (VUG), which represents more than $150 billion in assets under management. Like QQQ, VUG contains a high degree of exposure to the mega-cap growth names of the S&P 500.

Diversified growth ETFs like QQQ and VUG are arguably more core than satellite.

Growth and tech have led the market for many years but can underperform from time to time and have (like in 2022). These ETFs can be useful for establishing long-term exposure when growth falls out of favor.

What about individual stocks?

Investors can utilize ETFs to set up a base of passive stock market exposure while also engaging in stock picking.

Diversified funds give access to stocks as an asset class and can potentially even represent a majority of one’s investments.

At the same time, an individual investor can very selectively curate a portfolio of individual stock holdings.

The focus should be on stocks that are viewed as especially attractive that may otherwise be buried within diversified funds.

For investors who have accumulated a highly diversified portfolio of individual stocks, diversified funds may become less necessary.

Yet even in this scenario, core ETFs should probably still be owned to some degree as they can at least capture success stories that might otherwise be missed.

Consider NVIDIA (NVDA), which now represents around 7% of the S&P 500.

There were some investors who were fortunate to hold the stock before it took off and became one of the most valuable businesses on the planet.

But it is worth noting that the vast majority of long-term NVDA investors, especially those who established positions many years ago, owned the stock because of its strength in video games.

NVDA’s recent surge has in fact had little to do with gaming but has been driven by AI.

The point is, NVDA’s wild success took almost all investors by surprise and ended up contributing enormously to overall market returns.

Those who had indirect exposure to NVDA through diversified funds like SPY or QQQ at least extracted some material benefit from this positive surprise.

While many if not most investors will, very rationally, create a base of long-term passive stock market exposure, we view our Model Portfolios as a resource that can be used to layer on individual stock holdings.

Similar to how we describe satellite ETFs, individual stocks can provide exposure to specific upside scenarios or help achieve portfolio goals like inflation protection or income generation.

In general, we suggest individual investors think about ETFs as convenient and efficient financial tools that can help them create a solid foundation in stocks and other attractive asset classes.

After establishing this base layer of exposure, investors can then focus on pursuing more selective opportunities in individual stocks.

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