ETF Inner Circle – February 2013 Issue

3 ETFS TO GET YOUR PORTFOLIO OFF TO
A GREAT START

Welcome to the ETF Inner Circle!

We’re delighted to have you as a member of what we believe is the world’s premier investment
newsletter focused exclusively on exchange traded funds. But we’re even more excited to begin helping you build a fortune through strategic investments in ETFs.

If you don’t understand the themes, you’ll have a tough time understanding the rationales behind our ETF recommendations.

With that said, our investment themes aren’t set in stone.

History shows that themes only tend to work for a certain period of time before losing relevance.
While it’s impossible to know exactly when a theme will end, we’ll be keeping a sharp eye out for signs that any of our themes are becoming irrelevant.

And as circumstances change, you can count on us to modify or even change our themes
to reflect the new investing landscape.

So, what are the three major investment themes we’ve identified? How are these themes impacting the markets? And what ETFs are we recommending to profit from them?

We’re glad you asked! Keep reading for answers to these key questions and many more…

3 Timely Investment Themes And 3 ETFs To Profit From Them

Investment Theme #1: Low Interest Rates & Fed Money Pumping Is Bullish For US Stocks

The Financial Crisis of 2007-2008 was arguably the worst financial crisis since the Great Depression of
the 1930s. Not only did it threaten to destroy the US banking system and throw the economy into a second Great Depression, it caused the stock market to lose half its value in a span of just 17 months.

For all of us who lived through this crisis, it was a very scary time indeed.

Fortunately, the financial system didn’t fall apart and the economy avoided another Great Depression. Of course, the best part is that the stock market has rebounded in unbelievably strong fashion.

And it was due in large part to the unprecedented action of the US Federal Reserve.

First, the central bank lowered interest rates to nearly zero in an effort to lower longer-term financing costs for home buyers, companies, and consumers. Next, the Fed implemented three rounds of quantitative easing – an unconventional monetary policy designed to stimulate economic growth.

These policies have injected more than $3 trillion dollars into the US financial system and the economy.

While the Fed has been widely criticized, it appears they prevented the financial system from failing and helped the economy from falling into a longer and deeper recession. With that said, the long term consequences of these policies remain to be seen.

Now, the third round of quantitative easing or QE3 as it’s called is still ongoing.

Under the program, the Fed’s buying $85 billion worth of long-term Treasury bonds and mortgage-backed securities every month. And Fed Chairman Bernanke assures us QE3 will continue until employment levels show “substantial improvement.”

What’s more, Mr. Bernanke has said the Fed will maintain near-zero interest rates until at least mid-2015.

But if economists at Goldman Sachs are correct, these Fed policies are likely to last beyond mid-2015. The economists recently opined that QE3 will inject another $2 trillion into the economy before it’s finished, and the Fed won’t begin raising interest rates until 2016.

In other words, the US economy stands to benefit from near-zero interest rates and another $2 trillion infusion from the Fed for the next 2 to 3 years!

Here’s the key…

These extraordinary Fed policies are rocket fuel for stocks.

Since the Fed began implementing its controversial monetary policy, the major market indices have more than doubled in value from their crisis lows. In fact, the NASDAQ has eclipsed its pre-crisis highs. And both the Dow Jones Industrials and the S&P 500 are very close to hitting theirs.

There’s just no other way to explain these outstanding stock market gains.

They’re certainly not the result of red hot economic growth.

From December 2007 to June 2009, the US economy went through what is now familiarly called the Great Recession. During that time, the economy shrank by 4.7% and included a terrifying 8.9% drop in GDP during the fourth quarter of 2008.

What’s more, GDP growth has not been very impressive in the years after the recession’s end.

Since the recession officially ended, GDP has been growing at an annualized rate of just 2.1%. While that’s better than the government’s minimum growth target of 2.0%, it’s well below the 5.4% GDP growth seen in the three-and-a-half years following the end of the last major recession in 1982.

There’s no question about it, the spectacular stock market gains off the financial crisis lows are due largely, if not entirely, to the Fed’s money pumping policies.

And since these policies will continue for another two-and-a-half to three years, the US stock market is poised to make big gains going forward.

So, to recap…

Our first theme is to invest in a variety of ETFs focused on US stocks. We’ll look to add exposure to companies of all sizes in those sectors and industries most likely to benefit from the Fed’s policies.

Which brings us to our first ETF recommendation… the iShares Dow Jones US Home Construction ETF (ITB).

Homebuilder Stocks Have More Room To Run

The US homebuilding industry is a direct beneficiary of the Fed’s low interest rate and quantitative easing policies. Thanks to these policies, mortgage rates have been and continue to be extremely low.

As I write, the average 30-year fixed mortgage rate stands at just 3.56%.

Of course, these incredibly low rates are prompting first-time buyers as well as those who lost homes to foreclosures or short sales to buy homes. In fact, we’re now seeing signs the housing market is gearing up for a multi-year recovery.

The S&P/Case-Shiller home price index shows home prices jumped 6.8% in December, the biggest year-over-year gain since July 2006. And new home sales rocketed 15.6% higher in January on strong demand in all four regions of the country.

What’s more, the supply of homes for sale dropped to 4.1 months in January from 4.8 months in December. That’s the lowest level for the indicator since March 2005.

Rising demand combined with low supply certainly bodes well for a long-term recovery in the housing market.

And that’s great news for the homebuilders!

We’re recommending ITB to play this trend for several reasons…

First off, the fund is highly liquid with $2.1 billion in assets, 97.7 million shares outstanding, and average daily volume of 3.8 million shares. Second, ITB is more heavily concentrated in the homebuilder stocks than other ETFs out there, so it’s a purer play on the housing market recovery. And third, ITB has a low annual expense ratio of just 0.46%.

Now, ITB did pull back about 10% recently from its 52-week high of $23.87 before moving higher again the past couple of days. But we see this as a healthy correction after the ETF’s 29% gain off the November low. Given the recovery happening in the housing market, we believe this is a “buy-the-dip” opportunity.

ITB is currently trading at $22.68. Go ahead and buy ITB up to $23.25 per share. With the US housing market in just the early stages of a multi-year recovery, ITB has huge upside potential.

Investment Theme #2: Higher Economic Growth Rates Abroad Are Bullish For Select International And Emerging Market Stocks

Investing in stocks of international and emerging market countries is a must for most investors these days. They offer much needed diversification, and they can reduce your overall portfolio risk.

But the most important benefit of investing internationally is that you gain exposure to faster growing economies.

The US economy is expected to grow by just 2.1% this year before jumping to a rate of 3% in 2014. That’s not bad considering the US is still recovering from the Financial Crisis of 2007-2008 and the Great Recession that followed.

However, there are higher growth opportunities in other parts of the world just waiting to be tapped by savvy investors.

According to the International Monetary Fund (IMF), emerging market economies overall are projected to grow by 5.5% this year and then 5.9% in 2014. And China is expected to lead all countries with growth of 8.2% and 8.5% respectively.

Why are these countries growing faster than the developed nations?

Emerging market countries tend to have lower household incomes and lower debt levels. This allows them to grow much faster than developed countries which have higher incomes and debt levels.

In fact, many emerging market countries are just now seeing a middle class develop. This is very
important for them to keep growing. As more citizens reach middle class, these countries will see steady increases in consumer spending.

And higher consumer spending will drive even more robust economic growth.

Take China for example…

China didn’t have a middle class 15 to 20 years ago. Today, the country has a middle class of 300 million people. That’s larger than the entire US population, and it’s four times larger than the
American middle class.

And they’re spending like crazy.

The Chinese are now spending $600 billion a year on groceries. The travel industry generates $232 billion in sales annually. And the wealthiest Chinese are spending $25 billion a year on luxury items.

It’s no wonder that consumer spending has grown by double-digits every year for the past decade.

But here’s the shocking reality…

This same scenario is playing out in hundreds of countries around the world.

Emerging markets now account for 86% of the world’s population – that’s over 6 billion people. They control 75% of the earth’s land mass and resources. And they generate 50% of world GDP.

Clearly, the emerging market nations are going to grow and prosper for decades to come.

Nevertheless, emerging markets account for just 12% of the global equity market capitalization. In other words, there’s huge growth potential in the stocks of emerging market companies.

With that said, we won’t be limiting our ETF recommendations to just emerging market opportunities. We expect there to be terrific money-making opportunities in developed nations around the globe as
well.

In fact, our first International ETF recommendation is play on a developed nation experiencing a quantum shift in its economy.

A New Growth Era Is Just Beginning In The Land Of The Rising Sun

Back in the 1980s, Japan was revered as the most dynamic economy on the planet. The tiny island nation had grown rapidly in the decades after World War II to become the third largest economy behind the US and the USSR.

Japanese businesses were held up as the standard of efficiency and productivity. Tokyo became a major financial center. And the country’s stock market at one point held nearly half the world’s stock market value.

But then in the early 1990s, Japan’s real estate and stock market bubbles burst. The Japanese stock market lost a whopping 82% of its value. And the economy entered a deflationary environment that it still struggles with today.

However, it looks like a new day is dawning in Japan with the election of new Prime Minister, Shinzo Abe.

Mr. Abe won the election by promising to end deflation’s decades-long hold on the Japanese economy. And he plans to do it by taking a page from the US Federal Reserve’s playbook.

That’s right… he’s going to print money and manipulate interest rates.

Mr. Abe’s already succeeded in having the Bank Of Japan set a 2% inflation target. And he’s close to appointing a new central bank chief who will agree to make good on his promise of unlimited
monetary easing.

The plan is to use monetary policy to drive down the value of the Yen against the US Dollar. This will make Japanese products more affordable overseas and help boost sales for the country’s exporters.

And so far, the plan is working…

The Japanese Yen has already declined 7.7% against the Dollar, while the Japanese stock market has gained 9.7% for the year. That’s an impressive gain in such a short period of time.

But there’s plenty more upside in Japanese stocks ahead.

To profit from this trend, we recommend buying the Wisdom Tree Japan Hedged Equity ETF (DXJ).

DXJ is designed to provide exposure to Japanese stocks while at the same time hedging exposure to
fluctuations between the value of the US Dollar and the Japanese Yen. We think this fund provides an advantage over Japanese stock ETFs that are not hedged against currency fluctuations.

You see, un-hedged Japanese stock ETFs will take a hit to their returns as the Yen falls.

But that’s not the only reason why we like DXJ…

The fund is also highly liquid with nearly $4 billion in assets and average daily volume of 3.6 million shares. It’s broadly diversified with 274 holdings and only 36% of assets concentrated in the top ten holdings. And it’s one of the cheapest Japanese stock ETFs available with an annual expense ratio of just 0.46%.

DXJ has made a nice move off the November 2012 low, but we believe this is just the beginning of a longer-term uptrend. There’s plenty of room for this ETF to move significantly higher over the months ahead.

DXJ is currently trading at $40.61 per share. Grab your shares of DXJ at a price of $41.60 or less. The new growth era for Japanese stocks is just beginning… don’t miss out on the huge potential profits in this area.

Investment Theme #3: The Fed’s Low Interest Rate Policy Requires You To Look Beyond Savings Accounts, CDs, And Money Markets To Generate Income

While the Fed’s low interest rate and quantitative easing policies are bullish for stocks, they present a real challenge for income investors. The Fed’s near-zero rates make it very difficult, if not impossible, to find conservative investments that pay a decent yield.

As a result, investors must get creative when looking for ETFs to generate income.

One thing we can count on right now is that the Fed under Ben Bernanke is committed to continuing QE3 until employment levels improve. Just yesterday, Mr. Bernanke testified before the Senate Banking Committee and said this:

“In the current economic environment, the benefits of asset purchases, and of policy accommodation more generally, are clear… Monetary policy is providing important support to the recovery.”

Mr. Bernanke also said this in response to a recent statement made by Fed Governor, Jeremy Stein, suggesting that low interest rates are encouraging excessive risk-taking by investors:

“To this point, we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more job creation.”

These statements clearly show Mr. Bernanke intends to continue with QE3 for the foreseeable future.
That means the Fed will continue to hold short-term interest rates at close to zero. But more importantly, it means the Fed will keep buying $85 billion worth of Treasury bonds and mortgage-backed securities every month.

For just how long will these policies continue?

Based on Mr. Bernanke’s past statements, it’s likely the Fed will continue with QE3 until the unemployment rate falls below 6.5%.

Given the Fed’s continued commitment to QE3, we’re recommending the iShares FTSE NAREIT Mortgage Plus Capped Index Fund (REM).

Mortgage REITs Directly Benefit From QE3

REM seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the FTSE NAREIT All Mortgage Capped Index. This index measures the performance of the residential and commercial mortgage real estate, mortgage finance, and savings associations sectors of the US equity market.

The fund is quite liquid with assets of $1.03 billion and average daily volume of 775,348 shares. However, REM is not widely diversified with just 30 holdings and more than 70% of its assets invested in the top ten holdings. But it’s expense ratio is near the low-end for the real estate category at just 0.48% per year.

And most importantly, it pays an annual dividend of $1.72 for a whopping 11.49% annual yield. Dividends are paid on a quarterly basis.

But REM isn’t just an income generator.

In the current ultra-low interest rate environment, the fund is also providing share holders with significant capital appreciation. REM has gained 9.7% year-to-date, and it’s up 21.7% over the past year.

Now, keep in mind, REM is vulnerable to a rise in interest rates. However, we’ll be keeping a close eye on the Fed and interest rates as always. Once we see signs rates are headed higher, we’ll look to exit this trade.

All in all, we think REM will provide growth and steady income for some time to come.

Remember, QE3 is expected to continue until at least mid-2015 and possibly into 2016. And in this low-yield environment, we wouldn’t be surprised to see investors bid up shares of REM in order to
capture its hefty yield.

REM is currently trading at $15.15. Go ahead and buy REM up to $15.55 per share. With the Fed committed to QE3 and low interest rates, REM offers terrific total return potential.

ETF INNER CIRCLE PORTFOLIO REVIEW

In future issues, we’ll discuss the market and review our ETF holdings in this section. Since this is our first issue, we don’t have any positions yet to review.

Just keep in mind that we plan on reviewing our portfolio every month.

In that way, we’ll keep you up to speed on what’s happening with your ETFs. And we’ll advise you of any changes to the portfolio we think need to be made.

ETF INNER CIRCLE PERFORMANCE

Data as of 2/27/13