One ETF Trading Strategy to Beat the Market in 2023

Key Points

• Wall Street believes the S&P 500 will have another bad year in 2023.
• The good news is that investors can use ETFs to allocate funds to indices that are likely to have a better time.
• Specifically, people can benefit from greater gains, more diversification, and less downside risk by investing in negatively correlated and uncorrelated ETFs to the US stock market.

This year is poised to be chaotic for stock market investors. The Fed has signaled its intentions to raise rates in February and March, which would tally interest rates above 5 percent for the year. This, in turn, will weigh heavily on the S&P 500, with FAANG stocks Apple (NASDAQ: APPL), Alphabet (NASDAQ: GOOG), Microsoft (NASDAQ: MSFT), and Amazon (NASDAQ: AMZN) representing around 21% of the index's value.

Big tech crated 30% in 2022, with some estimates putting it at a $7.4 trillion loss. Moreover, rising interest rates will likely put continued pressure on the valuation of tech companies, especially as investor sentiment continues to dissipate around them in favor of more defensive investments.

Meanwhile, other major sectors of the S&P 500, such as consumer discretionary and financials, are also predicted to underperform in the wake of a recession later this year, thus likely making the index the star underperformer in 2023.

With this thesis in mind, it then stands to reason that an investment the S&P 500 will likely yield a significant loss. More so when one considers the opportunity cost of forfeiting potential gains that could've been yielded through buying units in various exchange-traded funds (ETFs).

For those comfortable with an active investing style this year, selecting defensive ETF investments along with uncorrelated and negatively-correlated assets to US equities could see one's portfolio beat the S&P 500. Let's look at how that could be accomplished by laying down some ground rules.

Don't make a loss

Central to beating the broader market is avoiding realized losses. In practice, this means several things. First, don't sell ETFs when they are down. Part of the selection process of beating the S&P 500 this year is to be happy with buying funds we'd be comfortable to hold for a decade or longer as a disaster scenario if the trade moves against us in the short term. To do this, we look for ETFs with quality (often diversified) holdings with low expense ratios. 

Second, don't use a stop loss or buy exotic instruments such as leveraged or inverse ETFs. Since we are holding for the long term, even if our trades don't work out, it doesn't make sense to use a stop-loss. Leveraged and inverse ETFs are also designed to be held for no longer than a couple of days or overnight due to how quickly they can incur losses and therefore are unsuitable for this strategy.

Core holdings

A well-diversified portfolio to beat the market this year will likely consist of individual ETFs that hold US value dividend stocks, gold, short-term US corporate bonds, emerging market stocks and bonds, and US real estate investment trusts (REITs).

As a rule of thumb, ETFs that provide these holdings should have assets under management (AUM) of at least $100 million, but the higher, the better. A higher AUM typically means a higher trading volume and liquidity, and thus narrower spreads between the bid and ask prices - which is essential for getting sell orders filled and at precise prices.

Why this portfolio?

According to analysts at Goldman Sachs, US value stocks will likely come out on top this year as they did in 2022, with one analyst writing: "big cap technology sees further margin pressure, commodity prices rise, and real interest rates remain higher, we think this trend has further to go."

Meanwhile, the lower stock prices of value stocks mean a higher dividend yield for investors and, ultimately, more dividend income because people can afford to buy more shares. Companies are reluctant to reduce or stop paying dividends even when times are bad due to the catastrophic consequences this can have on their share prices, making relying on dividend income a safe bet. The Vanguard High Dividend Yield Index is a suitable ETF for investing in quality dividend stocks with value characteristics. 

Gold is negatively correlated to the stock market, so when stocks fall, gold rises and vice versa. The precious metal has also increased by over 350% from the 1990s, making it a valuable asset in many portfolios. This asset could take off to new heights as uncertainty rises in the stock market this year. Investors can track the price of gold using a high-quality ETF such as the SPDR Gold MiniShares Trust.

Bonds are usually uncorrelated to US stocks, meaning they move up and down independently of each other. Short-term corporate bonds are also seen as desirable due to being less affected by the rise in interest rates than those with a more extended maturity date. The Vanguard Short-Term Corporate Bond ETF is a popular option to invest in a basket of high-quality bonds from blue-chip companies in the US.

This mix of value stocks with high yields and juicy dividends, gold which acts as a downside hedge to the stock market (while also appreciating on its own), and short-term corporate bonds to smooth out volatility and provide further diversification is likely to be a winning combination for beating the S&P 500 this year.

Optional ETFs for active investors

The rest of the mix consists of stocks and bonds in emerging markets due to their high growth potential and not being so tightly tethered to the US markets, as well as REITs that are still expected to grow in value throughout the year.

An optional overlay to this strategy is to include short-term momentum and trend-following ETF trades in specific sectors or asset classes. For example, you could invest in the Pro Shares Bitcoin Strategy ETF for exposure to a rally in the crypto market or the KraneShares CSI China Internet ETF to ride the trend in China's reopening and the rebound of consumer spending in the country. 

Other plays include those that track specific commodities. For instance, the price of Brent Crude is expected to increase to USD 110/bbl by the middle of this year, thus making oil ETFs like United States Oil Fund LP a viable option.

Investors may reinvest some of the gains from these short-term plays into their long-term investments, such as US value dividend stocks or gold, to increase compounding returns in their desired asset class.