Using ETFs for portfolio building: Part 3

Reader Alert: This is the final installment of a three-part series on how ETFs can help control costs when constructing core portfolios.

After the past couple of years, investors not only know about volatility, they likely have the scars to prove it! Exchange-traded funds (ETFs) are well known for their low cost, tax efficiency and diversified exposure to markets, asset classes, sectors, commodities and industries. Less well known is that ETFs provide neat packets of stable risk that can be used not only to construct tailored portfolios, but also to control risk easily and more effectively than ever before.

Case for more volatility

Capital-market volatility threatens the adequacy of RRSPs, the solvency of defined benefit pension plans, the patience of clients and the sanity of advisors. Systemic risk — from deregulation and interconnected global financial and banking structures, exacerbated by an explosion in derivatives use, high-frequency trading and advances in information technology — suggests that “returns are likely to remain highly heteroskedastic, showing periods of consistently high and low volatility,” says Ioulia Tretiakova, manager of quantitative strategies, PU•R Investing Inc. Nothing in currently proposed banking reform legislation suggests otherwise. The problem is capital markets dislike uncertainty most of all.

Even if you believe the credit crisis was a once-in-a-lifetime aberration, as an advisor, you have a duty to clients to protect them from it.

Managing volatility

Diversification theory suggests selecting assets that don’t move in the same direction at the same time (uncorrelated). This is smart, because if one asset class (say, Canadian equities) is zigging while another (gold) is zagging, the volatility of the combined portfolio is dampened. But very much like a balance sheet, these relationships are more a snapshot than an income or cash flow statement, which shows changes between periods.

Two important things to keep in mind: The correlation between asset classes can and does change over time; and Market volatility can override correlations.

These caveats are too often ignored or forgotten by investment professionals and retail investors alike. Because they are already individually diversified, ETFs provide reliable risk that can be assembled into effective portfolios. Low and negative correlations are the best combinations for diversification.

Market volatility is a big challenge for investors and their advisors. Let’s assume a 60% stock, 40% bond portfolio was considered appropriate for an investor in 2005. As the stock market rose in 2006 and 2007, the portfolio sold stocks and bought bonds to rebalance to the 60:40 fixed-asset mix. This seems reasonable, because we’re supposed to sell high and buy low, right? But was the risk of the portfolio the same in 2008-2009 as it was in 2005? Clearly not.

A better solution would have been to maintain the risk represented by the 60:40 asset mix consistently through periods of market volatility. The risk of a portfolio should represent the risk tolerance of the investor — that doesn’t change in good or bad markets. If “12” represents the risk of a 60:40 mix in 2005, the risk of the portfolio would have spiked to over 30 in 2008-2009! To keep this portfolio at 12, equities would have needed to represent 20% and bonds 80% in mid-2008. A less-disruptive alternative would have been to add the iPath S&P 500 VIX Short Term Futures ETN (VXX) to the mix. Either approach, though, would have saved serious money for investors.

ETFs level the playing field

The idea of managing to a consistent risk is a sophisticated institutional approach on two levels. Firstly, the idea of budgeting risk is a concept used only by the largest pension funds and institutional pools of capital. No mutual fund in Canada uses this strategy as far as I know. Secondly, managing volatility is a cutting-edge idea. The availability of volatility ETFs like VXX and VXZ (the mid-term version of VXX) makes these tactics available to individual investors. Hedging long positions with short or inverse ETFs is also a tactical option, but that’s a subject for another time.

ETFs offer the potential to bend and shape risk in ways previously available only to institutional portfolio managers with hundreds of millions of dollars under management. This capability comes with the responsibility for advisors to up their game, but the payoff will benefit both their clients and their practices.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.