ETF strategies for a downturn

When a market sell-off occurs, as witnessed over the last couple of weeks, it’s frustrating for both advisors and their clients. Historically, investors were limited in investment options that preserve capital—or even profit—in a downturn. Used appropriately, exchange traded funds (ETF) available in Canada could do just that.

Bear Market Asset Classes

Certain ETFs can serve as ideal vehicles for tactically moving into asset classes that tend to outperform during equity market pullbacks With increasingly higher correlations demonstrated over the last few years, equity asset classes generally move in the same direction as a market downturn. There are limited asset classes investors can use to get non-correlated returns. First on the list is gold bullion, which performed exceptionally well in the depths of the global financial crisis, and is doing so again.

ETFs have been the tool of choice for household-name fund managers, such as John Paulson and George Soros, to make large bets on gold. Both investors used the SPDR Gold Trust to get exposure to bullion. Several bullion-tracking ETFs exist in Canada, all charging a management fee of less than 1%, and can be bought and sold throughout the day. Many mutual funds offer exposure to gold equities but as seen in the last while, the correlation in performance between gold equities and physical gold has broken down, and equities are not benefitting from the run-up in the price of bullion.

According to Bloomberg, an ounce of gold was US$923.14 on Oct. 1, 2008, during the depth of the financial crisis. As of writing, it’s at approximately US$1,700. The upside of gold this time is not as powerful as three years ago, but gold still offers good diversification benefits through its low or even negative correlation to some equity markets and the U.S. dollar.

The other asset class that delivered impressive returns during the financial crisis was government-backed bonds, most notably U.S. Treasurys. In a flight to quality, investors piled into bonds to preserve capital. This time around though, bond managers, such as Pimco’s Bill Gross, warned investors away from U.S. Treasurys, due to potential interest rate risk and concerns about the States’ ability to sustain its high debt levels.

Concerns about sovereign credit risk means a future flight to safety could be into high-quality corporate bonds. ETFs are well suited for corporate bonds since investors can again take advantage of low management fees, as well as institutional pricing on bond purchases. Buying bonds at institutional rates, particularly in a low-yield environment, enhances the effectiveness of this asset class.

Within corporate bonds, there are different ETF strategies, including ETFs that offer laddering, and a floating interest rate corporate bond ETF that strives to protect investors from future rate increases. Almost every ETF provider in Canada has at least one type of corporate bond ETF. Investors should visit ETF websites to compare costs and investment objectives.

Another investment solution is volatility ETFs and ETNs linked to the S&P 500 VIX Short-Term Futures Index, which tracks the performance of near-month VIX futures activity on the S&P 500. Historically, volatility spikes are associated with periods of steep negative equity returns. From July 19 to August 8 this year, the value of the S&P 500 VIX Short-Term Futures Index increased 52.54% as market uncertainty grew around the U.S. and global growth concerns.

Volatility ETFs are powerful tools during market turmoil. But note they are not suitable buy-and-hold investment solutions since volatility spikes are short-term in nature and historically, as confidence returns to the market a volatility ETF or ETN declines in value.

ETFs can provide tax advantages as well. Click through below to find out more.

Tax Loss Selling

ETFs can also maintain market exposure while harvesting tax losses from equity positions. Tax rules prevent an investor from selling a security at a loss to harvest tax losses, then re-buy it immediately. To be eligible for a capital loss, the same security can’t be repurchased within 30 days of the sale.

Index-tracking ETFs typically offer a high degree of equivalent market beta to the mutual funds or stocks investors hold in their portfolios. An investor could sell those securities at a capital loss for tax purposes to offset capital gains from the previous three years, or apply to any current or future gains. The investor could then purchase an ETF that invests in the same asset class, or one with a similar or high correlation to the original security.

Holding an ETF to maintain market exposure is commonly referred to as cash “equitization.” It’s a common strategy to use an ETF as a market-exposure placeholder until specific securities are found to meet portfolio objectives.

The Short Side Of Things

There are two sides to every trade. A buyer takes the long position and a seller takes the short position. Mutual fund investors are mostly limited to the long side, so they’re at the mercy of broad market direction.

Tactically betting both sides of the market can be an effective investment strategy. ETFs have a huge advantage over mutual funds because they can be borrowed and shorted if an investor feels an asset class will decline. Similarly, investors can now also buy options on several Canadian-listed ETFs, meaning they can use option strategies to profit from or mitigate the impact of negative market returns.

Index ETFs are well suited to shorting because they offer 100% beta exposure, which is the market return of the underlying asset class. Potentially, not only can an investor profit from shorting an ETF during a market decline, but they can use short positions as a hedge to protect long positions in the market.

Shorting could be a powerful strategy on high-yield equity mandates, such as dividend paying stocks or mandates that harvest income through covered calls. An investors could take a short position on the underlying stock index of these mandates to minimize the market risk while harvesting the yield. Some of these strategies yield anywhere from 2 to 12%.

Shorting does bring its own set of risks, including margin call risk and unlimited downside risk, since the investor borrows to invest and eventually has to buy back the position. There are single inverse and leveraged inverse ETFs that let investors get around those issues while still providing short exposure to an asset class.

As the name implies, the investment objective of inverse ETFs is to provide daily opposite performance of a specific index or commodity. The market exposure of these ETFs reset on a daily basis, effectively limiting the risk of the ETF market value. This means investors can never lose more than what they invest. Investors should monitor their positions daily to maintain their target market exposure. Single inverse ETFs only seek to provide one-times the inverse performance of the specific index or commodity. Leveraged inverse ETFs seek multiples. Generally, singles inverse ETFs are less affected by daily resets in a negative market than leveraged inverse ETFs.

Consider what would have been possible in the last two bear markets if the majority of investors had been able to short the S&P 500. From March 2000 to October 2002, there was a potential 49% return by shorting the index from peak to trough. From October 2007 to March 2009, there was a potential 59% return.

There is no performance data available for single inverse ETFs in Canada, since they weren’t launched until after the last downturn. However, during the worst of the financial crisis from September 8, 2008 to its eventual bottom on March 9, 2009, the Horizons BetaPro S&P 500 Bear Plus ETF delivered 118%, while the Horizons BetaPro S&P/TSX 60 Bear+ ETF returned 63.4%. Both ETFs seek to deliver two-times the opposite performance of the S&P 500 and the S&P/TSX 60 Index respectively.

These returns were achieved without any re-weighting in either ETF over the six-month period. Typically, seasoned practitioners who use leveraged ETFs periodically re-weight holdings to mitigate market volatility.

Of course, as an advisor, you understand your client’s risk tolerance and goals better than anyone else so changing their tactical allocation is something you and your client have to be comfortable with. ETFs offer a range of solutions that weren’t available in previous market downturns. Opportunities are out there for clients comfortable with a tactical allocation, and ETFs offer a great way to take advantage of them.

Howard Atkinson, CFA, CIMA, ICD.D, is the CEO of Horizons Exchange Traded Funds and author of four books including The New Investment Frontier III: A Guide to Exchange Traded Funds for Canadians, (Insomniac Press, 2005) and Les Fonds Négociés en Bourse: Un outil de placement novateur pour l’investisseur avisé (Transcontinental, 2003). In 2011, he was named the chair of the recently created Canadian ETF Association.