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.
