This article was originally published in April 2012.

In the March issue of Advisor’s Edge Report, we discussed the need for a balanced and aggressive attack during neutral and positive markets (see “ETF tips from the rink”). This month, we examine the neutral zone trap for protecting against a potentially hostile market.

Setting the trap

When the opposition controls the puck in its own end, the neutral zone trap can be used to counteract the rush before it develops into a major threat. In recent years, capital markets have appeared unpredictable for extended periods. They seem to react to one crisis after another, while dominating investors by keeping them off balance. Current events, rather than longer term disciplines, seem to be most important.

Both Jacques Lemaire (Devils and Wild) and Guy Carbonneau (Canadiens) have leveraged the trap effectively to thwart attacks. Randy Carlyle, too, used it to coach Anaheim to the 2007 Stanley Cup (Leaf fans can dream on!).

It was so effective that the National Hockey League moved to strictly enforce obstruction rules, while allowing the two-line pass to make the trap less useful (see “Two-line passes,” right).
Anything below the blue line is the neutral zone.

Meant to disrupt momentum, players space themselves in the neutral zone in a 1-2-2 formation with one fore-checker looking to take advantage of a turnover.

In a portfolio, this checker can be an aggressive equity fund like a small-cap or an emerging-markets fund that will respond quickly if the market trend suddenly turns positive (see “Fore-checker: smallcap and emerging-market funds,” below).

Fore-checker: small-cap and emerging-market funds

Exchange traded fund Symbol MER
iShares Russell 2000 Index Fund (CAD hedged) XSU 0.35%
Vanguard MSCI Emerging Markets Index VEE 0.49%
iShares S&P/TSX SmallCap Index Fund XCS 0.55%
BMO Emerging Markets Equity Index ZEM 0.57%
Claymore BRIC ETF CBQ 0.67%
Claymore Broad Emerging Markets ETF CWO 0.71%
iShares MSCI Emerging Markets XEM 0.82%

Two forwards block any attack lanes along the boards, forcing the play toward the centre. These players must be ready to strike if they create a turnover.

Broadly based equity positions would serve this two-way function well, perhaps one domestic like XIC or VCE and one global or international like XWD, VEF or ZIN (see “Forward: Canadian Equity,” and “Forward: Global or International Equity,” below).

Forward: Canadian-equity (broad lowest-cost) funds

Exchange traded fund Symbol MER
Horizons BetaPro S&P/TSX60 Index (swap) XHT 0.07%
Vanguard MSCI Canada Index VCE 0.09%
BMO Dow Jones Titans 60 Index ZCN 0.16%
iShares S&P/TSX 60 Index XIU 0.17%
iShares S&P/TSX Capped Composite Index XIC 0.25%

Forward: global or international equity

Exchange traded fund Symbol MER
Vanguard MSCI EAFE Index (CAD hedged) VEF 0.37%
iShares MSCI World Index XWD 0.45%
BMO International Equity Hedged to CAD Index ZIN 0.50%

What about defence?

The two players on defence delay attackers while their forwards reposition to defend if no turnover can be forced. In a portfolio, these positions will depend on the risk tolerance of the investor.

In a low-interest-rate environment, some return potential is important, but defence is the primary objective. High-yield or convertible bonds are risky, but offer better upside. Pairing with a defensive offset, like a short term/duration or laddered ETF, would provide the right mix of defence with offensive potential. (See “Defence: High-Yield and Convertible Bonds,” and “Defence:
Short-Term or Laddered Bonds,” below).

Defence: high-yield and convertible bonds

Exchange traded fund Symbol MER
Claymore Advantaged Convertible Bond CVD 0.45%
iShares DEX Hybrid Bond Index XHB 0.45%
Claymore Advantaged High-Yield Bond CHB 0.56%
iShares U.S. High-Yield Index XHY 0.60%
XTF Canadian Convertible Liquid Universe CXF 0.65%
Powershares Fundamental High-Yield Corporate Bond PFH 0.65%
BMO High-Yield Corporate Bond ZHY 0.69%

Defence: short-term or laddered bonds

Exchange traded fund Symbol MER
Claymore 1-to-5 Year Laddered Government Bond CLF 0.17%
BMO Short Federal Bond Index ZFS 0.22%
iShares DEX Short Term Corporate Universe + Maple XSH 0.25%
Powershares 1-to-5 Year Laddered Inv. Grade Corp. Bond PSB 0.25%
iShares DEX Short-Term Bond Index XSB 0.25%
Claymore 1-5 Year Laddered Corporate Bond CBO 0.28%
BMO 2013 Corporate Bond Target Maturity ZXA 0.30%
RBC Target 2013 Corporate Bond ROA 0.30%
BMO Short-Term Bond ZCS 0.32%

Mounting a defence in the face of a powerful market onslaught can be a challenge. When volatility picks up, there are few tactics —other than cash or high-quality short-term bonds—that can preserve capital.

Whether or not you have a sense about the kind of market threats ahead, ETFs can be useful players in positioning you correctly to defend and attack.

Mark Yamada is President of PÜR Investing Inc., a software development firm. Disclosure: PÜR Investing Inc. provides risk-based model portfolios to Horizons ETFs.

Originally published in Advisor's Edge Report