Investors turn to ETFs to fight volatility

By Mark Noble | July 2, 2008 | Last updated on July 2, 2008
4 min read
Exchange-traded fund providers are doing brisk business, as investors snap them up as stop-gap portfolio solutions to deal with volatility in equity markets and the surging price of commodities.

Apart from shifting a client’s money into more conservative assets, such as money-market funds or fixed income, the most basic way to offset volatility in a client portfolio is diversification.

According to Heather Pelant, head of iShares for Barclays Canada, ETFs are the cheapest way to get quick exposure to sometimes very specific asset categories. As equity markets as a whole swing wildly, clients can look at expanding their asset allocation to categories that are non-correlated or have an inverse relationship to traditional equity markets.

The most basic of these is fixed income, into which Pelant says iShares is seeing significant inflows.

“A lot of people are looking to do a strategic rebalance right now — asking do I have enough stocks versus bonds?” she says, noting that fixed-income ETFs may provide even greater advantages than their equity-based brethren.

“Fixed-income mutual fund MERs are about 170 bps, versus a fixed-income fund at 30 bps,” she says. “Very few bond managers outperform their index. It’s a notoriously difficult asset class for managers to outperform.”

ETFs are also proving popular as a hedging vehicle, particularly those that use leverage to double their exposure to an underlying index. For instance, Horizons BetaPro’s Oil Bear ETF, which offers 200% negative exposure to crude oil prices, has been one of the most widely traded securities on the Toronto Stock Exchange, as investors bet that oil must eventually decline.

“For several weeks it’s been the most actively traded ETF in Canada. We’re pushing about 60% or more of the trading volume of ETFs on the TSX,” says Howard Atkinson, president of BetaPro Management. “We launched an oil pair along with the natural gas in February at a net asset value of $20. Oil has gone higher since then, so the NAV [of the Bear fund] is under $10. It’s lost a significant amount of value, but the fund has grown in size from $20 million to over $300 million in assets under management.”

Atkinson says, at first glance it doesn’t make much sense that investors would be piling on to a losing endeavour, but he says the oil-bear fund has proven itself a cheap and efficient hedging tool against oil prices for investors of all stripes.

“Investors are hedging or protecting their energy stock positions from declining oil prices or believing the spread will narrow,” he says. “That’s been a huge trade, and it’s been a profitable one because energy stocks on balance have gone up more than [the Bear fund] has gone down. It’s a great example of a pair-trade — long the stock, short the commodity. We’ve seen similar plays with gold stocks and gold bullion in the past.”

Using Horizons BetaPro Bear products as a de facto short to protect the downside risk of its clients’ majority long positions is the number one reason retail advisors are using them, Atkinson says. Using an ETF for shorting is safer than actually shorting a stock, because you won’t lose more than the principal investment. In addition, most retail clients do not meet the requirements to short, nor do they get the interest accruals on their short proceeds, as institutional investors do.

“With the ETFs, we do pass on the interest accruals on the short proceeds, so you’re not forgoing that at all,” he says. “The management fee is charged on the capital, not the two-for-one exposure.”

Investors can also take a long position with leveraged ETFs as a way to minimize their actual capital exposure to a specific asset class or to offer long-term volatility protection. For example, Horizons BetaPro has recently launched a pair of 30-year U.S. bond ETFs with 200% exposure. Investors can hold one of these investments as a play on their long-term inflation expectations.

“You could use the U.S. 30-year Bond Bear Plus ETF to protect your fixed income portfolios from rising rates or inflation,” he suggests. “The effective duration of our product is around 20 years. If long-term interest rates rise by about 20%, [the bear fund] should rise about 20%.”

Mark S. Yamada, president and CEO of PUR Investing, a portfolio management firm that uses ETFs in customized client portfolios, says investors need to survey the ETF landscape before they deploy them in any type of hedging or tactical strategy.

“The first thing we do when we look at any ETF is the MER. There has to be an offset risk equivalent. If you’re not getting the bang for the buck we just won’t use it. There are 665 to 775 ETFs right now to choose from, and there are going to be more than 1,000 next year to choose from. Cost is the most important element in all of that,” he says.

Yamada does use some of the Horizons BetaPro products because they allow him to diversify a portfolio with less capital.

“Because they give you two times the exposure, you can buy one of their products and it gives you double the risk on a daily basis. That gives you a lot more flexibility to diversify with the rest of the money,” he says.

Yamada says the amount of capital deployed to any asset class must equate to the risk profile of the client — if you use an inverse-exposed ETF to short, the client should be prepared to lose all of his or her initial investment.

“Absolutely, you can lose all your money, but that may be the good news,” he says. “If you’re going to short an energy stock, your downside risk is unlimited. With an ETF you’re only risking the money you put up. Still, if you’ve lost all your money, you’ve lost all your money.”

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Mark Noble