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 fundSymbolMER
iShares Russell 2000 Index Fund (CAD hedged)XSU0.35%
Vanguard MSCI Emerging Markets IndexVEE0.49%
iShares S&P/TSX SmallCap Index FundXCS0.55%
BMO Emerging Markets Equity IndexZEM0.57%
Claymore BRIC ETFCBQ0.67%
Claymore Broad Emerging Markets ETFCWO0.71%
iShares MSCI Emerging MarketsXEM0.82%

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 fundSymbolMER
Horizons BetaPro S&P/TSX60 Index (swap)XHT0.07%
Vanguard MSCI Canada IndexVCE0.09%
BMO Dow Jones Titans 60 IndexZCN0.16%
iShares S&P/TSX 60 IndexXIU0.17%
iShares S&P/TSX Capped Composite IndexXIC0.25%

Forward: global or international equity

Exchange traded fundSymbolMER
Vanguard MSCI EAFE Index (CAD hedged)VEF0.37%
iShares MSCI World IndexXWD0.45%
BMO International Equity Hedged to CAD IndexZIN0.50%

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 fundSymbolMER
Claymore Advantaged Convertible BondCVD0.45%
iShares DEX Hybrid Bond IndexXHB0.45%
Claymore Advantaged High-Yield BondCHB0.56%
iShares U.S. High-Yield IndexXHY0.60%
XTF Canadian Convertible Liquid UniverseCXF0.65%
Powershares Fundamental High-Yield Corporate BondPFH0.65%
BMO High-Yield Corporate BondZHY0.69%

Defence: short-term or laddered bonds

Exchange traded fundSymbolMER
Claymore 1-to-5 Year Laddered Government BondCLF0.17%
BMO Short Federal Bond IndexZFS0.22%
iShares DEX Short Term Corporate Universe + MapleXSH0.25%
Powershares 1-to-5 Year Laddered Inv. Grade Corp. BondPSB0.25%
iShares DEX Short-Term Bond IndexXSB0.25%
Claymore 1-5 Year Laddered Corporate BondCBO0.28%
BMO 2013 Corporate Bond Target MaturityZXA0.30%
RBC Target 2013 Corporate BondROA0.30%
BMO Short-Term BondZCS0.32%

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.