This week’s stock volatility is the latest reminder that it’s time to review the risks in your investment portfolio. In addition to the traditional ways to reduce risk — moving money from stocks to bonds and owning the most defensive options in each asset class — there are some alternative strategies that help investors navigate choppy waters.
Tactical allocation ETFs steer clear of riskier assets when markets turn south; managed futures ETFs try to bet against and benefit from falling assets; while reserve ETFs use options to limit your losses at the cost of potential gains.
down 16% year-to-date and the small-cap Russell 2000 down 21%, investors have been pouring billions of dollars out of the stock. A recent survey of
finds that more than half of traders expect the stock market to have a significant correction in the second quarter of 2022 and think that it is not a good time to invest in stocks. Meanwhile, bonds, the traditional hedge against equity volatility, have been hit by the double whammy of high inflation and rising interest rates.
The good news is that investors today have more alternatives to stocks and bonds than ever before. But it is important to understand how these products work, as well as the benefits and costs of such strategies, as there is no free lunch when it comes to investing.
Tactical Allocation ETF
Allocation funds automatically switch between different asset classes based on their performance in the recent past. The idea is to move away from riskier assets, like stocks, when the markets stray.
Cambria Global Boost
(ticker: GMOM) oversees 50 ETFs in stocks, bonds, real estate, commodities and currencies, but only invests in a third of them with the best trailing momentum. The ETF has managed to gain 5.7% in 2022, while most funds are down, and it attracted a lot of new assets. It currently has large appropriations for energy, natural resources, utilities, and infrastructure funds.
Trend-seeking strategies like this one are retrospective in nature, meaning they can be one step behind when market trends suddenly change. During the March 2020 sell-off, for example, the Cambria ETF dodged much of the loss by selling risky assets like stocks and real estate, but was slow to re-enter as they took a sharp turn. The fund underperformed the S&P 500 by 16 percentage points that year.
Other allocation funds monitor various macro indicators to assess the economy and allocate assets accordingly. The problem is that if the market does not act according to the “pattern” that its algorithms have predicted, the fund could be affected.
The Cabana Group has five ETFs that allocate assets according to perceived changes in the business cycle. Each targets a different maximum drawdown, ranging from 5% to 16%, depending on how aggressive investors want to be. So far this year, all five funds have fallen more than their respective targets.
Cabana CEO Chadd Mason pointed to factors that contributed to the excessive withdrawals from the funds: bonds have experienced volatility and price declines similar to stocks; earnings remained strong, but market prices are disconnected from fundamentals.
Still, he remains optimistic: “Having been through conditions like these that are unique and to some extent unprecedented, we can now incorporate this new data into our models going forward.”
Managed Futures ETF
Managed futures funds use futures contracts to bet for or against trends in different asset classes. Since these funds can take short positions, they could potentially earn higher profits during bear markets. But a wrong bet could also hurt more.
The actively managed
First Trust Managed Futures Strategy ETF
(FMF) has returned 14.6% so far this year. His largest positions now are bets against German and Japanese government bonds. Tracking Index
KFA Mount Lucas Index Strategy ETF
(KMLM) has delivered 36.8% year to date. He is currently short a basket of global currencies and bonds, while long commodities.
Instead of choosing their own positions, the
iM DBi Managed Futures Strategy ETF
(DBMF) seeks to match the performance of 20 leading managed futures hedge funds by identifying and replicating their market exposures. In this way, investors can reap the diversification benefits of hedge fund strategies without paying hefty fees, says Andrew Beer, managing partner at Dynamic Beta Investments, the firm behind the ETF.
The iM DBi ETF is up 25.3% this year and has tripled its assets under management. Since its inception in 2019, the fund has returned 15% annualized with a low correlation to both stocks and bonds.
Buffer ETFs track an index like the S&P 500, but use options to limit losses and limit potential gains. Such offsets are not a good bet In the long term, investors are more likely to sacrifice upside yields than benefit from downside protection. But in today’s precarious market, they may seem attractive.
Will Hullinger, financial advisor and founder of VERITY Wealth Partners in Detroit, started using reserve funds for some clients last year. “As customers received new cash or bonus in 2021, they were a little hesitant [to put the money into the market],” he said Barron’s. “They would like to have some exposure to the market, but they don’t want to have all the downside potential in case 2022 or 2023 is negative.”
Like Hullinger, many advisers have been allocating to cushion ETFs rather than rebalancing them into bonds, a way to make the portfolio more conservative without the interest rate risk. In the first four months of 2022 alone, reserve ETFs, nearly 150 of them offering different levels of protection for various periods, they have added $2.7 billion in new cash. That’s a 30% growth in total assets.
Investors must choose carefully. Generally speaking, the more protection a fund offers, the lower its potential earnings. Furthermore, the promised caps and reserves only apply if investors hold a fund for the entire defined period.—a best practice for most retail investors, according to Hullinger.
Counterintuitively, the profit limit is typically higher when markets become volatile and interest rates rise. That means now might be a good time to buy.
Innovative US Equity Buffer ETF
(BMAY) protects investors from the first 9% of S&P 500 losses, while capping gains at 20.55% if they bought the fund on May 1 and held it for the next 12 months. The same fund that covered the same period last year offered a much lower limit of just 13.6%.
Email Evie Liu at email@example.com