As the present elongated bull run is beginning to make some market participants nervous, investors may do well to assess which products on the ETF market could help them navigate changes in market conditions.
Exchange-traded funds have instantaneous valuation.
This transparency, although potentially hair-raising in times of erratic market movements, is no reason to disregard ETFs, according to those working in the sector.
For Bryon Lake, head of international ETF at JP Morgan Asset Management, investors should consider any critique of it using all the evidence.
“The wrapper has had two major stress tests since it was introduced in 1993,” he says. “In the early and late 2000s, underlying securities fell and so did ETFs. But it was nothing to do with the wrapper. These funds gave an accurate representation of what they were meant to track.”
For Antoine Lesne, head of investment strategy at State Street’s SPDR, the wrapper has withstood further tests – the 2011 euro-zone crisis, the 2013 taper tantrum and its reprise two years later.
“When investors are looking at how to weatherproof their portfolio, it is not the ETF wrapper they need to look at,” he says. “It is their asset allocation.”
Concerns over illiquidity have also subsided since the last major downturn.
A report from DWS’s Xtrackers found that ETFs tracking less liquid market segments, such as high-yield bond markets, actually helped enhance market liquidity, as they created a two-tier trading system by operating like a secondary market. Even international regulators have relaxed their tone in recent years.
Eric Wiegand, ETF strategist at Xtrackers, says that, compared with trading a basket of fixed income instruments separately, buying and selling an ETF is much quicker for investors wanting to get in or out of the asset class.
“Fixed income markets limit who can trade,” says Weigand. “They are very fragmented and it can be hard to find a buyer who wants a security with the exact credit and duration profile at short notice. It is much easier to trade an ETF.”
Horse for the course
This ease of trading makes an ETF an ideal vehicle to manage a market downturn, according to those in the sector. With a huge range of products now on offer, investors will not be stuck for options.
Across all exchange-traded products, global assets under management have exploded from $813bn at the end of 2007 to $5.1trn, according to data from ETFGI. The number of products has also increased almost fivefold to 7,282 listed on exchanges around the world If you can invest in a security through a mutual fund, it is pretty certain there will be an ETF to match.
Wiegand says options for investors rang from physical gold to quality stocks that pay a reasonable dividend. Xtrackers recently launched a fund that looks at a company’s business model, rather than just its level of pay out to shareholders, to ensure they are not being compensated for taking a risk by backing them. “There would still be drawdowns,” he says. “But these are defensive equities.”
There are yet more alternatives. Many providers have launched smart beta ETFs in the past few years, to take advantage of growing investor sophistication and understanding of factors. By the end of July, some $659bn was invested in these products, according to ETFGI.
Anthony Kruger, a smart beta specialist for iShares in Europe, Middle East and Africa, says: “Taking a factor lens to a portfolio means investors can go down another level. They can build defensive and resilient portfolios.”
Factor-based strategies allow investors to drill down to the risks that push or pull a security through the market.
“A whole portfolio analysis will allow you to see where you might have correlation across all strategies,” adds Kruger.
Independent provider WisdomTree runs a range of multi-factor ETFs. For Chris Gannatti, head of research, using smart beta strategies through ETFs is an efficient way of investing in a downturn.
“An ETF vehicle is lower in cost than an active, mutual fund,” he says. “It is also entirely transparent, so you can see what you are invested in each day.”
Additionally, unlike human asset allocators – even those operating algorithm-based systems – factor-based ETFs are not swayed by emotion and rebalance automatically, according to their schedule.
Smoothing the bumps
One of the factors that has performed well in previous downturns is low volatility, according to Lesne. As the term suggests, the strategy chooses securities relatively insulated from the erratic moves of the market to give a smoother return.
Lesne’s analysis shows that in the 18 years to the end of April 2018, low volatility ETFs outperformed straight S&P 500-tracking vehicles on a cumulative basis. “The strategy will not protect you completely,” says Lesne. “But it is likely to have lower drawdowns, allowing you to get back in to a healthy position more quickly.” Since 2011, this factor has seen $45bn flow into its ETFs across the board.
Howie Li, head of ETFs at Legal & General Investment Management, notes investors have begun considering commodities as an option that is lowly correlated to other asset classes.
He says investors have been asking over the past year how commodities ETFs, usually constructed using futures based on underlying securities, were constructed and performing.
For those wanting to derisk almost completely, providers have developed a range of funds that hold safe haven government bonds and short-dated debt.
As part of its recently launched ETF proposition, JP Morgan Asset Management has the Ultra Short Suite of money market funds.
“A lot of clients are reaching their threshold for cash,” says Lake. “These funds are an intelligent way to invest it.”
Xtrackers also offers funds based on the Eonia overnight bank lending rate. These ETFs hold physical government bonds but have swap overlays – made with a range of large banks – to provide additional yield.
At the other end of the scale, investors who fear the worst can use ETFs to hedge their existing holdings or even short indexes they think are going to fall.
Brett Pybus, who leads the investment and product strategy team at BlackRock iShares in Emea, says the vehicles can play a role in taking this stance.
“Investors can use ETFs to short, they can use options or pair ETFs with derivatives – for example hedging out interest risk of a credit portfolio,” says Pybus. “The market has evolved significantly, relative to five years ago, and investors are more comfortable using and constructing bespoke solutions.”
Li at LGIM says investors wanting to use ETFs as a tactical tool should carry out a full investigation of how they work.
“They are very specialist tools,” he says.
Introduction: Competition and innovation
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The market: ETF products and the current market