With a volatile start to share markets in 2016, we take a look at 7 strategies that may help get through periods of volatility and some of the Exchange Traded Funds (ETFs) that utilise these strategies.
In our last post we looked at some of the Listed Investment Companies (LICs) that investors could use to smooth out periods of volatility like global share markets have experienced in the first few weeks of 2016. Today we’re going to look at 7 strategies that may help get through periods of volatility and some of the Exchange Traded Funds (ETFs) that utilise these strategies.
We touched on Equal Weight ETFs in our post Getting Smart about Beta. These are funds which invest in an equal weighting across an index, rather than based on the market caps of the underlying companies. For example, currently Commonwealth Bank of Australia (CBA) represents around 9.5% of the ASX 200 makeup, so in a traditional market cap ETF such as Vanguard Australian Shares Index (VAS) will represent around 9.5% of that fund’s holdings, however in a market weighted ASX 200 fund would represent just 0.5% (1/200th).
Why can this help with volatility? Particularly relevant in Australia, the top 4 companies in the ASX 200 by market cap and the big 4 banks (CBA, Westpac, ANZ, NAB) make up around 28% of the index. Until recent falls, Australia’s big miners also contributed significantly. This means that investors’ portfolios are not as well diversified as they may believe. Whilst an investor in VAS has exposure to Australia’s 200 biggest companies, 28% of their performance will be determined by 4 companies which are extremely similar.
In Australia the Market Vectors Australian Equal Weight ETF (MVW) is currently the only equal weight ETF available. It does not track the entire ASX 200, just around 60 of the most liquid companies on the ASX and offshore companies which generate at least 50% of their revenues in Australia. Its entire holding list can be found here. We think by the end of 2016 MVW will be one of a few equal weight ETFs available in Australia.
Along with equal weight ETFs, Managed Risk ETFs are another ‘Smart Beta’ option which we think we’ll see further growth in. Essentially, through an algorithmic approach the portfolio self protects itself in market falls. Generally this involves hedging against falls with derivatives (such as options and futures). There are 2 very new options available on the ASX:
Another Smart Beta strategy, yield maximiser ETFs generally invest in high dividend paying companies, and sell call options against these companies. This means if the share price does not rise above the option strike price, the option premium is collected as additional yield. Of course if the share price rises, any gains are capped to the option strike price. Whilst portfolio protection is not the core objective of these funds, they tend to perform comparatively well in falling markets due to their option strategy. With dividend yield such a must have for so many investors, there are a few funds which use this strategy including:
There are entire books written on the merits of investing in Gold (both for and against), so we won’t get into the nitty gritty here, but basically ‘experts’ can fall into two camps: the first being those who think Gold is the ultimate reserve currency and one day when all modern currencies fail we’ll be buying loaves of bread with gold coins, and the second group being those who see it as a useless shiny metal that does nothing other than look pretty. Nevertheless, gold often rises in price when everything else is falling, and in 2016 where global share markets are all down around 8%, gold is actually up a few percent (this does not mean it always goes this way!). There are a four gold ETFs available on the ASX, which include:
Of the above funds, ZGOL and GOLD are very similar where the ETFs are backed up by vaults of physical gold. PMGOLD is a little different where the right to gold is held through derivatives rather than physical gold. QAU as the name suggests is currency hedged to AUD/USD, meaning its performance has lagged its peers over the last couple of years due to the fall of the AUD.
For the ultimate Bear, there are now a number of ETFs which allow you to bet and profit on markets continuing to fall, meaning a 10% fall in an index will translate to a roughly 10% increase in price of the ETF. There are three of these funds available on the ASX:
Betashares Australian Equities Bear (BEAR) – Negative correlation to S&P ASX 200
Betashares Australian Equities Strong Bear (BBOZ) – Leveraged negative correlation to S&P ASX 200 (a 1% fall in the ASX200 will result in 2.00 to 2.75% increase in the value of the fund)
Betashares US Equities Strong Bear Hedged Fund (BBUS) – Leveraged negative correlation to US S&P500 index hedged to Australian dollars.
We recommend investors tread carefully with Inverse ETFs. History has shown share market bounces can be just as sharp & quick as the falls, so there is significant risk in taking bets against declining markets. This risk is amplified of course with the leveraged options.
With generally low volatility and consistent income, Bond ETFs can help to smooth out returns and mask the day to day volatility that can occur by holding equities. There are now 14 fixed interest ETFs available on the ASX, focusing on local and international (currency hedged and unhedged) markets, as well as government and corporate bonds. Some of the biggest bond ETFs in Australia include:
Both of the above funds have similar market capitalisations, similar performance history and similar fees, although VAF is slightly cheaper, has a slightly higher yield and generally greater daily volume traded. Vanguard and iShares have recently launched a number of global fixed income ETFs which can provide further diversification for those interested in bonds. We discussed these in a prior post.
It sounds boring, and it is, but the best way to manage volatility is often plain old diversification. We looked at what a diversified portfolio might look like in our post analysing the lowest cost ETF on the ASX. With the number of ETFs available on the ASX growing rapidly in 2015, there are now opportunities to diversify across asset classes, investment styles and geographic locations. Our Fund Finder can be used to help find the funds you need to build a diversified portfolio.