Last week’s stock volatility was the latest reminder that it’s time to revisit risks in your investment portfolio. Besides the traditional ways of reducing risk—shifting money from stocks to bonds and owning the more defensive options in each asset class—there are some alternative strategies that help investors navigate choppy waters.
Tactical-allocation exchange-traded funds move away from riskier assets when markets turn south; managed-futures ETFs try to bet against and profit from falling assets; while buffer ETFs use options to limit their losses at the cost of potential gains.
With the S&P 500 down 16% year to date and the small-cap Russell 2000 down 21%, investors have been pulling billions of dollars out of stocks. A recent survey from
Charles Schwab
founds that more than half of traders expect the stock market to have a significant correction in the second quarter of 2022, and think it isn’t a good time to invest in equities. Meanwhile, bonds––the traditional hedge against stock volatility––have been the hammered by the double whammy of high inflation and rising interest rates.
The good news is investors have more alternatives to stocks and bonds today than ever. But it’s 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 investment.
Tactical-allocation ETFs
Allocation funds automatically shift between different asset classes depending on how they performed in the recent past. The idea is to pivot away from the riskier assets, such as stocks, when markets turn south.
The Cambria Global Momentum (GMOM) monitors 50 ETFs across stocks, bonds, real estate, commodities and currencies, but only invests in one third of them with the best trailing momentum. The ETF has managed to gain 5.7% in 2022 while most funds are down, and attracted a lot of new assets. It currently has large allocations to energy, natural resource, utilities and infrastructure funds.
Trend-chasing strategies like this are backward-looking by nature, which means they can be one step behind when market trends shift suddenly. During 2020’s March selloff, for example, the Cambria ETF dodged much of the losses by selling risky assets like stocks and real estate, but was slow to get back in as they made a sharp turnaround. 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 if the market doesn’t act in the “pattern” its algorithms have predicted, the fund could suffer.
The Cabana Group has five ETFs that allocate assets according to perceived changes in the economic cycle. They each target 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 tumbled more than their respective targets.
Cabana CEO Chadd Mason pointed to factors that contributed to the funds’ excess drawdowns: Bonds have experienced similar volatility and price declines as stocks; earnings remained strong, but market prices are disconnected from the fundamentals.
Still, he remains upbeat: “Having been through conditions like these that are unique and to an extent unprecedented, we are able to now incorporate this new data into our models moving forward.”
Managed-futures ETFs
Managed-futures funds use futures contracts to bet on––or against––trends across different asset classes. Since these funds can take short positions, they could potentially harvest bigger gains during bearish markets. But a wrong bet could also hurt more.
The actively managed First Trust Managed Futures Strategy ETF (FMF) has returned 14.6% year to date. Its largest positions now are bets against German and Japanese government bonds. The index-tracking
KFA Mount Lucas Index Strategy ETF
(KMLM) has delivered 36.8% year to date. It is currently shorting a basket of global currencies and bonds, while long commodities.
Instead of choosing its 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. This way investors can get the diversification benefits of hedge fund strategies without paying the 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 an annualized 15% with low correlation to both stocks and bonds.
Buffer ETFs
Buffer ETFs track an index like the S&P 500, but use options to limit losses while capping potential gains. Such trade-offs don’t make a good bet over the long term––investors are more likely to sacrifice upside returns than benefit from downside protection. But in today’s precarious market, they might appear attractive.
Will Hullinger, financial advisor and founder of VERITY Wealth Partners in Detroit, started using buffer funds for some clients last year. “As the clients received new cash or bonus in 2021, they were a little hesitant [to put the money into the market],” he told Barron’s. “They’d like to have some market exposure, but don’t want to have all the downside potential in case 2022 or 2023 is negative.”
Like Hullinger, many advisors have been allocating to buffer ETFs instead of rebalancing into bonds––a way to make the portfolio more conservative without the interest-rate risk. In the first four months of 2022 alone, buffer ETFs––nearly 150 of them offering different levels of protection for various periods––have added $2.7 billion in new cash. That’s 30% growth in total assets.
Investors need to choose carefully. Generally speaking, the more protection a fund offers, the lower its potential gains. What’s more, the promised buffers and caps only apply if investors hold a fund throughout the entire defined period––a recommended practice for most retail investors, according to Hullinger.
Counterintuitively, the cap on gains is usually higher when markets become volatile and interest rates go up. That means now might be a good time to buy.
The Innovator U.S. Equity Buffer ETF (BMAY) protects investors from the first 9% of the S&P 500’s losses, while capping the gains at 20.55% if they bought the fund on May 1 and hold it through the next 12 months. The same fund covering the same period last year offered a much lower cap, at just 13.6%.
Write to Evie Liu at evie.liu@barrons.com
