To Protect and To Serve

The success of absolute return funds is evidence of investor appetite for downside protection, but how can you protect against market downturn in a portfolio built with ETFs?

Ben Johnson 8 July, 2010 | 10:33AM
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Recent market volatility underscores the tremendous degree of uncertainty shrouding the economic outlook. The strength of the 2009 rebound in equity, fixed income and commodities markets suggest a V-shaped recovery. But bloated sovereign balance sheets, stubbornly high unemployment and signs that China is reining in liquidity have left market participants pausing to ponder the shape of things to come.

Many are left wondering if the financial markets may be a few steps ahead of the underlying fundamentals. With this uncertainty, many investors are seeking ways to build downside protection into their portfolios.

Defensive strategies can take a number of forms, ranging from liquidating your investment portfolio and shoving the proceeds under a mattress (a practice that seemed prevalent in the autumn of 2008 and early 2009) to piling into gold, which has been another popular trade of late. But there are other, less drastic, ways to navigate uncertainty and mitigate downside risk in your portfolio. For investors with a long time horizon, we suggest building downside protection is as simple as creating a well-diversified portfolio accompanied by a dose of regular rebalancing.

The proliferation of transparent, low-cost, liquid exchange-traded funds (ETFs) tracking a wide array of asset classes has done a good deal to make this strategy simpler than ever. This admittedly dull approach has proved its mettle over the years and should continue to do so into the future.

Opt to Diversify
ETFs have given investors easy access to instant, low-cost diversification across a wide array of asset classes (stocks, bonds, cash, property, commodities and so on) and provide a level of transparency superior to that of actively managed funds. These features make ETFs excellent building blocks for our suggested approach to taking some of the sting out of a potential swoon in the markets.

Recent experience has shown us that the correlation of returns among disparate asset classes can move toward one (that is, perfect correlation) under extreme circumstances. But over an extended period, their returns have been largely un-correlated. As such, simply allocating assets among these various classes in a manner that suits your unique investment considerations will serve to mitigate volatility at the portfolio level.

This is where ETFs enter the picture. You can build a balanced asset allocation in a matter of minutes that includes equities (perhaps tracking the FTSE 100 Total Return Index), fixed income (FTSE UK All Stocks Gilt), cash, property (FTSE EPRA/NAREIT Developed Europe ex UK Index), commodities (Deutsche Bank Liquid Commodities Index), and even alternative asset classes (db x-trackers DB Hedge Fund Index ETF). Creating an appropriate mix of uncorrelated asset classes is perhaps the best way to mitigate downside risk.

Regular rebalancing is the second step in this simple strategy for mitigating downside risk. Adhering to a regular rebalancing regimen ensures the appropriate weightings between the various asset classes are maintained over time. This discipline forces the paring back of positions in better performing asset classes and subsequent reallocation to the relative laggards. It harnesses the tendency of asset classes toe xhibit mean-reverting returns over time. Regular rebalancing can improve performance.

Price of Protection
Downside protection is not free. Diversifying away some of the volatility associated with risky asset classes comes at the expense of diminished potential for higher future returns. For instance, introducing government bonds into an all-equity portfolio is an excellent way to reduce volatility.

The historical correlation between stocks and government debt is extremely low. The value of government debt tends to rise when all other asset classes are in a synchronised swan dive, as we saw at the peak of the crisis. This makes an allocation in government obligations one of the best diversifiers. But holders of these instruments are compensated in proportion to the levels of risk they face. Any downside protection obtained from increasing exposure to less risky asset classes will inherently lead to lower returns.

Alternative Strategies
ETFs tracking inverse indices and options strategies can afford some shelter from stormy markets. But it is important to fully understand the risks and costs associated with such funds.

Inverse or leveraged inverse ETFs may seem like a sure-fire way to mitigate downside risk in a portfolio. They provide investors exposure to the inverse (or leveraged inverse as the case might be) of the daily return on their relevant index. They work exactlya s advertised for investors with a time frame that begins and ends today.

But those that hold them over an extended period could be in for an entirely different ride, as the compounding of daily returns can lead to a divergence between the performance of the ETF and the inverse return of the underlying index. Gaining short exposure seems to be a simple solution for those looking to limit potential losses. But investors should beware the nuances of inverse ETF construction that could result in buyers’ remorse.

A handful of ETFs seek to replicate the returns of common options strategies which could serve to reduce volatility or enhance returns. The largest of these--with about €45 million (£41 million) in assets under management (AUM)--is Lyxor ETF’s Dow Jones Euro Stoxx 50 BuyWrite Fund. This fund simultaneously buys the Dow Jones Euro Stoxx 50 and sells a one-month out-of-the-money Euro Stoxx 50 call option.

The income earned from selling call options can enhance investor returns. But this strategy puts a lid on performance in a rising market, as the potential upside in a given month is limited to the strike price on the index call option. It offers income potential while limiting upside price performance and offering no downside protection.

Lyxor ETF’s DAXplus Protective Put Fund is designed with the downside in mind. It tracks the DAXplus Protective Put Index, which is long both the DAX portfolio and a 5% out-of-the-money put option. A long put provides downside protection without limiting upside potential. But, as always, protection comes with a price. In this case the premiums paid for the protective put options are coming out of investors’ pockets.

The allure of these ETFs is undeniable. But a good understanding of their structure and costs (both explicit and implicit) is necessary before using them as a means of managing market volatility.

What’s To Come
ETF innovation will continue as fund providers battle to attract new assets. This scramble to provide unique offerings will likely benefit adherents of old-fashioned asset allocation and more exotic strategies alike.

On the asset allocation front, db x-trackers has already introduced a Portfolio Total Return Index ETF. It provides investorsi nstant exposure to a globally diversified portfolio of equities and fixed income. The product’s 0.72% TER compares favourably with that of the average European open-ended allocation fund, which is 1.7%. We expect similar offerings in the future that are uniquely suited to a wider array of risk and return objectives, offering instantaneous asset allocation and diversification at an extremely low cost.

We anticipate ETF providers will continue to concoct more exotic diversifiers that could play a supporting role in a balanced asset allocation. One current gap in the European ETF menu is a long/short commodities fund. In the US, Elements S&P CTI ETN tracks S&P’s Commodity Trends Indicator Index, which is a long/short index meant to capture the roll yields and momentum of a wide variety of exchange-traded commodity futures to produce a more stable return with little correlation to traditional asset classes.

Commodities have historically provided a hedge against inflation and nearly 0% correlation with equities, which makes them a worthwhile diversifier despite low long-term returns. But this fund has the potential to provide better long-term returns while keeping its diversification value. We anticipate that strategies such as this will become more widely available in the ETF wrapper in the near-future.

A Means to an End
ETFs provide investors with a new means to a familiar end: a balanced asset allocation. An appropriate asset mix and regular rebalancing form perhaps the simplest solution to simultaneously mitigate and benefit from downside risk in your portfolio. But while the ETF world has developed more exotic strategies for managing volatility readily available to a wider audience, the complexity and costs involved in implementing these tools may outweigh their potential benefits in practice.

This article first appeared in the April 2010 edition of Portfolio Adviser.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.