In the past January Year-End review, I noted that ValuEngine models were predicting a down market for 2022. In March, as fears of interest rate hikes, continued runaway inflation and global implications of the Russian invasion played on investors’ minds, I wrote a column specifically on potential safe harbors in the wake of the perfect storm. I recommended that concerned investors, especially those near or in retirement, consider moving about 30% of their current core equity exposure to less volatile options. This should allow them to better weather a potential storm without bailing out altogether.
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The question for investors concerned with a downturn is what to do and if reallocation from assets committed to core equity is required, how much should be reallocated and where should these assets go? My column from March 13 “ETFs Comging Wealth Preservation and Equity Objectives” turned out to be quite timely. Year-to-date S&P 500 ETF SPY was down more than 17% by May 13, taking its rolling 12-month return into negative territory at -2%.
All cash is not a solution, especially for people living on a fixed income. For every year that inflation rises at 7% or above, the purchasing power of money in savings accounts falls 7%. Take compounding into account, and after five years purchasing power has fallen by 40%; after 10 years, the amount of goods and services that savings nest egg can purchase will be worth less than 10% of what it is now. Therefore, most of the money in the equity market must stay there but not necessarily in top-heavy portfolios weighted heavily toward the most vulnerable sectors. Furthermore, in such a sharp rising rate environment, fixed income is no longer a safe harbor. The largest bond ETF, iShares AGG, which is diversified across the entire US bond market, fell more than 9% thus far this year.
Taking all of this into account, we reviewed in that article 11 ETFs designed to provide equity market participation with a level of downside protection when the market gets hammered. Three of these were low-volatility equity ETFs or utilities ETFs since utilities are the lowest volatility sector and typically provide a better dividend income stream than the market. Those streams act as a cushion mitigating total return impact during a sharp downturn. The other six ETFs combine equity market exposure with derivatives in order to mitigate downside exposure.
Given that the downturn has more than doubled in magnitude with even more volatility during the past two months, an update is warranted as the level of concern seems much greater than it was in March, perhaps greater than it has been since 2009. So let’s take another look at our “safe harbor” ETFs. How did our list of more defensive equity options hold up and where should investors consider putting money now?
Current ValuEngine reports on these ETF’s can be viewed HERE
Once again, the list includes:
SPLV, the Invesco S&P 500 Low Volatility ETF. It selects about 100 S&P 500 stocks with the lowest daily volatility over 12 months.
USMV, the iShares MSCI USA Min Vol Factor ETF. USMV is optimized to minimize overall portfolio price volatility while keeping other factor exposures similar to the S&P 500 Index. It follows a complex factor optimization approach to reconstitute and rebalance portfolios.
DIVZ, the TrueShares Low Volatility Equity Income ETF, holds an actively managed, concentrated portfolio of U.S.-listed companies that are favorably valued and have attractive dividends. The fund also seeks to deliver lower volatility than the overall market. The fund adviser initially screens U.S.-listed securities for sustainable dividend growth using various quantitative and qualitative indicators. Then high-quality companies are identified based on high cash flow, stable revenue streams and capital reinvestment programs. This process is expected to deliver lower volatility than the overall U.S. equity market. Finally, the fund adviser selects securities trading at attractive valuations. The actively managed fund’s methodology results in a narrow selection of 25-35 stocks. TrueShares is the ETF brand of hedge fund True.
XLU+, the Select Sector SPDR Utilities ETF, was the first Utilities ETF. It is composed of all the utilities in the benchmark index. The chart below illustrates that for 21 years, XLU has generally, but not always, risen about half as much as SPY in strong years for the benchmark index and fallen about half as much when the S&P 500 fell. Its Beta of 0.47% reflects exactly that.
UTES, the Virtus Reaves Utilities ETF, is an actively managed ETF that focuses on the stocks of utility companies. Active exposure is rare among sector funds, especially with respect to utilities. Managed by Reaves Asset Management, the fund uses fundamental, growth, and risk-based metrics such as capital structure, historical earnings growth, and share price volatility.
The following ETFs are partially derivative-based and do not have ValuEngine reports available. All of them were engineered to mitigate losses in equity market downturns. Among these six, only SWAN was analyzed in my January article.
SWAN, the Amplify Black SWAN ETF, is designed to participate in 30% of S&P 500 returns by holding laddered 10-Year Treasury Bonds and using the income to purchase long-dated call options on the S&P 500.
BJAN, Innovator U.S. Equity Buffer ETF, uses options in an effort to moderate losses on the S&P 500 over a one-year period starting each January. The fund foregoes some upside return as well as the S&P 500’s dividend component because the options are written on the price (not total) return version of the index. In exchange for preventing realization of the first 9% of the S&P 500’s losses, investors forgo upside participation above a certain threshold, which is reset annually. Investors who buy at any other time than the annual reset day may have a very different protection and buffer zone. The issuer publishes effective interim levels daily on its website. The fund must be held to the end of the period to achieve the intended results. The targeted buffers and caps do not include the fund’s expense ratio. The fund is actively managed, resets annually, and uses listed options exclusively. Innovator has 11 clone funds: BFEB, BMAR, BAPR, etc. to accommodate investors who want to invest on the first day of other months and wish to lock in the same kind of protection.
SPD, the Simplify US Equity PLUS Downside Convexity ETF, owns S&P 500 ETFs but can have up to 20% of its portfolio in put options as warranted by market conditions according to its decision rules. SPD aims to deliver simple convexity without the complexity of buffered ETFs.
ASPY, ASYMShares Asymmetric S&P 500 ETF, is an indexed and rules-based alternative strategy to hedging US large-cap equities. The fund targets between -25% and 75% net long equity exposure based on market risk. The strategy aims to provide protection against bear market losses, by being net short, and to capture the majority of bull market gains, by being net long, with respect to exposure to the S&P 500® Index. The strategy is powered by ASYMmetric Risk Management Technology™ intellectual property that uses price-based algorithms to identify “risk-off”,” risk-elevated.”
QAI, IQ Hedge Multi-Strategy Tracker ETF, seeks investment results that track, before fees and expenses, the price and yield performance of the IQ Hedge Multi-Strategy Index. The IQ Hedge Multi-Strategy Index attempts to replicate the risk-adjusted return characteristics of hedge funds using multiple hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed-income arbitrage, and emerging markets. IQ is managed by New York Life Investment Management, owner of the Index IQ brand.
RPAR, the Risk Parity ETF is actively managed yet nonetheless aims to align its exposure to an index, the Advanced Research Risk Parity Index. The index is diversified across four asset classes (TIPS, US Treasury Bonds, global equities and commodities), seeking returns similar to global equities with less risk over time. It is sponsored by LA-based hedge fund provider Evoke Aris.
The table below lists data in pertinent categories for all 11 ETFs explained above as well as two benchmarks. SPY, the original SPDR owning the S&P 500 Index portfolio, is a standard equity benchmark ETF. We also include AGG, the iShares Core AGGregate Bond ETF, the oldest bond ETF, because many of the derivatives-based ETFs benchmark themselves against the traditional 60/40 stocks-to-bond ratio portfolio. Despite the fact that we showed in last week’s blog that there are cheaper and better options for buying new exposures to the same portfolios, SPY and AGG are still considered the standards by most professionals because they have the most assets under management and the deepest liquidity.
Current ValuEngine reports on these ETF’s can be viewed HERE
| Category/ ETF Ticker | VE
Rating |
YTD Price Change | 12-Mth Price Change | Dividend Yield | Standard
Deviation |
Beta | Expense Ratio |
| SPLV | 3 | -6.1% | 8.1% | 1.7% | 13.9 | 0.48 | 0.25% |
| USMV | 4 | -11.9% | 1.2% | 1.4% | 13.9 | 0.64 | 0.15% |
| DIVZ | 1 | +1.1% | 18.7% | 4.3% | 12.4 | 0.58 | 0.65% |
| XLU | 4 | -0.7% | 13.0% | 2.8% | 15.5 | 0.48 | 0.10% |
| UTES | 4 | -4.4% | 11.9% | 2.0% | 14.9 | 0.49 | 0.49% |
| SPD | N/A | -15.1% | -1.8% | 1.0% | 17.5 | 0.75 | 0.29% |
| SWAN | N/A | -18.6% | -9.5% | 0.8% | 9.3 | 0.41 | 0.49% |
| QAI | N/A | -8.6% | -8.1% | 0.3% | 4.9 | 0.31 | 0.79% |
| ASPY | N/A | -9.1% | +3.1% | 0.2% | N/A | N/A | 0.95% |
| RPAR | N/A | -16.6% | -8.6% | 2.9% | N/A | N/A | 0.51% |
| BJAN | N/A | -11.8% | -4.6% | 0.0% | 12.6 | 0.68 | 0.79% |
| SPY | 3 | -17.1% | -2.1% | 1.5% | 16.6 | 1.00 | 0.09% |
| AGG | N/A | -9.3% | -8.0% | 1.9% | 4.6 | 1.00* | 0.04% |
Key Findings:
- 10 of the 11 ETFs — the five that contain volatility through equity selection without derivatives and the six that employ derivatives to varying extents — delivered in terms of the two risk measures. They all posted betas and standard deviations lower than the S&P 500. This is in line with the expectations that their websites try to convey to investors. The lowest beta and standard deviation overall belong to market-neutral QAI. The exception to this rule was SPD which produced a higher standard deviation of 17.5 compared to all ETFs in the table and at 0.75, the highest Beta other than SPY.
- SWAN and RPAR were both engineered to use derivatives to guard against “black SWAN” events in the stock market. Both failed miserably to do so. The main reason is that the long portfolio against which both buy and sell derivative products held US Treasury Bonds which have performed horribly in the rising rate environment. SPD, another synthetic built to mitigate losses, only fared slightly better. Given that the rising interest rate environment is expected to continue as the Fed continues to contain inflation, it would be reasonable to expect further disappointing risk and return statistics posted by these three ETFs.
- Market-neutral QAI fared somewhat better. In addition to producing the lowest volatility, it also contained its loss this year to half as much as that of SPY. However, its 12-month return of -8.1% is considerably worse than that of SPY and although SPY’s dividend yield of 1.5% is still a somewhat meager offset, QAI’s 0.3% dividend yield provided no offset at all.
- Two other synthetics built to shield against black SWAN markets, ASPY and BJAN, performed much better. Although they could not prevent negative returns, they did succeed in mitigating some of the downside. ASPY could be considered the star of the category in this regard as it only participated half as much as SPY in the year-to-date correction and is the only one of the ETFs that use derivatives to maintain a positive 12-month rolling return, +3.1% as compared with -2.1% for SPY. Overall, ASPY’s methodology seemed to do an above-average job of distinguishing risk-on environments from normal conditions and allocated accordingly.
- In contrast, the five low-volatility stock ETFs delivered superior performance to SPY in both the year-to-date and 12-month rolling periods. In fact, on a 12-month rolling return basis, all five delivered positive returns, distinguishing themselves from most ETFs and mutual funds. The two most diversified ETFs, USMV and SPLV, delivered on the low-volatility implied objective of participating less in downturns than their more volatile counterparts. Of the two SPLV was the better performer.
- Most investors in the utility sector are more concerned with dividend income than above-market performance. In this strange market environment, Select Sector SPDR XLU and actively managed UTES managed to deliver both with the lower-fee index-based XLU outperforming UTES while delivering a higher yield.
- Actively managed DIVZ, built specifically for conservative investors to deliver income and very low volatility, navigated this volatile vortex of a market with singular aplomb. It actually has positive capital appreciation of better than 1%, a feat achieved by less than 5% of all stock-based ETFs. Better still for its investors, it delivered on its income objective with a current dividend yield of 4.2%.
- Having summed up what happened in the past 12 months, prudent investment allocations must focus on the present and the future, not the past. As long as this level of turbulence continues, it makes sense to move some core equity allocation to more defensive products. And as represented by the largest bond ETF, AGG, most bond ETFs are unlikely to provide traditional safe harbor alternatives. So howlong will the current combination of global supply chain issues, inflationary and interest rate pressures and political instability continue and what will be the next shoe to drop? How long will the markets continue to get worse before they get better? Most importantly, which are the best ETFs to use for re-allocating up to 50% of a core equity position until outlooks become more positive?
One important thing to remember is that when markets recover, up to 50% of that recovery can come in the rebound’s first five days. Therefore, being totally out of the market can be more costly than staying in even during an environment as nerve-wracking as this one.
Of the seven ETFs that delivered better performance than SPY in both the year-to-date and 12-month environments, ASPY’s elastic methodology may give its owner’s the best chance to preserve capital while staying invested. The shortcoming of ASPY is that it has very little dividend income to provide a cushion during such environments.
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For investors near or in retirement, moving some core equity money into the utility sector via XLU makes sense. This is because the sector is relatively immune to inflationary spikes, supply chain shortages and consumer confidence. Additionally, ValuEngine’s models rate XLU to outperform during the next six-to-twelve months with a 4 rating on its 5-point scale. The models also rate USMV and UTES as 4 and both are also worthy of consideration. If you consider active management to provide better risk management than algorithms to contend with uncharted waters, then UTES might be the best choice. SPLV fared better than USMV during the past 12 months but only gets a rating of 3 for the next year from our models. On the other hand, ValuEngine’s models do not expect actively managed DIVZ to continue its spectacular success giving it the lowest rating of 1 and looking for some mean reversion in its holdings. That said, DIVZ has proven to be very adroit in navigating choppy waters throughout its existence.
In summary, the nature of Black Swan events is such that I would not extrapolate too much from performance comparisons. The next phase of this tornado may take a very different path in destroying wealth in its wake.
That said, I’d eliminate SWAN, RPAR, and SPD from my list of potential reallocation candidates. The construction of their ETFs did not account for an equity market correction being accompanied by sharply falling bond prices. All of the others are solid and well-constructed products for deployment in risk-on and risk-alert environments. In conclusion, there are some good reasons to consider diverting 20% – 30% of core index fund money to vehicles that put safety over price gains. Four ETF options that advisors and investors may find particularly worthy of review and potential allocation include some combination of ASPY, DIVZ, USMV and XLU. Diversifying that allocation among all four is another potential solution that may be worthy of consideration depending on the specific needs of end investors. Shelters are only as good as their construction provides protection against the next unanticipated maelstrom, not the previous ones.