After speculation on Fed tapering rose earlier this year, bonds fell and equities faltered, and with Fed tightening on the horizon, this could be just a taste of things to come. Consequently, exchange traded fund investors should begin to branch out to diversify potential risks ahead.
“Next year could mark a turning point as policy makers exiting the triage phase of recovery from the Great Financial Crisis move away from a material reliance on monetary activism into the potentially more volatile territory of forward guidance,” writes Ewen Cameron Watt, chief investment strategist of the BlackRock Investment Institute, for the Financial Times.
In the fixed-income market, investors will see a changing dynamic as risk and volatility grows on diminished Fed spending and economic recalibration to meet the shift, along with slowing growth in abroad. However, there are some so-called shock absorbers, like the growing demand for yield from an aging population in developed markets, and Japan’s expanding monetary policy.
“The conclusion? Do not expect a fixed income bloodbath in 2014 – but brace for more volatile returns,” Cameron said.
In the equities space, stock prices have outpaced earnings growth as a “risk-on” environment, refinancing and tight debt spreads fueled a bull market rally.
“This works well for a while, but at some point earnings need to come through,” Cameron added.
Looking ahead, volatility will rise as the Fed moves away from its accommodative measures. Volatility is especially pronounced by small changes in a low interest rate environment.
“If the major driver of returns (policy) becomes more volatile, so do the assets that have benefited from that support,” Cameron said.
Nevertheless, Cameron points out that investors can focus on alternative strategies to help diversify away from traditional assets in a volatile environment. For instance, he points to market neutral long-short strategies.
ETF investors can gain consider the ProShares Large Cap Core Plus (NYSEArca: CSM), which overweights attractive stocks while taking a short position in unfavorable stocks. [ETF Spotlight: Long/Short Large-Caps]
There are also some funds that try to provide a market neutral investment strategy, including the Credit Suisse Market Neutral Equity ETN (NYSEArca: CSMN) and the QuantShares U.S. Market Neutral Momentum Fund (NYSEArca: MOM).
ProShares recently launched a couple long/short bond ETFs to help mitigate the effects of rising rates. The ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) and the ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) are comprised of long positions in USD-denominated corporate bonds issued by U.S. and foreign companies and take short positions in U.S. Treasury notes. [Alternative ETFs Mitigate Rising Rates Risk]
WisdomTree also came out with 6 new ETFs for a rising rate environment. [WisdomTree Launches 6 ETFs for a Changing Rate Environment]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.