Exchange traded fund investors should keep up with the ever-changing market conditions to hedge portfolio positions and diversify risk exposure.
Many long-term investors are content with just diversifying their portfolios with broad non-correlated assets to manage risk in traditional equities and fixed-income positions. However, quick market turns could could create problems in the short-term.
“Interactions and correlations between asset classes and market risks can change suddenly,” writes Euan Munro, chief executive of Aviva Investors, for Financial Times.
For instance, Munro points out that the credit and equity markets, along with interest rates, have seen correlation rise in the wake of quantitative easing, and he believes that the link between the two asset classes will change again when QE is toned down.
Additionally, Munro argues that investors should monitor their overall exposure to the markets, instead of just breaking it down to equity and fixed-income assets. For instance, investors may be overexposed to the corporate sector since a typical portfolio may include equities and broad fixed-income, which also includes corporate bonds. Both stocks and corporate debt are issued by companies, so investors may be underexposed to safer government debt.
Among broad diversified bond ETFs, the iShares Core U.S. Aggregate Bond ETF (NYSEArca: AGG) includes 13.6% industrial and 6.9% financial institutions, and the Vanguard Total Bond Market ETF (NYSEArca: BND) holds 8.9% finance and 16.1% industrial.
“What might look like a well-diversified portfolio could be nothing of the sort,” Munro added.
Consequently, Munro advises investors to build diversified portfolios by measuring risk exposures and correlations between assets. For instance, investors can diminish equities risk by going short U.S. small-cap stocks while being long U.S. large-caps, which could help investors garner a positive return during a market sell-off since small-caps typically underperform during bearish conditions.
Traders can hedge against further dips in small-caps with inverse and leveraged ETF options. For instance, the ProShares Short Russell 2000 ETF (NYSEArca: RWM) reflects the -1x or -100% daily performance of the Russell 2000 Index and the ProShares Short Small Cap 600 (NYSEArca: SBB) takes the -100% of the S&P Small Cap 600.
Additionally, for the more aggressive trader, the ProShares UltraShort Russell 2000 ETF (NYSEArca: TWM) tracks the -2x or -200% daily performance of the Russell 2000. The Direxion Daily Small Cap Bear 3X Shares (NYSEArca: TZA) tracks the -3x or -300% daily performance of the Russell 2000. Lastly, the ProShares UltraPro Short Russell 2000 ETF (NYSEArca: SRTY) also takes the -300% performance of the Russell 2000.
In the currently weak oil market conditions, Munro also suggests taking positions in currencies of oil-importing countries as opposed to those of oil exporters. Commodity importers or countries with more stable currencies could benefit from the cheaper raw materials, including South Korea, Taiwan, the Philippines, eastern European countries, Turkey and South Africa. [Falling Commodity Prices a Boon for Some EM ETFs]
For more information on investing in ETFs, visit our ETF 101 category.
Max Chen contributed to this article.