Using Passive ETFs to Track Risk Appetite for Active Gains | ETF Trends

Exchange traded funds can be handy tools for gauging market interest and risk appetite at a glance. Because of their liquidity, ETFs are often accurate, up-to-date measurements of how investors are viewing market environments and risk, and they are something that active managers are constantly tracking, particularly in more volatile markets.

Risk appetite is essentially how willing an investor is to take chances in market conditions; if they are more tolerant of taking on greater risk, price action tends to be bullish and rise, and, conversely, if investors are less willing to take on risk, then pullbacks and downtrends could be seen in prices. Risk appetite is a measure of what investors are willing to lose while pursuing their investment objectives.

It’s important to understand risk appetite because changing risk appetite is what drives market movements and behaviors. In environments that are considered riskier by investors, where the risk appetite is low, momentum-focused strategies generally have a harder time performing than they would in an environment with high risk appetite and rising prices. Markets with lower risk appetite tend to be more volatile, with changes happening quickly.

Looking at Risk Appetite Through ETFs

One of the primary ways to tell the overall risk appetite in the broad market at a glance is to look at how stocks are performing compared to bonds. This evaluation can become somewhat muddled when the Fed alters interest rates, but by and large, equities and fixed income tend to move in inverse proportion to each other. When stocks are performing strongly, bonds tend to pull back, indicating that risk appetite is strong; when bonds are outperforming, risk appetite is weaker.

Another way to look at the markets is to track their major indexes and how they are performing compared to their 200-day moving averages. This is an alternate way to measure bull and bear market movements beyond the 20% loss gauge and can give indicators of overall market interest and risk appetite.

The ETFs that track the major indexes are the SPDR S&P 500 ETF Trust (SPY), which tracks the S&P 500; the Invesco QQQ ETF (QQQ), which tracks the Nasdaq-100; the SPDR Dow Jones Industrial Average ETF Trust (DIA), which tracks the Dow Jones; and the iShares Russell 2000 ETF (IWM), which tracks the Russell 2000. Understanding how the broader indexes are moving is important for active managers who are working to beat their benchmarks.

A different perspective on the overall U.S. market is to look to how developed markets are performing compared to emerging ones. It’s important when using this approach to understand if the risk appetites extend broadly or if instead they are region-specific. Understanding what sectors trend heavier in different markets is also important. To look at the broad U.S. market, investors and advisors need only look to SPY in comparison to the iShares MSCI Emerging Markets ETF (EEM).

If the broad markets are too volatile or difficult to get a good gauge on, digging into individual sector and industry risk appetite can prove a way to gauge investor sentiment. In times of stronger risk appetite, cyclicals like consumer discretionary and technology tend to perform better. The Vanguard Consumer Discretionary ETF (VCR) tracks the former, and the latter can be tracked by ETFs such as QQQ.

Weaker risk appetite markets tend to see improved performance in defensive sectors like utilities, trackable with ETFs like the Vanguard Utilities ETF (VPU), and consumer staples that are trackable through ETFs such as the Consumer Staples Select Sector SPDR Fund (XLP).

A final way to gauge risk appetite within markets is to watch the safe havens that tend to see heavier investments in times of volatility and downturns. These are considered low-risk avenues of investment and include gold, (trackable with the SPDR Gold Trust (GLD)), the U.S. dollar (trackable with ETFs like the Invesco DB US Dollar Index Bullish Fund (UUP)), and treasuries (trackable with ETFs like the iShares U.S. Treasury Bond ETF (GOVT)).

Outperforming in Changing Investor Risk Appetite Environments With Active Management

Active management offers flexibility, responsiveness, and better risk management in changing market environments with shifting risk appetites of investors. By gauging overall market sentiment and risk appetite from passive ETFs, active managers are able to work to outperform their passive benchmarks, particularly in times of changing investor risk appetite. Active management firm T. Rowe Price offers eight different actively managed ETFs.

The firm brings a bevy of experience and research to its products, with portfolio managers averaging over 20 years in investing each, as well as over 400 investment professionals dedicated to researching companies within ETFs.

For more news, information, and strategy, visit the Active ETF Channel.