An Active Approach to Help ETF Investors Weave Through Potential Market Risks

Investors can look to a targeted exchange traded fund to position a risk-managed strategy into a diversified portfolios and manage any further market risk in the year ahead.

In the recent webcast, Fact & Fiction About Hedging Strategies, Phillip Toews, Portfolio Manager, Agility Shares, warned that markets have and may again produce losses that are far and above those that are navigable by advisors and their clients. Consequently, Toews argued that having a starting place of explicit investor objectives changes the portfolio construction process. Maximizing returns for a given level of risk can then become specific objectives such as avoiding principal losses, preserving gains, and generating consistent returns.

Consequently, Toews argued that if we want a probability curve to match this prospect theory with portfolios designed to meet the economic and behavioral needs of our investors, a shorter left tail with a low risk of significant losses is preferred. However, this lowered downside risk will inevitably require the entire rest of the probability curve to shift left, implying a cost of shortening the left tail also referred to as a positive skew.

“One of the most important aspects of this visualization is that you understand the objective of lowering risk, and that there is a cost or, another way of thinking about this is, there is a budget for spending to accomplish the reducing tail risk,” Toews said.

As a way to better-manage risk exposure in an equity portfolio, Toews highlighted some characteristics that investors look for, including full market exposure, upmarket correlation of greater than 50%, and low down market correlation.

An investor “can’t afford to not be in S&P and can’t afford to be in unhedged,” Dan Kullman, Head of Education and Training, Toews Asset Management, said.

As an alternative to the traditional buffered equity market approach that can help manage market risk but limit potential returns, the Agility Shares Managed Risk ETF (MRSK) provides risk managed exposure with uncapped equity index exposure through actively managed hedging.

As a critical differentiator from other risk managed strategies, MRSK can generate additional returns with an allocation to aggregate bonds that are tactically managed, which may also help to manage interest rate risk. Specifically, the portfolio may include cash equivalents, 5-7 year investment-grade bonds, and 1-3 year investment grade bonds.

The ETF defines the maximum loss of domestic equity exposure through the implementation of an options strategy through purchases of at-or-near-the-money two-year equity index put options, rolled annually. The ETF sells the contracts 12 months before expiration and buys new 2-year contracts because the put contracts’ lost of value accelerates in the final months.

Furthermore, the fund attempts to mitigate the cost of hedging strategy by writing out-of-the-money equity index calls and put options spreads.

Kullman explained that the Agility Shares Managed Risk ETF methodology provides full market exposure to equity indices via index futures, allows for approximately 80% of capital to go into the cash strategy, and provides uncapped equity index exposure. The 80% of capital in the tactical aggregate bond strategy attempts to add approximately 3% per year to offset drag from the put contracts. Lastly, the actively managed option overlay allows for rolling put options near market as markets advance without a defined cap.

Financial advisors who are interested in learning more about hedging strategies can watch the webcast here on demand.