As we consider the risks and opportunities in the markets for 2022, investors can consider exchange traded fund strategies that can help achieve attractive risk-adjusted returns in the challenging road ahead.
In the recent webcast, Shifting Portfolios With the Shift in Fed Policy, Marc Odo, client portfolio manager, Swan Global Investments, highlighted the dual dilemmas that investors face when constructing a traditional stock and bond portfolio in today’s market environment. Specifically, on the equity side, we see that U.S. equity markets are still near all-time highs, valuations appear rich, the quantitative easing “punchbowl” is being removed, and long-term return expectations are muted. On the bond market side, the bond bull market appears to be out of gas with inflation at 40-year highs, and Federal Reserve interest rate hikes threaten values.
Odo also noted that interest rates are coming, which means that the easy returns from the three-decade long bull run in fixed income assets will come to an end. To put this lower return outlook in perspective, from 1945 to 1981, when interest rates gradually rose up above 14%, a traditional 60/40 portfolio showed an average real annual return of 3.08%. From 1982 to 2021, when interest rates gradually fell to their near-zero levels today, a 60/40 portfolio returned an average of 7.48%. As we can see, a rising rate environment has historically been unkind to overall portfolio returns.
In anticipation of the headwinds ahead, Rob Swan, COO and portfolio manager, Swan Global Investments, noted that investors need to find the right balance between market exposure and managing further risks. Investors need some kind of hedge that addresses left tail risks like a market crisis, COVID-19, large loss, and a long recovery process, while simultaneously tackling right tail risks like under-allocation to equities and missing out on potential returns.
Swan also noted that investors and financial advisors have increasingly dipped into the options market as another way to capture returns or hedge market risks.
As a way to maintain equity market exposure with some downside protection, Odo argued that investors can turn to the Swan Hedged Equity U.S. Large-Cap ETF (HEGD).
HEGD is always passively invested in S&P 500 Index ETFs, and it hedges against this equity-side risk through actively managed long-term put options purchased at- or near-the-money to mitigate risks of bear markets. Finally, HEGD has actively managed option trades utilizing a disciplined, time-tested approach as a means to generate additional return to offset the cost of the hedge.
HEGD uses Long-term Equity Anticipation, or LEAP, option contracts that expire at least one year from the date of purchase. The long-term hedge is used because it may last longer than bear markets, may not be under duress to re-hedge during crisis, and may provide the opportunity to acquire more shares of underlying equity ETFs during major market sell-offs. The hedge is also rolled annually so that the portfolio is always hedged and mitigates exposure to declines in value of put options.
The monetization of hedge in large market moves provides cash for buying at market lows and protection of gains in rallies. Additionally, active management is designed to take advantage of market opportunities since the managers are not constrained by calendar or hedge contract expiration. In comparison, a passive put spread collar could experience capped upside, full downside market exposure, hedges that expire in unfavorable times, hedges that expire worthless if the market is above the strike price, and no room for active management to optimize real-time moves.
HEGD can also serve different objectives for different investor types. For example, it may help increase return potential while maintaining a similar risk target for traditional allocation. The strategy can help shift cash off the sidelines and remain invested to increase market exposure. Finally, the ETF can help re-allocate to equity positions as a means of mitigating downside risk or volatility while maintaining a level of equity upside exposure.
Financial advisors who are interested in portfolio strategies for 2022 can watch the webcast here on demand.