An ETF to Stay Invested, Hedge Risks in Today's Pricey Markets

In today’s market environment, investors can consider an exchange traded fund strategy to pursue returns while mitigating risk in a low-yield world.

In the recent webcast, A Dual Dilemma: Combating Low Yields and Equity Risks, Marc Odo, client portfolio manager at Swan Global Investments, highlighted the dual dilemma in today’s market environment. Bond markets appear to be out of gas, and the traditional role of bonds is in peril as inflation risks erode real yields. Meanwhile, US equities are near all-time highs, valuations appear rich, and long-term expectations are more muted after the recent rally.

Odo pointed out that fixed income investors will require up to $160 invested in 10-year Treasuries to generate $1 of income today, compared to about $15 invested to generate $1 of income back in 1990.

On the equity side, Oda noted that indicators of valuations like price-to-sales, price-to-book, and free cash flow, among others, are all hovering around the 100% percentile relative to historical values.

Odo warned of the ongoing concerns over how inflation will affect the market outlook. On the supply side, there are bottlenecks in the global supply chain while lingering effects of the trade wars have added pressure. On the demand side, pent-up demand from a year of lockdowns and copious stimulus have helped fuel consumption. The combination of limited supply and increased demand could contribute to higher prices and inflationary pressures.

Looking ahead, Rob Swan, COO and portfolio manager at Swan Global Investments, warned that interest rates are more likely to go up than down, 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 2020, when interest rates gradually fell to their near-zero levels today, a 60/40 portfolio returned an average 7.48%.

In this type of environment, conservative investors have had to adapt to a lower-for-longer rate environment by turning to cash, structured products, and gold as safe-haven plays. On the other hand, more aggressive investors have raised stock allocations, chased momentum technology winners, turned to speculative-grade bonds, and bought speculative bets like crypto in search of higher returns.

Consequently, investors need some kind of hedge that addresses left tail risks like 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.

As a way to maintain equity market exposure with some downside protection, Odo pointed 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 (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.

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.

Financial advisors who are interested in learning more about an alternative investment strategy in today’s markets can watch the webcast here on demand.