An ETF Strategy to Better Manage the Downside Risks of Market Exuberance | ETF Trends

As we tackle the volatile market conditions today, investors should consider an alternative exchange traded fund strategy that can help better navigate the many risks and challenges ahead.

In the upcoming webcast, Irrational Exuberance: Risk Management Lessons from Shiller’s Classic, Marc Odo, Client Portfolio Manager, Swan Global Investments, highlighted the current period of irrational exuberance fueled by several factors, such as an expansion of media reporting of business news in the age of communication, including web 2.0 services, decentralized peer-to-peer financial advice, and social media platforms like Reddit, Instagram, and TikTok.

Odo also pointed to analysts’ increasingly optimistic forecasts that have fueled the bullish sentiment to record highs.

The expansion of defined contribution plans have also contributed to an increased total amount of American retail investments in the financial markets. This has also coincided with the increased popularity of easy-to-use investment vehicles like exchange traded funds that offer quick and efficient access to global markets. ETF assets under management are even projected to exceed that of traditional mutual funds by 2024.

Meanwhile, the expansion of the volume of trades through discount brokers, day traders, and 24-hour open market trading has attracted a broad range of retail investors that can easily access financial markets. The current market environment is being backed by app-based trades, “stimi” trades, increased retail investors using options, and smaller pricing increments to efficiently put money to work.

Odo also argued that there is an increase in gambling opportunities through new technologies and changing habits. For example, people can easily gamble through online betting platforms. Trading apps now appear more like video games, obscuring people’s perception of money in reality. Additionally, there are moonshot bets like SPACs, NFTs, and cryptocurrencies, among others.

In anticipation of the headwinds ahead, Rob Swan, COO and portfolio manager of 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, significant 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, Swan argued that investors could turn to the Swan Hedged Equity U.S. Large-Cap ETF (HEGD).

“By actively seeking to not lose big, we believe investors will be better off in the long run,” Swan said.

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 to generate an additional return to offset the hedge cost.

HEGD uses Long-term Equity Anticipation or LEAP options 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 the 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.

“There are new worries that make today more difficult. Investors are stuck with the dual dilemma where both equities and bonds look unfavorable. We believe hedged equity can help investors navigate these markets,” Swan said.

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 to mitigate downside risk or volatility while maintaining a level of equity upside exposure.

Financial advisors who are interested in learning more about the risk management strategy can watch the webcast here on demand