ETFs Strategies to Diversify Risk in a Pricey Market | ETF Trends

As we look to the current market environment, exchange traded fund investors may consider why a tail risk investment strategy might help hedge a portfolio against potential risks ahead.

In the recent webcast, Market Update: Investing in Both Tails, Meb Faber, Co-Founder and CIO, Cambria Investment Management, highlighted the elevated valuations in the market and the potential for mean reversion to drag the currently lofty markets down to more reasonable levels. Specifically, the S&P 500 Shiller CAPE ratio was hovering near a 30 level at the end of June, compared to the historical average of close to 15. Consequently, “we argue valuations appear stretched,” Faber said.

However, this does not mean there aren’t ways for investors to remain in the market. Faber also pointed out that the U.S. only makes up a portion of the global equity market, with U.S. stocks accounting for 58% of the global market capitalization. However, American investors hold onto a high home bias or focus on domestic U.S. equities.

Looking at historical CAPE ratios, the U.S. currently trades at a significant premium to the rest world, but the historical premium has been closer to zero. Faber argued that attractive valuations exist internationally, notably in developed foreign markets with a CAPE ratio of 18 and foreign emerging markets with a CAPE ratio of 12, compared to the U.S. at 30.

“Foreign developed and in particular, foreign emerging markets offer reasonable, if not downright inexpensive valuations,” Faber said.

As a way to help investors focus on these cheap overseas opportunities, Faber highlighted the Cambria Global Value ETF (NYSEArca: GVAL) that exploits valuation opportunities in markets outside the U.S. The fund invests in about 100 stocks from the world’s most undervalued markets, targeting the cheapest, most liquid picks in countries where political or economic crisis have depressed valuations. The strategy tries to play on the historical attribute where future stock market returns tend to be lower when starting valuations are high, and future returns tend to be higher when starting valuations are low.

The underlying index begins with a universe of 45 countries taken from developed and emerging markets. The Index then selects the top 25% cheapest country stock markets as measured by Cambria’s proprietary long term valuation metrics, similar to the CAPE ratio. It then uses a valuation composite across traditional metrics such as trailing P/E, P/B, P/S, P/FCF, and EV/EBITDA to screen for the ten most undervalued stocks out of the top 30 largest stocks by market capitalization within each country.

“Research shows that the Cyclically Adjusted Price to Earnings Ratio (Shiller’s CAPE) is a very powerful predictor of future returns. This strategy identifies some of the least expensive equity markets by this measure. Within those markets, the fund invests in the most attractively priced stocks using Cambria’s proprietary valuation model,” Faber said.

Looking at Cambria Global Value ETF’s portfolio, GVAL shows a 6.24 price-to-earnings, a 0.75 price-to-book, and an attractive 4.23% 30-day SEC yield. In comparison, the S&P 500 has a 22.7 P/E, 3.3 P/B, and 1.86% yield.

Investors also face potential risks ahead in as an overpriced market has a higher likelihood of experiencing steep drawdowns or lower performance. Nevertheless, Faber pointed to the Cambria Tail Risk ETF (Cboe: TAIL) as a way to help investors diversify a portfolio by mitigating any further downside risks.

TAIL is “engineered to hedge against significant US equity market drawdowns”, and it is “managed with exposure to US Treasuries and a ladder of out-of-the money puts on the US equity market,” Faber said.

A put option provides the buyer the right to sell the underlying index to the put seller at a specified price within a specified time period. In the event of a decline in the underlying index, the put may help reduce the downside risk. Consequently, the put option becomes more valuable as the underlying market weakens relative to the strike price.

“We feel TAIL has performed exactly as we’d expect. As the market sold off, TAIL experienced gains. As the market has recovered somewhat since it’s low in March, TAIL has declined in a similar fashion,” Faber said.

Financial advisors who are interested in learning more about the tail-risk investment strategy can watch the webcast here on demand.