Exchange traded funds can consider a managed-risk strategy to help build a controlled, diversified domestic, and international equity portfolio.
In the recent webcast, Managed Risk: A Solution for Today’s Markets, Matt Kaufman, Principal, Milliman Financial Risk Management, pointed out how the equity market’s recovery has been the fastest ever, with the S&P 500 breaking its February all-time high in under 130 days, compared to the next fastest recovery, which took about 300 days. Yields remain depressed as central banks follow a lower-for-longer rate environment to help sustain an economic recovery.
However, investors are still faced with heightened levels of volatility and ongoing risks that threaten to derail the growth. Phillip Brzenk, Senior Director, Strategy Indices, S&P Dow Jones Indices, noted that the CBOE Volatility Index, or so-called VIX, remains elevated, and the measure of future volatility shows that 2% market moves may continue to be the norm. Investors will continue to see above-average dispersion among S&P 500 components as spreads of returns remain higher than average.
Meanwhile, the international markets continue to experience uneven recoveries, and investors should treat these separate global market segments differently, according to Irma Bribiesca, Director, ETF Product Manager/Strategist, Transamerica Asset Management.
In this type of environment, it has become harder for investors, especially those thinking about retirement, to find a stable investment strategy. Kaufman argued that this might be an opportune time for more conservative or risk-averse investors to consider a volatility management component to limit further downside risks or reduce severe market declines.
For example, the DeltaShares S&P 500 Managed Risk ETF (NYSEArca: DMRL) tracks the S&P 500 Managed Risk 2.0 Index. The DeltaShares S&P 400 Managed Risk ETF (NYSEArca: DMRM) tracks the S&P 400 Managed Risk 2.0 Index. The DeltaShares S&P 600 Managed Risk ETF (NYSEAcra: DMRS) tracks the S&P 600 Managed Risk 2.0 Index. The DeltaShares S&P International Managed Risk ETF (NYSEAcra: DMRI) tracks the S&P EPAC Ex. Korea LargeMidCap Managed Risk 2.0 Index. Lastly, the DeltaShares S&P EM 100 & Managed Risk ETF (NYSE: DMRE) tracks the S&P EM 100 Managed Risk 2.0 Index.
Brzenk explained that the ETFs’ underlying indices use a managed risk strategy seeking to limit losses and capture the upside in rising markets. They are designed to simulate a portfolio that dynamically adjusts allocations across the equity benchmark, investing in a combination of stocks, U.S. Treasury Bonds, and T-bills or cash. The funds strive to optimize investment choices by utilizing rules-based, transparent strategies based on stock market volatility trends.
The weight of each customized smart beta index may vary from 0% to 100% of the underlying benchmark index, and the sum of their weights will equal 100%. The methodology seeks to address increases in annualized volatility and reduce the effect of severe sustained market declines by changing the allocations among the three stocks, Treasury bonds and T-bill components, which make up the so-called Constituent Indices.
If the annualized volatility of the Equity Index increases, the Underlying Index’s allocation to the Equity Index may be reduced, and the remainder allocated to the Treasury Bond Index and/or T-Bill Index. Conversely, a subsequent decrease in the annualized volatility of the Equity Index may result in an increase in allocation to the Equity Index and a decreased allocation to the Treasury Bond Index and/or T-Bill Index.
The methodology allocates more of the shift from the Equity Index to the T-Bill Index when the yield-to-maturity on the Treasury Bond Index is not sufficiently higher than the effective Federal Funds Rate for a sustained period of time when the volatility of the Treasury Bond Index is high, and/or when the correlation between the Treasury Bond Index and the Equity Index is positive.
For example, the DeltaShares S&P 500 Managed Risk ETF saw its U.S. Treasury weight surge to 84% by March 31. However, with market volatility diminished and equities rallying, DMRL’s U.S. Treasury position has shrunk to 40% as of August 24.
Kaufman explained that these types of managed risk ETF strategies could help investors maintain market exposure through systemic risk-off events, which may help investors put a lid on downside risks through the dynamic methodology. In comparison, low volatility or minimum volatility strategies will expose investors to the full risk-off selling in equities during broad systemic events.
Financial advisors who are interested in learning more about managed risk solutions can watch the webcast here on demand.