Have Your Cake And Eat It Too

Call it a case of having your cake and eating it: investors want to hold stocks and reduce risk at the same time. Is that possible?

Let’s first look at the equity markets. Markets began getting choppy after the S&P500 reached a new all-time high in mid-May of this year. Fresh worries began to influence market participants as news flow increased surrounding Greece’s ongoing dilemma, slowing growth in China, energy prices, and valuations in the US. Current market volatility may continue until mid-summer or the fall. Seasonal studies have shown a tendency for markets to underperform between the spring and fall of each year (“Sell in May and Go Away!”). Worries surrounding valuations, uncertainty surrounding Greece and Europe, and slowing growth in China worsen this tendency. Other factors here in North American stock markets, such as declining breadth is disturbing. Breadth is a measurement of total market participation. If too few stocks or sectors are driving the stock market, that can be a bad sign. Some of the breadth indicators that I watch, such as the “New High / New Low” indicator and “Dow Theory Confirmation” which looks to ensure that Industrials and Transports are moving together, are not looking very healthy. Nor is investor sentiment, which shows a high level of confidence in future returns by retail investors (”dumb money”) vs. a lower level of confidence by sophisticated investors (“smart money”).

Another risk factor is an emerging pattern around the U.S. Federal Reserve monetary stimulus programs. In the early years following the 2008-2009 crash, the Fed initiated “QE” and “Operation Twist” monetary easing programs. These programs, which provided “easy money” to markets by adding liquidity and reducing interest rates did their job. Markets have moved higher. However, markets became choppy and volatile following the end of these programs. The chart on this page illustrates that phenomenon – I made notations for each of the QE and stimulation programs. If the pattern for market underperformance surrounding the end of Fed stimulus programs repeats itself, markets could experience a pullback in the months following a hawkish comment from the Fed.

Now let’s look at reducing risk in a stock portfolio. In light of these factors, defensive moves such as holding cash and focusing on low beta equities make sense. Sectors that tend to hold up well in volatile markets may include utilities and the consumer staples sectors.

The Canadian utilities sector has a beta of about 0.7, meaning its 30% less volatile than the broader markets. Both the iShares Capped Utilities ETF (XUT-TSX) and the BMO Equal Weight Canadian Utilities ETF (ZUT-TSX) hold mixtures of Canada’s prominent power & utilities companies. Both securities offer dividends near 4%. Be aware that, should interest rates climb in Canada, these ETF’s would probably react negatively due to their interest rate sensitivity. Having said that, the potential for Canadian rates to rise in the near term is fairly low. On the US side, you can hold the SPDR utilities ETF (XLU). It too has a lower than market beta at around 0.75, and it pays a dividend of over 3%. US dividends, of course, do not receive the Canadian dividend tax credit. We at ValueTrend hold a position in this ETF.

The Consumer Staples sector can be traded via the Select Sector SPDR ETF (XLP-US). Big-name soft drink makers Coca Cola and Pepsi are in this ETF, along with other staples like Kraft, Philip Morris, Proctor & Gamble and Wal-Mart. XLP’s 2.5% dividend and low volatility (beta 0.8) make it an attractive position to hold now. We also hold a position in that ETF.

Hedging strategies can also help offset the negative impact of market volatility. Portfolio Managers will sometimes estimate the beta (risk) relationship of their portfolios. From there, they attempt to neutralize negative returns by allocating some capital into assets that are inversely correlated to the markets. Adding an allocation to your portfolio of an ETF that has a negative performance correlation to stocks, you can offset some or all of the losses of your stock portfolio should a correction occur.

By owning a proportional component of an inverse ETF for a stock index, losses incurred during a correction will be offset by gains on the inverse ETF. Unleveraged single inverse ETF’s such as Horizons S&P TSX 60 Inverse (HIX-T) or their S&P 500 Inverse ETF (HIU-T) will rise in a falling market, and can be an excellent hedging strategy if timed correctly. My favorite way to offset at least some of the market-driven losses on the portfolios I manage is through the Ranger Equity Bear ETF (HDGE-US). It has an almost perfect negative correlation to the S&P500. In other words, it will rise if the S&P500 falls in an almost exact proportion. If used in the right way, this ETF can offset losses in your equity portfolio during times of market negativity. It should be noted that I would recommend that you avoid making an outright bearish bet on stock market downside by investing solely in an inverse or short- ETF. I prefer to recommend these securities as a hedge held within your portfolio to be used as an offset against downside.

VIX ETF’s can also be an excellent vehicle to offset the effects of a volatile stock market within your portfolio. Often called the fear index, the VIX represents CBOE options traders’ expectations for stock market volatility for the next 30 days. ETF’s and ETN’s (Exchange Traded Notes) that mirror this index, such as the iPath S&P VIX ETN (VXX-US) or the Horizons BetaPro S&P VIX ETF (HUV-TSX) are examples of such securities. An allocation to a VIX ETF, allows you to profit by the very activity that is causing pain to most investors. Because volatility tends to be greatest during corrective periods on the market, these ETF’s can be an excellent hedge for a stock portfolio. However, I do recommend that only those traders who are a little quicker to move consider VIX ETF’s. The VIX can act violently and turn on a dime at a moments notice. You don’t want to be caught holding one of these securities if it begins moving against you.

If you want to hold equities in a potentially volatile market, why not use strategies that can offset some of that market volatility? By holding cash, low volatility stock sectors, and conservative allocations of negatively correlated ETF’s, you will stand a good chance of having — and eating — your cake.

Keith Richards, Portfolio Manager, can be contacted at krichards@valuetrend.ca.

He may hold positions in the securities mentioned. Worldsource Securities Inc. – Member: Canadian Investor Protection Fund, and sponsoring investment dealer of Keith Richards. The opinions expressed are those solely of Keith Richards and may not necessarily reflect that of Worldsource Securities, its employees or affiliates. The contents are for information purposes only and do not represent investment advice. ETFs may have exposure to aggressive investment techniques that include leveraging, which magnify gains and losses and can result in greater volatility in value, and be subject to aggressive investment risk and price volatility risk. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the prospectus before investing.