Smith: Equity ETF Investors Defensive

February 27, 2014

What does getting defensive look like for ETF investors facing a pullback?

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is co-authored by Anthony Parish, vice president of Research & Portfolio Strategy at Austin, Texas-based Sage Advisory Services, as well as Bob Smith, the firm’s president and chief investment officer.

For equity managers who are mandated to have all or most of their investments in the stock market at all times, their choices for defending against equity corrections are somewhat limited.

But that doesn't mean they’re doomed when equities sell off. The ETF market now offers more choices than ever to help equity investors to get defensive.

We went back in history to see which types of ETFs did the best job defending against corrections in the equities market.

Criteria for inclusion in our study include:

  • No fixed-income funds (this includes preferreds and vehicles whose performance is driven by bonds, interest rates and other factors normally found in the domain of fixed income)
  • Long only (no shorting)
  • No leverage
  • Large funds (we set the minimum at $100 million in assets)

This narrowed down the ETF universe to a few basic groups, including real assets such as precious metals and agriculture; defensive equity sectors, such as utilities and staples; currencies, like the dollar, the yen and the Swiss franc; MLPs; as well as some low-volatility strategies such as SPLV, the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-47).

This left us with a short list of 21 ETFs, though readers could come up with a different list if they used different screening criteria.

We also decided to divide the market corrections into three categories—small, medium and large, which we defined as 5-10 percent; 10-20 percent; and greater than 20 percent sell-offs, respectively.

There were 21 correction periods from 2000 to 2014 though, to be clear, some of the pullbacks were smaller market drops within much larger corrections. For instance, we had a large correction from October 2007 to March 2009, but there were also five smaller corrections within that period. Once we calculated all the returns for each correction, we sorted the mean return for each fund in each correction category.

Of course, the usual caveats apply; namely, just because something worked in the past doesn't guarantee it will work in the future.

Also, not all these ETFs have track records going back to 2000, which means their numbers don’t reflect corrections that occurred in the early years. By commingling young funds and older funds, the process may have penalized those that experienced all of the correction periods—mainly MLPs and precious metals. See the table below for specific performance numbers.

 

Findings

So, what did we find?

During the seven large correction periods from 2000 to 2014, investors would have done well to be out of equities altogether. The average performance of the S&P 500 and MSCI EAFE was -36.3 percent and -38.7 percent, respectively. The best performers were currencies, gold and MLPs.

The dollar, through the lens of the PowerShares DB US Dollar Index Bullish Fund (UUP | B-39) and yen, as measured by the CurrencyShares Japanese Yen Trust (FXY | A-99), posted average performance of 10.5 percent and 9.4 percent, respectively.

Gold—in this instance, the iShares Gold Trust (IAU | A-100) or SPDR Gold Shares (GLD | A-100), rose slightly more than 6 percent.

MLPs were slightly positive, which may not sound like a huge accomplishment until you realize they outperformed the broad equity markets by upward of 40 percentage points. Meanwhile, defensive stock sectors lost less than the broad market, but generally had losses in the double digits.

Medium-Sized Corrections

For the six medium-sized corrections, the S&P and EAFE indexes fell by an average of 15.7 percent and 15.9 percent, respectively. Again, precious metals and currencies performed the best.

Gold vehicles such as GLD, IAU and SGOL, the ETFS Physical Swiss Gold (SGOL | A-100), were the top performers, followed by silver, as measured by the iShares Silver Trust (SLV | A-99).

The yen, dollar and Swiss franc—as measured by the CurrencyShares Swiss Franc Trust (FXF | B-99) came next, followed by agricultural commodities through the lens of the Elements Rogers International Commodity - Agriculture Total Return ETN (RJA | C-49), which posted slightly positive performance.

U.S. utilities—as measured by Utilities Select Sector SPDR Fund (XLU | A-93) and the Vanguard Utilities ETF (VPU | A-98)—and global utilities as in the iShares Global Utilities ETF (JXI | A-85) were roughly flat.

Platinum, or more specifically, the ETFS Physical Platinum (PPLT | A-100) performed roughly in line with the indices (-14.4 percent) and palladium—or the ETFS Physical Palladium (PALL | A-100) grossly underperformed (-24.7 percent). But again, they’re relatively young funds with short track records.

There were eight periods of smaller corrections involving equity-market declines ranging from 5-10 percent. The S&P 500 and EAFE averaged drops of 7.3 percent and 8.3 percent, respectively.

As before, currencies did the best. They include the yen, dollar and Swiss franc. All other categories had negative performance, on average. That said, utilities and global utilities were again the best equity sectors, with performance the only slight negative.

Perhaps even more interesting, all of our defensive vehicles outperformed the S&P and EAFE during these small correction periods.

So, if history is any guide, investors would do relatively well using any of these vehicles during small drawdowns. For larger corrections, however, investors should think about being out of stocks altogether.


Tactical Strategies?

If we broaden our list of choices to include the possible application of a tactical shorting strategy using ETFs that represent some of the most vulnerable market sectors mentioned above, or using ETFs that are structured to provide inverse exposure to the broad market, the possibility of outperforming during equity sell-offs increases.

However, to capture market outperformance with either of these approaches, investors would have to be reasonably accurate with their market timing—a practice we believe should come with the warning label: “Don't try this at home.”

And let's not forget the simplest option for investors who want to be defensive but are less than confident about their market-timing skills: cash or ultra-short-cash-alternative ETFs such as the AdvisorShares Sage Core Reserves ETF (HOLD). (Full disclosure: Sage’s name is on the security because we are the subadvisor.)

Provided investors have the flexibility to hold cash, and are willing to forgo the possibility of making money for short periods, a good option may be to exit the markets altogether until volatility subsides.

Though few investors can accurately predict when market corrections will take place, they can keep a short list of strategies to help them get defensive.

Defensive_ETF_Strategies_2000_2014

 


Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330 or sageadvisory.com.


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