New Ways To Diversify Equity Risk

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based TOPS ETF Portfolios.

Most investors need exposure to equities to reach their goals, looking at average 401(k) balances in the U.S as an easy proxy.

However, investing in equities typically provides a higher risk assumption to go along with a higher return opportunity. Also, many investors cannot stomach full equity risk. Even if the recent bull market may have convinced some investors they can handle it, they will quickly be reminded about true equity risk when volatility eventually returns.

Compounding the difficulty for investors, fixed income faces several challenges in the coming years. Many investors who have historically relied upon fixed income for risk management are concerned about holding bonds, or at least lowering their return expectations for bonds going forward.

To reduce the risk of equities, investors have balanced equity risk with bonds for decades.

For the last 30 years, bonds worked pretty well with equities. As interest rates have decreased from double digits to historic lows, bonds have provided respectable returns and acted as a buffer against the risk of stocks.

With the 10-year U.S. Treasury bond yielding about 1.5%, replicating the bond return of the past 30 years is almost impossible. Adding to the difficulty of the situation, credit spreads on corporate bonds are relatively tight, the U.S. dollar is historically strong and inflation numbers are high and uncertain.

These parameters lead us to believe that investors should entertain alternatives to using bonds as the mixer. While we are not advocating investors fully exit bond positions, or that bonds no longer provide benefits, we think investors should consider additional alternatives to diversify further and reduce the use of bonds as the sole diversifier.

Many New Investors Unprepared

To further complicate the situation, many of the investors in today’s equity markets are incredibly fresh. In a recent survey by CNBC of 5,523 U.S. investing adults, more than 25% had started investing just in the last 18 months.

As a professional portfolio manager for about two decades, I am concerned about these new investors. Likewise, I am worried that even seasoned investors are ill-prepared for what could be a very different market than we have experienced in recent years.

Additionally, the ETF industry is predominantly focused on feeding the demands of investors. From the preponderance of bitcoin solutions being launched, to marijuana ETFs, to the countless ways ETF providers have used factors to slice equities, very few are tackling the problem of equity risk. Many new products are focused on repackaging equity risk, and in some cases, increasing it.

Don’t Forget About Risk

We all know stocks have been on a historic run for over a decade, with a particularly strong bull market since the COVID pullback in early 2020. Some investors took significant risk over these periods, overweighting U.S. stocks as the majority (or entirety) of their portfolio.

That worked very well (note the historical tense). While the S&P 500 provided an annualized return of 16.63% over the last 10 years (through Sept. 30, 2021), the Barclay’s U.S. Aggregate Bond Index returned only 3.01% annualized.

Our investors benefited from participating in these strong markets as well, with large cap U.S. stocks as our largest equity concentration in our primary portfolios over this time.

For the past decade, the focus for many has been primarily on return, with only short reminders of what risk is. There is no doubt that ignoring risk has paid off. In the next 10 years, due to market parameters, risk and return may have very different roles in portfolios.

Many stocks face historically rich valuations. The strong market was a combination of underlying market success and an increase in valuations. As such, valuations of stocks are now largely above historical averages. According to our research of monthly forward P/E values for the last 16 years, large cap growth U.S. stocks were more expensive at the end of September than about 96% of their valuations historically. 

As an institutional portfolio manager, I believe investors should focus on the risk of their portfolios as much as—if not more than—they focus on return. I have a saying to stress this: “Don’t ever mention return without mentioning risk in the same sentence.”

What Should Investors Do?

Before now, investors did not have many ETF solutions to balance risk and return in a transparent manner without relying upon fixed income to contribute to returns. While there is no shortage of "magic " tactical strategies, sophisticated investors looking for transparent risk management tools have been left without a straightforward approach to the current investing environment. 

New ETFs have changed the game for investors though. To go along with traditional equity and bond investing, ETF investors now have two new powerful tools:

• Defined outcome ETFs
• Target range ETFs

Defined Outcome ETFs

Developed first by Innovator ETFs, defined outcome ETFs have helped to add a new risk management tool for investors. Innovator, and others such as First Trust, have developed full lineups of ETFs that use flexible exchange (FLEX) options contracts to provide a downside buffer against losses.

As competition has heated up, the providers have done a tremendous job of filling out their product lineups to provide more flavors than any of us could expect at the local ice cream shop. Not only do they provide a wide range of index exposures, they also provide several different levels of risk and return opportunity.

We expect the lineup for defined outcome ETFs to continue to expand. With over $7 billion in assets in defined outcome ETFs, there is no turning back. There is a plethora of resources available to learn more about defined outcome ETFs, so I won’t go into detail in this piece.

I would encourage investors to look closely at what they are buying. I often remind investors that “all ETFs are not created equal.” That cautionary phrase absolutely applies to the defined outcome space.

Target Range ETFs

A newer offering in the marketplace is target range ETFs. Target range ETFs sit in between traditional asset allocation and defined outcome ETFs. Likewise, Target Range strategies focus explicitly on reducing total left tail risk, as opposed to defined outcome ETFs which predominantly focus on buffering the first portion of potential loss only.

The first Target range ETF in the marketplace is the WisdomTree Target Range Fund (GTR). In full disclosure, GTR follows the methodology of the TOPS Global Equity Target Range Index I created; thus, I am closely attached to the benefits of this strategy.

The index implements a strategy that limits the downside return of underlying positions for 12-month rolling periods using exchange-listed options contracts. Also, the strategy has an opportunity to lock in market gains most months using an innovative “restrike” feature to reset any cap on returns.

Each January, the index implements a longstanding options strategy known as a “call spread” on each underlying exposure (ETFs that include SPY, IWM, EFA and EEM). The call spread is implemented by buying a 15% in the money 12-month call option on each underlying exposure and simultaneously selling a 15% out-of-the-money call option for each. By doing this, the ETF provides downside risk management protection.

Further, the ETF contains a unique “restrike” feature. For any month end (excluding December and January) where the value of an underlying exposure exceeds the strike price of the 15% short call, the call spread for that position undergoes a “restrike.” In the restrike, the original call spread is terminated, and a new call spread with a higher Target Range is implemented.

Further, the index has exhibited a risk level (standard deviation) of about 11% since the index inception of 2007 (Volos Research), which is similar to the overall risk level I would expect in a normal moderate allocation combining stocks and bonds.

A distinctive feature of Target Range solutions is that they can be easily used in combination with traditional asset allocation models. We are finding that some advisors are interested in reducing their current allocation by 15-50%, and allocating the proceeds into something like GTR, which can be held as part of a long-term strategic allocation or as a tactical position.

Summary

By implementing risk management tools—such as defined outcome ETFs and Target Range ETFs—we can focus on using stocks as our sole growth engine (or at least reducing the exposure to bonds) without taking the full risk of investing 100% in stocks.

In other words, without using bonds as a risk management tool, we can invest in a stock portfolio with an expected moderate overall risk level. Further, we can take advantage of targeted annual floor levels (created by the call spread), the opportunity for opportunistic restrikes to lock in shorter-term market gains for the remainder of the period, or the wide array of buffers and return enhancers in the marketplace.

ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages $7 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.