We have been witnessing a slowdown in global economic growth. We may or may not be headed into a recession here in the U.S. We don’t know what lies ahead, but we certainly know markets are jittery. Downside risk—or better yet, managing downside risk—is rightfully on everyone’s minds.
There are many ways to do that, chief among them the first rule of a good asset allocation plan: diversification. What’s nice today, however, is that the smart beta ETF universe is awash with new and novel ways to not only diversify your allocation at the asset class level, but within a single index.
S&P 500 Diversification
For example, let’s look at the S&P 500. You can own all the stocks included in that index with the same weighting and allocation as the index itself through a number of S&P 500 ETFs, including the SPDR S&P 500 ETF Trust (SPY), the iShares Core S&P 500 ETF (IVV) and the Vanguard S&P 500 ETF (VOO).
If you are really worried about downside risk, there’s a growing universe of smart beta ETFs built around the S&P 500 with downside protection at their core.
Many of these funds are young, and many have yet to find much traction on the heels of a bull market a decade in the making. They also carry higher expense ratios that the ultra-cheap S&P 500 ETFs mentioned above. But these off-the-beaten-path ETFs offer interesting ways to manage risk in an S&P 500 allocation.
Here are three ETF tools designed to do the job:
UTRN is an interesting fund. The impetus behind creating this ETF was a desire not to lose money in down markets. In a nutshell, this is a short-term reversal strategy that looks to buy the healthy losers who are about to be the next winners.
This weekly rebalance portfolio separates healthy from unhealthy companies by assessing low volatility and high volatility price swings. Here, volatility is the key metric for selecting the stocks most likely to make a “U-turn” in coming days.
UTRN performs best in times when volatility is high and asymmetric—meaning, unforeseen. That’s due to the Chow ratio underlying the methodology (explained here). The portfolio invests in lower vol stocks whose price value declined in the previous week, and are less sensitive to a surprising spike in volatility.
Earlier this year, when markets were calm and the market was momentum driven, UTRN struggled to keep up with the S&P 500 due to the low vol environment, and because in a momentum market—when everything moves up together—there are fewer opportunities to find short-term reversal candidates.
But in recent months, as volatility picked up, UTRN has outpaced the S&P 500—much like other low-vol strategies such as the iShares Edge MSCI Min Vol U.S.A. ETF (USMV)—and year to date, it’s now ahead:
If the market indeed turns sharply lower, UTRN should deliver some downside protection with its lower vol profile. Since 2006, the index underlying UTRN—relative to the S&P 500—has captured about 87% of the market upside, but only 80% of the downside, according to data from the issuer.
UTRN has been steadily gaining traction in the 11 months it has been on the market, and today has $28 million in assets under management. The fund costs 0.75% in expense ratio, or $75 per $10,000 invested, and is offered by third-party label Exchange Traded Concepts on behalf of Vesper.
BJUL, with $68 million in assets, is one of a long—and growing—lineup of Buffer ETFs Innovator has been bringing to market in the past year. These strategies essentially offer a preset range of performance that captures much of the market’s upside and limits downside losses. As our fund report describes it, BJUL is “effectively an options spread play on the price version of the S&P 500.” Similar to UTRN, the fund carries a 0.79% expense ratio.
Specifically, in the case of BJUL, investors get about 14% of upside participation, but more importantly, they get 9% of downside protection—meaning, they don’t start losing money until the S&P 500 drops more than 9%, at which point BJUL begins participating in the downside. That range of participation is reset every year in July.
The first of its kind, which launched a year ago in July, BJUL is now one of 18 Innovator Buffer ETFs focused on the S&P 500 delivering a defined ride to investors. And in this lineup, Innovator also offers deeper levels of downside protection in the form of Power Buffer and Ultra Buffer ETFs, delivering 15% and 30% downside cushion on any S&P 500 downside move, respectively.
Year to date, BJUL has lagged SPY—as expected—and the path of returns seen in the chart below show the more rangebound performance this type of strategy delivers:
PHDG is an ETF that mixes exposure to S&P 500 stocks to VIX Index futures in an effort to manage downside risk. As our fund report for PHDG says, “The fund aims to stave off the impact of huge market downturns by a holding a security that often spikes up when the S&P plummets: VIX futures.”
The actively managed ETF should, by design, outperform the stock market when it crashes, but it should also underperform when things are going well for stocks. A look at year-to-date performance relative to SPY shows just that—downside protection has meant giving up much of the upside in the S&P 500 this year:
Charts courtesy of StockCharts.com
PHDG has beta of about 0.5, meaning the portfolio is only half as volatile as the broader market, according to our data.
This ETF has struggled to find a following. It has amassed only $23 million in assets gathered in almost seven years since inception. It costs 0.39% in expense ratio—not an outrageous price tag for an actively managed ETF that maintains a costly exposure to VIX futures. PHDG isn’t the only exchange-traded product to dip into the S&P 500 and VIX waters for an equity portfolio that offers some downside protection.
The Barclays ETN+ S&P VEQTOR ETN (VQT), for example, is a very similar strategy that hedges exposure to equities with VIX futures. It is even smaller, with $14 million in assets gathered in nine years. And it costs 0.95% in expense ratio, or $95 per $10,000 invested.
Plenty More To Choose From
These ETFs are a sampling of what tools are available to you today if managing downside risk in your U.S. large cap sleeve is your goal. With more than 1,000 smart beta ETFs slicing and dicing markets today, you can imagine these three funds highlighted here are hardly your only choices.
But they illustrate that innovation in ETFs is alive and well. These funds—particularly UTRN and BJUL, which are only about a year-old—are unique takes on a problem everyone faces: minimizing losses in downward-moving markets.
ETF issuers continue to break new ground on finding solutions to common investor problems by broadening access and sharpening tools at everyone’s disposal with the click of a single ticker.
Contact Cinthia Murphy at [email protected]