The 2008 financial crisis may be 10 years in the past, but that doesn’t mean investors aren’t still feeling its scars.
While most portfolios have since recovered and made large gains, investors may be fearing the return of bear markets.
The solution could be to think boring, as in unexciting, exchange-traded funds (ETFs). Here are a few options that might not stoke the fires of greed but rather dull the pain of a bear attack on your capital.
Medium-term bond funds
Bond funds are indeed “hard to get excited about” given their low yields, says Dan Bortolotti, portfolio manager with PWL Capital Inc. But this is the only asset class that provides a reliable safety net when equity markets fall.
“In the aftermath of the dot-com bubble, the 2008-09 crisis and even during the turmoil of 2011, only bonds propped up balanced portfolios, mitigating the losses,” says Mr. Bortolotti, author of the popular Canadian Couch Potato blog, which focuses on simple ETF strategies.
While short-term bonds provide the lowest volatility in up or down markets, medium-duration options have more upside when equity markets venture into bear territory. Options are plentiful, Mr. Bortolotti adds, including the BMO Aggregate Bond Index ETF (ZAG), the Vanguard Canadian Aggregate Bond Index ETF (VAB) and the iShares Core Canadian Universe Bond Index ETF (XBB). The downside is that as equity markets climb and central bankers hike interest rates, the losses sustained by these options will amount to more than those of the shorter-duration funds.
If medium-duration options provide a middle-of-the-road approach to fixed income, investors seeking a more aggressive tack to downside protection can consider funds with long durations.
The major drawback here is long bonds are most negatively affected by rising inflation, says Jin Choi, a PhD in financial mathematics who develops financial software and founded the investment blog moneygeek.ca. To counter inflation, he suggests the iShares Canadian Real Return Bond Index ETF (XRB), which offers exposure to long-duration bonds with a twist.
“If you have a situation where inflation goes up even as the economy declines [i.e. stagflation], XRB would protect the investor better than a more typical bond fund would,” says Mr. Choi. He adds that real-return bonds are designed to pay base yield plus the rate of inflation.
The downside is the fund currently yields less than longer-duration choices such as iShares Core Canadian Long Term Bond Index ETF (XLB). Furthermore, given that inflation usually falls during economic downturns, the XLB would likely perform better in typical recessionary conditions. “But XRB would keep investors safe from a wider range of situations.”
For individuals who can’t take any losses, an ultra-short-duration bond fund likely fits the bill. BMO’s Ultra Short-Term Bond (ZST) is one of the lowest-volatility options out there, says portfolio manager Gordon Ross with ModernAdvisor in Vancouver, which provides online financial advisory services.
“It would be a good place to store your money if you’re convinced you should get out of the market,” he says, adding the fund pays income monthly, though it has a twin ETF (ZST.L) that compounds annually.
The ETF is “basically accumulating interest from a whole bunch of bonds, and there is some active management intended to stay away from problems,” he says. Even this seemingly risk-free ETF has its drawbacks. “The risk is you’re getting out of the market and accepting very low yields … less than inflation.”
Sensible stock funds
Some stocks fare better than others when equity investors stampede for the exit. Consumer staples are the go-to defensive equity asset class, given that even in hard times, consumers still need to eat and run their households.
While options such as the iShares S&P Global Consumer Staples (KXI) provide broad-based exposure, Mr. Ross argues it also is bound to deliver painful losses during a bear market. “Through … late 2007 to early 2009, KXI dropped about 55 per cent … while a broad U.S. equity fund dropped about 65 per cent,” he adds. “This is not a great improvement.”
Investors might instead consider a new class of equity ETFs that uses active management aimed at finding “Goldilocks stocks" (not too hot or cold) that exhibit low volatility, high liquidity or deep value. Vanguard offers an ETF for each one: the Global Minimum Volatility ETF (VVO), the Global Liquidity Factor ETF (VLQ), and the Global Value Factor ETF (VVL).
The presumption is these funds are more diversified than a consumer staple fund and have lower standard deviation than a normal global equity fund. In other words, they should sustain fewer losses in a bear market. The catch is these ETFs were not around through the past crises, “so we can only speculate whether they would have declined less.”
A not-so-boring option
Trend-following strategies are generally the opposite of dull. But Mr. Choi says rule-based ETFs that aim to fully invest in bull markets and fully divest in bear markets are gaining traction in the industry. He should know; he’s developed some for asset management firms.
“There’s some good evidence that supports the notion that trend-following can minimize investor losses,” he says.
To that end, Mr. Choi suggests the Pacer Trendpilot US Large Cap ETF (PTLC), which provides exposure to the largest companies listed on the U.S. stock market. While this can help maximize gains and limit losses, the strategy can turn costly in very volatile conditions, in which bear and bull markets alternate over a short span.
“Also, there’s the fear that if trend-following becomes too popular, the popularity itself would introduce systemic risk to the market,” he says. “Many investors blame a similar type of strategy known as ‘portfolio insurance’ for causing the infamous 1987 crash.”