It may be wise for investors to take some risk off the table.
Stock markets have rallied since the December selloff, but it’s still debatable whether a recovery can be sustainable. Rising interest rates, the United States’s trade war with China and slower global growth are keeping markets on edge.
Given the uncertainty, exchange-traded funds (ETFs) with their diversified exposure to markets can be one way for investors to hedge their bets.
We asked three ETF experts for their top defensive picks.
Daniel Straus, ETF analyst, National Bank Financial Inc., Toronto
Management expense ratio (MER): 0.34 per cent
This low-volatility Canadian stock ETF can sometimes outpace the broader market, but there are no guarantees, says Mr. Straus. It has, however, beaten the S&P/TSX Composite Total Return Index by about 2.2 percentage points annually since inception in 2012 to the end of 2018. Much of the outperformance came when the index lost 8.3 per cent in 2015 when oil prices collapsed, while the ETF gained 0.11 per cent. In 2016, the index returned 21.1 per cent as oil prices recovered, while the ETF rose 15.4 per cent. “Lagging the market during a strong bull trend is part of the trade-off for a low-volatility strategy,” he notes. Canada’s six big banks are among the ETF’s 50 names. A risk is the overweighting of the utilities and real estate sectors, which could be hard hit if interest rates rise quickly, he adds. The ETF’s fee is among the lowest in its peer group.
MER: 0.73 per cent
This U.S. equity ETF’s defensive nature comes from the inclusion of companies with a strong earnings history and an ability to navigate multiple economic cycles, says Mr. Straus. Using a methodology popularized by the Yale University professor Robert Shiller, the ETF’s strategy compares stock prices with their 10-year average inflation-adjusted earnings to identify companies that can potentially weather economic downturns, Mr. Straus says. Kohl’s Corp., General Mills Inc. and Chubb Ltd. are among the top holdings. The fund’s focus on 80 stocks, however, is a risk because that is only a small segment of the U.S. market, he notes; because of its value-oriented strategy, this ETF, launched in late 2017, could miss out on returns from strong growth stocks. Even though the ETF’s fee is on the expensive side, its positioning could pay off in market slumps, he says.
Alex Bryan, ETF and mutual fund analyst, Morningstar Inc., Chicago
MER: 0.48 per cent
This global ETF, which owns equities in both developed and emerging markets, could be a core holding because it takes a holistic approach, says Mr. Bryan. It screens for low-volatility stocks in the MSCI All Country World Index (ACWI) as well as those with a low correlation to other names in the benchmark, he adds. For instance, the ETF holds the gold miner Newmont Mining Corp., whose shares can be volatile because of fluctuating commodity prices. But this stock can also “provide a hedge for the other stocks in the portfolio” because gold tends to rise when the market is down, he notes. This ETF can overweight or underweight sectors only by as much as 5 per cent. Top holdings include Johnson & Johnson, McDonald’s Corp., Pepsico Inc. and Merck & Co. Inc. While the ETF offers downside protection, the risk is that it might lag in rising markets, he says. Its fee, he adds, is competitive with those of its low-volatility-ETF peers.
Expected MER: 0.31 per cent
This U.S. equity, which screens for low-volatility stocks in the S&P 500 Index, provides “potent exposure” to a defensive play, says Mr. Bryan. The strategy ranks the least volatile 100 names over the past 12 months. While this ETF could be used as a tactical bet on a market downturn, such an event is hard to predict, he says. The fund is an option for risk-averse investors who want some exposure to equities, he adds. Holdings include Coca-Cola Co., Duke Energy Corp. and NextEra Energy Corp. Without sector constraints in this ETF, there can be overconcentration in utilities and consumer defensive stocks, he notes. Utilities make up 22 per cent of the fund. The risk is that this ETF could give up some returns in a rallying market, and rapidly rising interest rates could also hurt its utilities exposure, he notes. Invesco Canada expects the MER to fall to 0.31 per cent after last year’s management-fee cut.
David Kletz, ETF analyst and portfolio manager, Forstrong Global Asset Management Inc., Toronto
MER: 0.30 per cent
This ETF, which owns higher-quality companies outside North America, offers easy diversification for investors who tend to stick to Canadian and U.S. equities, says Mr. Kletz. While European and Asian stocks have lagged the U.S. market since the 2008 financial crisis, that is unsustainable in the long term and creates an opportunity, he says. Because this ETF screens for stocks using criteria such as return on equity, earnings stability and leverage, the result is a collection of profitable companies with solid balance sheets that can weather market slumps, he suggests. Among the holdings are Nestlé SA, Glaxosmithkline PLC and Diageo PLC. While shares of even the most resilient companies could slide, a bear market is not part of Forstrong’s market outlook this year, he says. The fund’s fee, he adds, is near the lower end of its peer group.
The pick: Franklin FTSE Japan ETF (FLJP-NYSE)
MER: 0.09 per cent
This Japanese equity ETF seems counter intuitive as a defensive play, given the country’s export-led economy and leverage to global growth, says Mr. Kletz. But this fund is attractive because corporate Japan has made large strides under Prime Minister Shinzo Abe’s economic policy, while governance reforms have helped Japan’s corporate return on equity climb to the highest level since 2007, he adds. Despite a stable political backdrop and an accommodating central bank, Japanese stocks have not been widely embraced, he says. Because the Japanese market is cheap relative to its global peers, that should limit risk stemming from global-trade hostilities or other events, he says. Since the Japanese yen is seen as a safe-haven asset in turbulent times, currency gains should help offset losses, he adds. The ETF’s fee is among the lowest of its North American-listed peers.