Taking account of the precise objectives defined by investors

Investors in US stocks have had a good year so far. 2012 year-to-date the Standard and Poor’s 500 Index is up over 11% while the Dow Jones Industrial Average has gained about 8%¹. Placed in the context of a historical equity risk premium of 4%² and a US ten-year Treasury bond yield of approximately 2%, many investors might be forgiven for wanting to protect 2012’s ‘excess’ year-to-date returns of about 5%³. Alternately, investors will at least look for ways to reduce the impact of a downturn in stocks on their equity portfolios.

Certainly, the traditional route to protecting equity portfolios against a market downturn would take the form of appropriate positions in the futures or options markets. However, many institutional investors may be unable to implement futures or options strategies due to restrictive investment guidelines. For example, many mutual funds are barred from purchasing derivative instruments. Moreover, many retail investors are both unfamiliar and uncomfortable with accessing derivative instruments as part of their investment strategies.

So is the only choice for such investors to liquidate all or a part of their portfolios for fear of an impending downdraft in US stocks? Surely, with all the financial engineering surrounding exchange traded funds (ETFs)⁴ , even ‘long only’ investors can take steps to protect stock portfolios.

Certainly, there are several ETFs which are appropriate for the purpose. However, the specific ETFs will depend on the precise objective defined by an investor, i.e. is the objective to hold onto capital gains if the market heads south or simply to reduce a portfolio’s ‘beta’.

Beta is essentially a measure of the volatility or systemic risk of a portfolio relative to its broader market. Reducing a portfolio’s beta means a portfolio gives up some potential future gains if stocks move higher in return for reduced losses should stocks decline.

There are several ETF options available for reducing the volatility of a portfolio. ETFs such as the PowerShares Standard and Poor’s 500 Low Volatility ETF (SPLV) and the Russell 2000 Low Volatility ETF (SLVY) are logical starting points. While the Russell ETF SLVY is small with a size of slightly over US$5 million, the PowerShares ETF SPLV has US$1.6 billion in assets and an operating history of just about one year. Three sectors comprise almost 75% of SPLV’s portfolio: consumer defensives, utilities and healthcare. As one expects from a low beta play, SPLV has underperformed the S&P 500 index year-to-date, 4.2% versus 12.6%⁵.

A different route to the same end is by adding ETFs with a bias towards dividend payouts. Typically, stocks paying good dividends tend to be less volatile relative to low or no dividend payers. Take Johnson and Johnson (JNJ) and Starbucks (SBUX). JNJ has a dividend yield of 3.5% and a beta of 0.43, or less than half of the broad stock market. Meanwhile, SBUX has a dividend yield of 1.2% with a beta of 1.2. SBUX yields less than JNJ but has more risk attached to it.

Dividend aristocrats

Consequently, an ETF like the US$9.3 billion SPDR Standard and Poor’s Dividend (SDY) is a prime candidate to lower portfolio risk. SDY “employs a replication strategy in seeking to track the performance of the S&P High Yield Dividend Aristocrats Index.”⁶ A dividend aristocrat is generally defined as a company which has raised its cash dividend payout for at least the previous 25 years. Year-to-date, SDY has returned 5.9% versus the stock market’s 12.6%.

Some investors may have the view that after a stock rally lasting three years, the baton will soon be handed to bears and stocks might be headed for more protracted declines. In this instance, an investor might choose to adopt a more aggressive portfolio protection strategy. Again, the ETF universe provides such investors with some alternatives to consider.

Inverse ETFs are an obvious choice. Inverse or bear ETFs are designed to benefit from a decline in their underlying benchmarks. Typically, inverse ETFs use derivative instruments to achieve gains proportionally inverse to the decline in the benchmark. The ProShares Short Standard and Poor’s 500 (SH) is a US$1.84 billion ETF which “seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the [S&P 500] index.” Year to date the SH ETF has delivered a return of minus 11.6% versus an index return of 12.6%. On a three year basis, the SH has returned minus 22.87% versus an index return of 23.4%⁷.

Inverse ETFs with negative return objectives relative to their benchmarks are available for the NASDAQ, Dow Jones Industrial Average, specific sectors and even international equity markets. Investors are almost spoilt for choice.

Another strategy to consider for a declining market is going long the ‘Fear Index’ or Market Volatility Index, otherwise known as the VIX. Historically, the VIX rises as the market declines. Hence, an investor expecting a market decline can expect the value of their VIX holding to increase. The VIX can be accessed through an ETF such as the iPath Standard and the Poor’s 500 VIX Short-Term Futures ETN (VXX). However, like many volatility linked products, the VXX’s performance may suffer from contango in the futures markets, i.e. when later month contracts are more expensive than the current contract as it uses long positions in the first and second month VIX futures contracts.

The third year of a bull market for US stocks has many investors wondering if it is time to turn slightly cautious with stock portfolios. For long only investors, the flexibility and diversity of ETFs lends itself to preparing for a downturn in stocks. Nevertheless, investors ought to carefully consider the merits of market timing and the tracking error associated with inverse or bear ETFs. Long-term investors may just find that companies in defensive industries with high dividend payout ratios serve portfolios well in both good and bad times – possibly better than attempting to time the market.

¹ Source: Yahoo Finance as at May 1, adjusted for dividends, accessed on May 1, 2012.
² Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2012 Edition. Stern School of Business, Aswath Damodaran,. P. 27.
³ Calculated as follows: S and P 500 return – (ERP + 10Yr bond) or 11% -(4% + 2%) = 5%
⁴ For the purposes of this article, the generic term ‘ETF’ refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs).
⁵ All information on SPLV and SLVY are from Yahoo Finance, accessed May 2, 2012. Performance data is at March 31,2012.
⁶ SBUX, JNJ and SDY data from Yahoo Finance, accessed May 2, 2012. Performance data as at March 31, 2012.
⁷ All information on SH are from Yahoo Finance, accessed May 4, 2012. Performance data as at March 31,2012.