The Best ETF Strategies To Survive Market Turmoil

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August 25, 2015 4:43pm NYSE:SDS NYSE:SPLV

etfsNeena Mishra:  This morning, US stocks are trending higher after indiscriminate and irrational sell-off over the past few days. Even though things may calm down in the near-term, investors are getting increasingly worried whether the 76 month long bull-run is finally coming to an end.

The selling was initially triggered by the surprise devaluation of the Chinese currency–which raised concerns that economic conditions in the world’s second largest economy may be much worse than suggested by official numbers. Recent commodity rout and emerging markets slump have added to these concerns.

Investors should remember that a healthy correction at times is a sign of a normal functioning market. This market had not seen a drop of 10% or more from a recent high in more than 46 months. While this sudden, steep sell-off was driven more by fear than facts, it is possible that we may see more frequent declines as the Fed gets ready to raise rates for the first time in almost a decade while the economic recovery in most parts of the world remains fragile.

At the same time, the US economy is growing steadily and stock valuations are not yet in the bubble territory. And while the rout started with worries over China’s economic malaise, exports to the emerging giant actually account for just 0.2% of US GDP.

Amid wild rout that defies all logic, it is important for investors to stay focused on their long term goals and not act rashly during times of panic. While it is difficult to predict whether the market has bottomed out, it is almost certain that we are likely to see more volatility ahead.

Buy High Quality Assets for Longer Term

Predicting stock market’s short term moves accurately is almost impossible but stocks deliver superior returns over longer term. So, if you are an investor with a long term horizon, then this sell-off presents an excellent opportunity to buy some high quality ETFs that are now available at deep discounts.

While growth stocks outperformed till earlier this month, value stocks have delivered higher returns with lower volatility compared with growth stocks over the long term in almost all the markets studied. Ultra-cheap value ETFs like Schwab U.S. Large-Cap Value ETF (NYSEARCA:SCHV) and Vanguard Value ETF (NYSEARCA:VTV) are excellent choices for long term focused portfolios.

Also consider adding some low volatility ETFs—like SPDR S&P Low Volatility ETF (NYSEARCA:SPLV) and iShares MSCI Minimum Volatility ETF (NYSEARCA:USMV) to the portfolio. These not only shine during highly volatile market environments but also deliver superior risk adjusted returns over longer term.

Stay Diversified

As stocks plunged, nervous investors piled into the so-called safe haven assets, particularly Treasury bonds, sending the yield on the benchmark 10-year Treasury note below 2% for the first time in about four months. Investors with well diversified portfolios were obviously less impacted than those with all stocks holdings.

Bonds still deserve a place in portfolios even as the Fed is on track to lift rates sometime in the coming months. Treasury bonds—in particular longer term–may continue to benefit from heavy buying by foreign investors, as long as interest rates remain ultra-low in Europe and Japan, the U.S. dollar continues to strengthen and long term inflation expectations remain benign.

Shorter term yields may however rise in anticipation of fed funds rate hike and thus the trend of yield curve flattening may continue this year. Take a look at iShares 10-20 Year Treasury Bond ETF (NYSEARCA:TLH) or Vanguard Long-term Government Bond ETF (NYSEARCA:VGLT) or other cheap longer term Treasury bond ETFs.

Similarly, a mix of cyclical and defensive stocks is essential for a core portfolio. My favorite ETFs are low cost sector ETFs–Vanguard Technology ETF (NYSEARCA:VGT) and iShares Healthcare Providers ETF (NYSEARCA:IHF), among others. 

Things to Know before Investing in Inverse/Leveraged ETFs

If your losses are making you very nervous during times of steep declines, then it may be a better idea to add some hedging to the portfolio rather than bailing out of stocks completely.

Leveraged/Inverse ETFs—like ProShares Short S&P 500 ETF (NYSEARCA:SH), ProShares UltraShort S&P500 ETF (NYSEARCA:SDS) and  ProShares UltraPro Short S&P500 (NYSEARCA:SPXU) can be effectively used by investors for short term market timing or hedging purpose during sell-offs. However, investors should remember that “timing” the market is never easy and should be prepared to monitor their positions closely and exit their short positions in case the market goes up.

Please note that these ETFs are typically designed to achieve their stated performance goal on a daily basis. The performance of leveraged ETFs, if held for longer than a day, is path dependent. That means not only the level of the index at the end of the holding period, but also how the index got there will determine the performance of these ETFs. In trending markets with low volatility, compounding works in investors’ favor and hence there should be no harm in holding these instruments for longer periods.

However, if the underlying index sees high volatility, compounding will work against investors and eat into returns, producing high tracking errors. Further if the index tracks a limited number of entities and/or faces contango risks, then it is safer to hold these positions just for a few days.

The Bottom Line

Investors should remember that patience and diversification are keys to long term investing success. And, while it is impossible to predict which way the market will turn in the next few days, the overall outlook for US focused stocks remains favorable in the medium term despite global concerns. It is important for investors to stay focused on their long term goals rather than fixating over short term market moves.

This article is brought to you courtesy of Neena Mishra.

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