Wealth Preservation, Income And Growth In A Black Swan Environment

Older clients in particular may be nervous about the downturn. Here’s what to consider.

At the beginning of the year, I noted that ValuEngine models were predicting a down market for 2022 and wrote a column on redeploying core assets for investors with short-to-medium equity time horizons.

The question for investors concerned with a downturn is what to do and if reallocation from assets committed to core equity is required, how much should be reallocated and where should these assets go?

The column turned out to be quite timely. Year-to-date S&P 500 ETF SPY was down more than 17% by May 13, taking its rolling 12-month return into negative territory at -2%.

Early in the year, I recommended that concerned investors consider moving about 30% of their current core equity exposure to less volatile options. This should allow them to better weather a potential storm without bailing out altogether.

Back in January, there was a troubling risk-on environment spurred on by macroeconomic dynamics even before Russia invaded Ukraine. Now, we have a full-on black swan environment that has only gotten deeper as the year has gone on.

But even for older clients — unless they are dying next week — you don’t want to go to all cash. If inflation stays above 6%, a very likely scenario, their purchasing power erodes by 6%. At this stage in life, income matters more than price change, as long as price change is not so negative that capital gets eroded.

The optimum would be to have income greater than 6% with no capital erosion. Total return, in that case, would be 6% or higher annually. That will be difficult to achieve in this environment, so the goal for clients with less than a 10-year life horizon would be options most likely to provide enough income to stay afloat without eroding capital by more than 3% per year or so.

How Did Our List Hold Up?

So how did our list of more defensive equity options hold up, and where should investors consider putting money now?

We examined a number of ETFs engineered to participate at less than 100% when SPY is performing well, but that have less participation when SPY rises. Now, we’ve added to the list five other ETFs that fit the category.

Four months later, let’s see how they’ve fared in this year’s significant YTD downturn as of the market close on May 13, 2022.

The list includes:

SPLV, the Invesco S&P 500 Low Volatility ETF

It selects about 100 S&P 500 stocks with the lowest daily volatility over 12 months.

USMV, the iShares MSCI USA Min Vol Factor ETF

USMV is optimized to minimize overall portfolio price volatility while keeping other factor exposures similar to the S&P 500 Index. It follows a complex factor optimization approach to reconstitute and rebalance portfolios.

DIVZ, the TrueShares Low Volatility Equity Income ETF

It holds an actively managed, concentrated portfolio of U.S.-listed companies that are favorably valued and have attractive dividends. The fund also seeks to deliver lower volatility than the overall market.

The fund adviser initially screens U.S.-listed securities for sustainable dividend growth using various quantitative and qualitative indicators. Then high-quality companies are identified based on high cash flow, stable revenue streams and capital reinvestment programs. This process is expected to deliver lower volatility than the overall U.S. equity market. Finally, the fund adviser selects securities trading at attractive valuations. The actively managed fund’s methodology results in a narrow selection of 25-35 stocks. TrueShares is the ETF brand of hedge fund True.

XLU, the Select Sector SPDR Utilities ETF

It was the first Utilities ETF. It is comprised of all the utilities in the benchmark index. The chart below illustrates that for 21 years, XLU has generally, but not always, risen about half as much as SPY in strong years for the benchmark index and fallen about half as much when the S&P 500 fell. Its beta of 0.47% reflects exactly that.

UTES, the Virtus Reaves Utilities ETF

It is an actively managed ETF that focuses on the stocks of utility companies. Active exposure is rare among sector funds, especially with respect to utilities. Managed by Reaves Asset Management, the fund uses fundamental, growth and risk-based metrics such as capital structure, historical earnings growth, and share price volatility.

The following ETFs are partially derivative-based and do not have ValuEngine reports available. All of them were engineered to mitigate losses in equity market downturns. Among these six, only SWAN was analyzed in my January article.

SWAN, the Amplify Black Swan ETF

SWAN is designed to participate in 30% of S&P 500 returns by holding laddered 10-year Treasury bonds and using the income to purchase long-dated call options on the S&P 500.

BJAN, Innovator U.S. Equity Buffer ETF

It uses options in an effort to moderate losses on the S&P 500 over a one-year period starting each January. The fund foregoes some upside return as well as the S&P 500’s dividend component because the options are written on the price (not total) return version of the index. In exchange for preventing realization of the first 9% of the S&P 500’s losses, investors forego upside participation above a certain threshold, which is reset annually.

Investors who buy at any other time than the annual reset day may have a very different protection and buffer zone. The issuer publishes effective interim levels daily on its website. The fund must be held to the end of the period to achieve the intended results. The targeted buffers and caps do not include the fund’s expense ratio. The fund is actively managed, resets annually, and uses listed options exclusively. Innovator has 11 clone funds: BFEB, BMAR, BAPR, etc. to accommodate investors who want to invest on the first day of other months and wish to lock in the same kind of protection.

SPD, the Simplify US Equity PLUS Downside Convexity ETF

It owns S&P 500 ETFs, but can have up to 20% of its portfolio in put options as warranted by market conditions, according to its decision rules. SPD aims to deliver simple convexity without the complexity of buffered ETFs.

ASPY, ASYMshares Asymmetric S&P 500 ETF

It is an indexed and rules-based alternative strategy to hedging U.S. large-cap equities. The fund targets between 25% and 75% net long equity exposure based on market risk. The strategy aims to provide protection against bear market losses, by being net short, and to capture the majority of bull market gains, by being net long, with respect to exposure to the S&P 500® Index. The strategy is powered by ASYMmetric Risk Management Technology™, intellectual property that uses price-based algorithms to identify “risk-off, risk-elevated.”

QAI, IQ Hedge Multi-Strategy Tracker ETF

It seeks investment results that track, before fees and expenses, the price and yield performance of the IQ Hedge Multi-Strategy Index. The index attempts to replicate the risk-adjusted return characteristics of hedge funds using multiple hedge-fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed-income arbitrage, and emerging markets. IQ is managed by New York Life Investment Management, owner of the Index IQ brand.

RPAR, the Risk Parity ETF

It is actively managed yet aims to align its exposure to an index, the Advanced Research Risk Parity Index. The index diversifies across four asset classes (TIPS, U.S. Treasury bonds, global equities, and commodities), and seeks returns similar to global equities with less risk over time. It is sponsored by LA-based hedge fund provider Evoke Aris.

The table below lists data in pertinent categories for all 11 ETFs explained above as well as two benchmarks. SPY, the original SPDR owning the S&P 500 Index portfolio is a standard equity benchmark ETF. We also include AGG, the iShares Core Aggregate Bond ETF, the oldest bond ETF, because many of the derivatives-based ETFs benchmark themselves against the traditional 60/40 stocks-to-bond ratio portfolio. SPY and AGG are considered the standards by most professionals because they have the most assets under management and the deepest liquidity.

Key Findings

1. Ten of the 11 ETFs — the five that contain volatility through equity selection without derivatives and the six that employ derivatives to varying extents — delivered in terms of the two risk measures.

They all posted betas and standard deviations lower than the S&P 500. This is in line with the expectations that their websites try to convey to investors. The lowest beta and standard deviation overall belong to market-neutral QAI. The exception to this rule was SPD, which produced a higher standard deviation, 17.5, of all ETFs in the table and at 0.75, the highest beta other than SPY.

2. SWAN and RPAR were both engineered to use derivatives to guard against “black swan” events in the stock market. Both failed miserably to do so.

The main reason is that the long portfolio against which both buy and sell derivative products held U.S. Treasury bonds, which have performed horribly in the rising rate environment. SPD, another synthetic built to mitigate losses, only fared slightly better. Given that the rising interest-rate environment is expected to continue as the Fed continues to contain inflation, it would be reasonable to expect further disappointing risk- and-return statistics posted by these three ETFs.

3. Market-neutral QAI fared somewhat better.

In addition to producing the lowest volatility, it also contained its loss this year to half as much as that of SPY. However, its 12-month return of -8.1% is considerably worse than that of SPY. Although SPY’s dividend yield of 1.5% is still a somewhat meager offset, QAI’s 0.3% dividend yield provided no offset at all.

4. Two other synthetics build to shield against black swan markets, ASPY and BJAN, performed much better.

Although they could not prevent negative returns, they did succeed in mitigating some of the downside. ASPY could be considered the star of the category in this regard. It only participated half as much as SPY in the year-to-date correction and is the only one of the ETFs that use derivatives to maintain a positive 12-month rolling return, +3.1% compared with -2.1% for SPY. Overall, ASPY’s methodology seemed to do an above-average job of distinguishing risk-on environments from normal conditions and allocated accordingly.

5. In contrast, the five low-volatility stock ETFs delivered superior performance to SPY in both the year-to-date and 12-month rolling periods.

In fact, on a 12-month rolling return basis, all five delivered positive returns, distinguishing themselves from most ETFs and mutual funds. The two most diversified ETFs, USMV and SPLV, delivered on the low-volatility implied objective of participating less in downturns than their more volatile counterparts. Of the two, SPLV was the better performer.

6. Select Sector SPDR XLU and actively managed UTES managed to deliver both dividend income and above-market performance.

The lower-fee index-based XLU outperformed UTES while delivering a higher yield.

Most investors in the utility sector are more concerned with dividend income than above-market performance. But in this strange market environment, they got both.

7. Actively managed DIVZ, built specifically for conservative investors to deliver income and very low volatility, navigated this volatile vortex of a market with singular aplomb.

It actually has positive capital appreciation of better than 1%, a feat achieved by less than 5% of all stock-based ETFs. Better still for its investors, it delivered on its income objective with a current dividend yield of 4.2%.

8. Based on what happened in the past 12 months, prudent investment allocations must focus on the present and the future, not the past.

As long as this level of turbulence continues, it makes sense to move some core equity allocation to more defensive products. And as represented by the largest bond ETF, AGG, most bond ETFs are unlikely to provide traditional safe harbor alternatives.

If the current combination of global supply chain issues, inflationary and interest rate pressures, and political instability continues, what will be the next shoe to drop? How long will the markets continue to get worse before they get better? Most importantly, what are the best ETFs to use for re-allocating up to 50% of a core equity position until outlooks become more positive?

One important thing to remember is that when markets recover, up to 50% of that recovery can come in the rebound’s first five days. Therefore, being totally out of the market can be more costly than staying in even during an environment as nerve-wracking as this one.

Summing Up

Of the seven ETFs that delivered better performance than SPY in both the year-to-date and 12-month environments, ASPY has an elastic methodology that may give its owners the best chance to preserve capital while staying invested. The shortcoming of ASPY is that it has very little dividend income to provide a cushion during such environments.

For investors near or in retirement, moving some core equity money into the utility sector via XLU makes sense. This is because the sector is relatively immune to inflationary spikes, supply chain shortages and consumer confidence. Additionally, ValuEngine’s models rate XLU to outperform during the next six to 12 months with a 4 rating on its 5-point scale.

The models also rate USMV and UTES as 4 and both are also worthy of consideration. If you believe that active management provides better risk management than algorithms to contend with uncharted waters, then UTES might be the best choice. SPLV fared better than USMV during the past 12 months but only gets a rating of 3 for the next 12 months from our models.

On the other hand, ValuEngine’s models do not expect actively managed DIVZ to continue its spectacular success, giving it our lowest rating of 1, looking for some mean reversion in its holdings. That said, DIVZ has proven to be very adroit in navigating choppy waters throughout its existence.

In summary, the nature of black swan events is such that I would not extrapolate too much from these comparisons. That said, I’d eliminate SWAN, RPAR and SPD from my list of potential reallocation candidates. The construction of their ETFs did not account for an equity-market correction being accompanied by sharply falling bond prices. All of the others are solid and well-constructed products for deployment in risk-on and risk-alert environments.

In conclusion, there are some good reasons to consider diverting 20% to 30% of core index-fund money to vehicles that put safety over price gains. My personal choices now include: ASPY, DIVZ, USMV and XLU.

Herb Blank is a senior quantitative analyst at ValuEngine and senior consultant and practice leader in the Global Finesse Product Strategy and Implementations Consulting Practice. He has more than 30 years of experience in financial product innovation and quantitative analysis. Recognized as a pioneer in the exchange-traded fund (ETF) industry, Blank established the first family of ETFs to trade on the NYSE and was a portfolio manager for the fund. He is credited with the product development and launch of iShares, GLD and X Shares. He is also well known for his development of the construction and maintenance methodologies for Dow Jones Global Indexes.

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