Investors worried about the next market downturn can find plenty of protection among exchange-traded funds (ETFs). Individual stocks can carry a lot of risk, while mutual funds don't have quite the breadth of tactical options. But if you browse through some of the best ETFs geared toward staving off a bear market, you can find several options that fit your investing style and risk profile.
Entering 2020, Wall Street keyed in on a multitude of risks: the outcome of the Democratic primaries and the November presidential election; where U.S.-China trade relations would head next; and slowing global growth, among others.
But Collaborative Fund's Morgan Housel hit it on the nose early this year in a must-read post about risk: "The biggest economic risk is what no one's talking about, because if no one's talking about (it) no one's prepared for it, and if no one's prepared for it its damage will be amplified when it arrives."
Enter the COVID-19 coronavirus. This virus, which has a fatality rate of about 2% and appears highly contagious, has afflicted more than 80,000 people worldwide in two months, claiming 2,700 lives. Those numbers almost assuredly will grow. The Centers for Disease Control and Prevention have already warned that they believe an expanded U.S. outbreak is not a question of "if," but "when." U.S. multinationals have already projected weakness due to both lower demand and affected supply chains, and the International Monetary Fund is already lowering global growth projections.
Whether a bear market is coming remains to be seen. But investors clearly are at least rattled by the prospects; the S&P 500 has dropped more than 7% in just a few days. If you're inclined to protect yourself from additional downside - now, or at any point in the future - you have plenty of tools at your disposal.
Here are a dozen of the best ETFs to beat back a prolonged downturn. These ETFs span a number of tactics, from low volatility to bonds to commodities and more. All of them have outperformed the S&P 500 during the initial market panic, including some that have produced significant gains.
iShares Edge MSCI Min Vol USA ETF
Type: Low-volatility stock
Market value: $38.5 billion
Dividend yield: 1.8%
Expenses: 0.15%, or $15 annually on a $10,000 investment
Return since Feb. 19: -5.0% (versus -7.2% for the S&P 500)
We'll start with low- and minimum-volatility ETFs, which are designed to allow investors to stay exposed to stocks while reducing their exposure to the broader market's volatility.
The iShares Edge MSCI Min Vol USA ETF (USMV, $66.15) is one of the best ETFs for the job, and it's the largest such fund at nearly $39 billion in assets. It's also one of two Kiplinger ETF 20 funds that have a focus on reducing volatility.
So, how does USMV do it?
The fund starts with the top 85% (by market value) of U.S. stocks that have lower volatility compared to the rest of the market. It then weights the stocks using a multi-factor risk model. It goes through another level of refining via an "optimization tool" that looks at the projected riskiness of securities within the index.
The result, at the moment, is a portfolio of more than 200 stocks with an overall beta of 0.65. Beta is a gauge of volatility in which any score below 1 means it's less volatile than a particular benchmark. USMV's beta, then, indicates it's significantly less volatile than the S&P 500.
The iShares Edge MSCI Min Vol USA is pretty balanced by sector, but heaviest in information technology (17.7%), financials (16.0%) and consumer staples (12.1%). That won't always be the case, as the portfolio does fluctuate - health care (10.6%), for instance, represented roughly 15% of USMV's assets more than a year ago.
When considering any low- or minimum-vol product, know that the trade-off for lower volatility might be inferior returns during longer rallies. That said, USMV has been a champ. Even prior to the recent market downturn, through Feb. 18, USMV had outperformed the S&P 500 on a total-return basis (price plus dividends), 85.1%-77.8%.
Legg Mason Low Volatility High Dividend ETF
Type: Low-volatility dividend stock
Market value: $861.1 million
Dividend yield: 3.3%
Return since Feb. 19: -4.3%
Low-volatility and minimum-volatility products aren't quite the same things. Min-vol ETFs try to minimize volatility within a particular strategy, and as a result, you can still end up with some higher-volatility stocks. Low-vol ETFs, however, insist on low volatility period.
The Legg Mason Low Volatility High Dividend ETF (LVHD, $32.97) invests in roughly 50 to 100 stocks selected because of their lower volatility, as well as their ability to generate income.
LVHD starts with a universe of the 3,000 largest U.S. stocks - with a universe that large, it ends up including mid- and small-cap stocks, too. It then screens for profitable companies that can pay "relatively high sustainable dividend yields." It then scores those stocks higher or lower based on price and earnings volatility. Every quarter, when the fund rebalances, no stock can account for more than 2.5% of the fund, and no sector can account for more than 25%, except real estate investment trusts (REITs), which are capped at 15%.
Right now, LVHD's top three sectors are the three sectors many investors think of when they think of defense: utilities (27.8%), real estate (16.6%) and consumer staples (14.3%). They're perfectly reflected by the fund's top three holdings: utility American Electric Power (AEP, 2.9%), telecom infrastructure REIT Crown Castle International (CCI, 2.8%) and PepsiCo (PEP, 2.7%).
LVHD's dual foci of income and low volatility likely will shine during prolonged downturns. The flip side? It tends to get left behind once the bulls pick up steam.
iShares Edge MSCI Min Vol USA Small-Cap ETF
Type: Low-volatility small-cap stock
Market value: $572.5 million
Dividend yield: 1.9%
Return since Feb. 19: -4.4%
Small-cap stocks simply haven't been "acting right" for some time. Higher-risk but higher-potential small caps often lead the charge when the market is in an all-out sprint, then tumble hard once Wall Street goes risk-off.
But the Russell 2000 small-cap index has significantly lagged for some time, up roughly 7% during the 52-week period ended Feb. 18, while the S&P 500 has shot 21% higher. And it has performed slightly better across the short selloff. Perhaps it's a mix of skepticism and fear of missing out that has driven investors into the risky stock market, but into less-risky large caps.
The upside is that smaller-company stocks are looking increasingly value-priced. But if you're concerned about investing in small caps in this environment, you can find more stability via the iShares Edge MSCI Min Vol USA Small-Cap ETF (SMMV, $34.64) - a sister ETF of the USMV.
The SMMV is made up of roughly 390 stocks, with no stock currently accounting for any more than 1.43% of the fund's assets. Top holdings at the moment include Royal Gold (RGLD), which holds precious-metals royalty interests; mortgage REIT Blackstone Mortgage Trust REIT (BXMT); and Wonder Bread and Tastykake parent Flowers Foods (FLO).
This ETF boasts a beta of just 0.68, compared to the market's 1 and the broader Russell 2000's beta of 1.19. It also boasts a slightly higher dividend yield (1.9%) than the S&P 500 (1.8%) at the moment.
Reality Shares DIVCON Dividend Defender ETF
Type: Long-short dividend stock
Market value: $7.2 million
Dividend yield: 0.8%
Return since Feb. 19: -2.4%
A few other funds take a different approach to generating more stable returns.
DIVCON looks at all the dividend payers among Wall Street's 1,200 largest stocks, and examines their profit growth, free cash flow (how much cash companies have left over after they meet all their obligations) and other financial metrics that speak to the health of their dividends. It then rates each stock based on a five-tier rating system in which DIVCON 1 means the company is at high risk for a dividend cut, and DIVCON 5 means the company is very likely to grow its dividends in the future.
The DFND ETF's portfolio is effectively 75% long these companies that have the best dividend health ("Leaders") while going 25% short those with lousy dividend health ("Laggards").
The theory? In times of market volatility, investors will huddle into DFND's high-quality long holdings and sell out of the stocks that DIVCON's system is warning about. And indeed, DIVCON's Leaders outperformed the S&P 500 on a total return basis, 10.5% to 6.9%, between Dec. 29, 2000 and Dec. 31, 2019. Laggards greatly underperformed with 3.7% returns.
Right now, the fund is most heavily invested in industrials (20.5%), information technology (15.8%) and health care (14.1%). Top holdings include the likes of Domino's Pizza (DPZ) - one of the best stocks of the 2010s - and Cintas (CTAS). Its biggest short positions are copper mining giant Freeport-McMoRan (FCX) and data-storage tech stock Western Digital (WDC).
Reality Shares DIVCON Dividend Defender ETF might be the most complex option among these best ETFs for a bear market, but it has delivered in good times and bad. DFND has slightly beat out the S&P 500 over the past year, and it has been roughly half as volatile while doing so.
iShares Cohen & Steers REIT ETF
Type: Sector (Real estate)
Market value: $2.4 billion
Dividend yield: 2.5%
Return since Feb. 19: -3.6%
As mentioned above, certain market sectors are considered "defensive" because of various factors, ranging from the nature of their business to their ability to generate high dividends.
Real estate is one such sector. REITs were actually created by Congress roughly 60 years ago to enable mom 'n' pop investors to invest in real estate, since not everyone can scrounge together a few million bucks to buy an office building. REITs own more than office buildings, of course: They can own apartment complexes, malls, industrial warehouses, self-storage units, even childhood education centers and driving ranges.
REITs' defensive allure is tied to their dividends. These companies are exempt from federal taxes ... as long as they pay out at least 90% of their taxable income as dividends to shareholders. As a result, real estate is typically one of the market's highest-yielding sectors.
The iShares Cohen & Steers REIT ETF (ICF, $121.22) tracks an index built by Cohen & Steers, which calls itself "the world's first investment manager dedicated to real estate securities." The portfolio itself is a fairly concentrated group of 30 larger REITs that dominate their respective property sectors.
Equinix (EQIX, 8.2%), for instance, is the market leader in global colocation data centers. American Tower (AMT, 8.2%) is a leader in telecom infrastructure, which it leases out to the likes of Verizon (VZ) and AT&T (T). And Prologis (PLD, 7.8%) owns 964 million square feet of logistics-focused real estate (such as warehouses) and counts Amazon.com (AMZN), FedEx (FDX) and the U.S. Postal Service among its customers.
REITs are far from completely coronavirus-proof, of course. Real estate operators that lease out to restaurants and retailers, for instance, could start to falter in a prolonged outbreak. Nonetheless, ICF still might provide safety in the short term, and its dividends will counterbalance some weakness.
Vanguard Utilities ETF
Type: Sector (Utilities)
Market value: $4.8 billion
Dividend yield: 2.7%
Return since Feb. 19: -4.2%
No market sector says "safety" more than utilities. Scared about the economy? Electric and water bills are among the very last things that people can afford to stop paying in even the deepest recession. Just looking for income to smooth out returns during a volatile patch? The steady business of delivering power, gas and water produces equally consistent and often high dividends.
The Vanguard Utilities ETF (VPU, $149.62) is one of the best ETFs for accessing this part of the market - and, at 0.10% in annual expenses, it's one of the cheapest.
VPU holds just shy of 70 companies, such as NextEra Energy (NEE, 11.9%) and Duke Energy (DUK, 6.6%), that generate electricity, gas, water and other utility services that you and I really can't live without, no matter how the stock market and economy are doing. This isn't really a high-growth industry, given that utility companies typically are locked into whatever geographies they serve, and given that they can't just send rates through the ceiling whenever they want.
But utilities typically are allowed to raise their rates a little bit every year or two, which helps to slowly grow their profits and add more ammo to their regular dividends. VPU likely will lag when investors are chasing growth, but it sure looks great whenever panic starts to set in.
Consumer Staples Select Sector SPDR Fund
Type: Sector (Consumer staples)
Market value: $13.9 billion
Dividend yield: 2.6%
Return since Feb. 19: -3.9%
You need more than just water, gas and electricity to get by, of course. You also need food to eat and - especially amid a viral outbreak - basic hygiene products.
That's what consumer staples are: the staples of everyday life. Some are what you'd think (bread, milk, toilet paper, toothbrushes), but staples also can include products such as tobacco and alcohol - which people treat like needs, even if they're not.
Like utilities, consumer staples tend to have fairly predictable revenues, and they pay decent dividends. The Consumer Staples Select Sector SPDR Fund (XLP, $62.02) invests in the 30-plus consumer staples stocks of the S&P 500 - a who's who of the household brands you've grown up with and know. It holds a significant chunk of Procter & Gamble (PG, 16.0%), which makes Bounty paper towels, Charmin toilet paper and Dawn dish soap. Coca-Cola (KO) and PepsiCo (PEP) - the latter of which also boasts Frito-Lay, a massive snacks division - combine to make up another 20% of assets.
The Consumer Staples SPDR has long been among the best ETFs to buy, from a sector standpoint, during corrections and bear markets. For instance, during 2007-09, while the S&P 500 was shedding more than 55%, the XLP only lost half as much, -28.5%. And in 2015, the XLP outperformed the S&P 500 7% to 1.3%. An above-average yield of 2.6% is partly responsible for that outperformance.
Vanguard Short-Term Bond ETF
Type: Short-term bond
Market value: $22.2 billion
SEC yield: 1.5%*
Return since Feb. 19: +0.5%
Much of the recent flight to safety has been into bonds. Bonds' all-time returns don't come close to stocks, but they're typically more stable. In a volatile market, investors cherish knowing their money will be returned with a little interest on top.
The Vanguard Short-Term Bond ETF (BSV, $81.52) is a dirt-cheap index ETF that gets you exposure to an enormous world of nearly 2,500 short-term bonds with maturities of between one and five years.
Why short-term? The less time a bond has remaining before it matures, the likelier it is that the bond will be repaid - thus, it's less risky. Also, the value of the bonds themselves tend to be much more stable than stocks. The trade-off, of course, is that these bonds don't yield much. Indeed, the BSV's 1.5% yield is less than what the S&P 500 at the moment.
But that's the price you pay for safety. In addition to a short-term bent, BSV also invests only in investment-grade debt, further tamping down on risk. Roughly two-thirds of the fund is invested in U.S. Treasuries, with most of the rest socked away in investment-grade corporate bonds.
Stability works both ways. BSV doesn't move much, in bull and bear markets. Even with the recent drop, the S&P 500's 14% gain over the past year dwarfs the BSV's 5.6% advance. But Vanguard's bond ETF likely would close that gap if the market continues to sell off.
* SEC yield reflects the interest earned for the most recent 30-day period after deducting fund expenses. SEC yield is a standard measure for bond funds.
SPDR DoubleLine Total Return Tactical ETF
Type: Intermediate-term bond
Market value: $3.4 billion
SEC yield: 2.6%
Return since Feb. 19: +0.7%
The actively managed SPDR DoubleLine Total Return Tactical ETF (TOTL, $49.77), a Kip ETF 20 component, is another bond-market option.
The downside of active management is typically higher fees than index funds with similar strategies. But if you have the right kind of management, they'll often justify the cost. Better still, TOTL is, as it says, a "total return" option, meaning it's happy to chase down different opportunities as management sees fit - so it might resemble one bond index fund today, and a different one a year from now.
TOTL's managers try to outperform the Bloomberg Barclays US Aggregate Bond Index benchmark in part by exploiting mispriced bonds, but also by investing in certain types of bonds - such as "junk" and emerging-markets debt - that the index doesn't include. The 1,010-bond portfolio currently is heaviest in mortgage-backed securities (54.1%), followed by U.S. Treasuries (25.3%) and emerging-market sovereign debt (8.1%).
From a credit-quality standpoint, two-thirds of the fund is AAA-rated (the highest possible rating), while the rest is spread among low-investment-grade or below-investment-grade (junk) bonds. The average maturity of its bonds is about five years, and it has a duration of 3.6 years, implying that a 1-percentage-point increase in interest rates will send TOTL 3.6% lower.
The 2.6% yield isn't much to look at, but it's a lot more than what you're getting from the "Agg" index and longer-dated Treasuries. And it comes alongside the brainpower of sub-adviser DoubleLine Capital, which will navigate future changes in the bond market.
GraniteShares Gold Trust
Type: Commodity (Gold)
Market value: $652.5 million
Dividend yield: N/A
Return since Feb. 19: +1.7%
Commodities are another popular flight-to-safety play, though perhaps no physical metal is more well-thought-of during a panic than gold.
A lot of that is a fear of a horrible-case scenario: If the world's economies collapse and paper money means nothing, humans need something to use for transactions, and many believe that something will be the shiny yellow element that we used as currency for thousands of years. At that point, however, your IRA will be the last of your worries.
But there is a case for gold as a hedge. It's an "uncorrelated" asset, which means it doesn't move perfectly with or against the stock market. It's also a hedge against inflation, often going up when central banks unleash easy-money policies. Because gold itself is priced in dollars, weakness in the U.S. dollar can make it worth more. So sometimes, it pays to have a small allocation to gold.
You could buy physical gold. You could find someone selling gold bars or coins. You could pay to have them delivered. You could find somewhere to store them. You could insure them. And when it's time to exit your investment, you could go to the trouble of finding a buyer of all your physical loot.
If that sounds exhausting, consider one of the many funds that trade based on the worth of actual gold stored in vaults.
The GraniteShares Gold Trust (BAR, $16.23) is one of the best ETFs for this purpose. Each ETF unit represents 1/100th of an ounce of gold. And with a 0.1749% expense ratio, it's the second-cheapest ETF that's backed by physical gold. Traders also like BAR because of its low spread, and its investment team is easier to access than those at large providers. All these factors have contributed to the fund's rising popularity. While BAR's price has climbed 24% amid a surge in gold over the past year, its assets under management have expanded by 41%.
VanEck Vectors Gold Miners ETF
Type: Industry (Gold mining)
Market value: $13.5 billion
Dividend yield: 0.7%
Return since Feb. 19: +2.5%
There's another way to invest in gold, and that's by purchasing stocks of the companies that actually dig up the metal. While these are publicly traded firms that bring in revenues and report quarterly financials like any other company, their stocks are largely dictated by gold's behavior, not what the rest of the market is doing around them.
Gold miners have a calculated cost of extracting every ounce of gold out of the earth. Every dollar above that pads their profits. Thus, the same pressures that push gold higher and pull it lower will have a similar effect on gold mining stocks.
The VanEck Vectors Gold Miners ETF (GDX, $29.97) is among the best ETFs for this purpose. It's the largest, too, at more than $13 billion in assets.
GDX holds 47 stocks engaged in the actual extraction and selling of gold. (VanEck has a sister fund, GDXJ, that invests in the "junior" gold miners that hunt for new deposits.) That said, the cap-weighted nature of the fund means that the largest gold miners have an outsize say in how the fund performs. Newmont (NEM) makes up 12.4% of assets, while Barrick Gold (GOLD) is another 11.0%.
But why buy gold miners when you could just buy gold? Well, gold mining stocks sometimes move in a more exaggerated manner - as in, when gold goes up, gold miners go up by even more. Over the past year, for instance, BAR has climbed 23.5%, but the GDX has outpaced it with a 32.5% price gain.
ProShares Short S&P500 ETF
Type: Inverse stock
Market value: $2.0 billion
Dividend yield: 1.8%
Return since Feb. 19: +7.5%
All of the ETFs shared are at least likely to lose less than the market during a downturn. Several might even generate positive returns.
But the ProShares Short S&P500 ETF (SH, $24.70) is effectively guaranteed to do well if the market crashes and burns.
The ProShares Short S&P500 ETF is a complex machine of swaps and other derivatives (financial instruments that reflect the value of underlying assets) that produces the inverse daily return (minus fees) of the S&P 500 Index. Or, put simply, if the S&P 500 goes up 1%, SH will go down 1%, and vice versa. If you look at the chart of this ETF versus the index, you'll see a virtual mirror image.
This is the most basic of market hedges. Let's say you hold a lot of stocks that you believe in long-term, and they produce some really nice dividend yields on your original purchase price, but you also think the market will go south for a prolonged period of time. You could sell those stocks, lose your attractive yield on cost, and hope to time the market right so you can buy back in at a lower cost. Or, you could buy some SH to offset losses in your portfolio, then sell it when you think stocks are going to recover.
The risk is clear, of course: If the market goes up, SH will nullify some of your gains.
Yes, there are much more aggressive "leveraged" inverse ETFs that provide double or even triple this kind of exposure, whether it's to the S&P 500, market sectors or even specific industries. But that's far too risky for buy-and-hold investors. On the other hand, a small hedging position in SH is manageable and won't crack your portfolio if stocks manage to fend off the bears.
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Copyright 2020 The Kiplinger Washington Editors