The recent pullbacks in the market, along with the increased volatility and geopolitical concerns, means that many investors have turned to trading exchange-traded funds instead of stocks.
ETFs, which are baskets of stocks, have several distinct advantages for investors since they price throughout the market day, can track an index and have lower fees than traditional mutual funds.
Investors who are more active have been buying and selling ETFs, especially those who want to “eliminate single-stock noise,” says Rich Messina, a senior vice president of investment product management at E-Trade, a New York-based brokerage firm.
[See: The 10 Best ETFs to Buy for 2018.]
“They can also be a cleaner play for active traders,” he says. “Investors are drawn to them because they are transparent, highly liquid and typically come with low expense ratios.”
ETFs also take the legwork out of diversification for investors who do not want to cherry-pick stocks to lower their risk.
“For many investors, broad index ETFs are the bones of their portfolio and serve as the foundation, while traditional stocks or opportunistic ETFs like sector or thematic ETFs are deployed to bolster returns or mitigate risks,” Messina says. “Foreign equities, emerging markets, commodities and bonds are now easily accessible to the retail investor through ETFs.”
Key factors for choosing ETFs to buy. Investors have thousands of ETFs globally to choose from, but not all of them are created equally.
“When you’re looking to trade ETFs, especially in times of increased volatility, consider the market cap and bid-offer spread and approach any ETF that is new to the market with a fair dose of skepticism,” he says.
The recent tech sell-off was an opportunity for investors who viewed it as the chance to buy into a sector at a sharp discount to recent valuations. Some options include buying sector specific ETFs in a variety of strategies like smart beta or equal weight or choosing from a number of defensive-sector ETFs like utilities or consumer staples to prepare for a market pullback.
ProShares Short S&P 500 (ticker: SH) is an unleveraged S&P 500 ETF that Bill DeShurko, president of 401 Advisor, a registered investment advisory in Centerville, Ohio, uses to hedge his portfolio.
“Let’s say I want to move to a 40 percent cash position, but don’t want to sell 40 percent of my portfolio,” he says. “If I sell 20 percent and buy SH, I can keep 20 percent instead of selling for cash and accomplish roughly the same thing as a 40 percent cash position.”
The daily volatility in the market is the result of turbulent political moves, making it “too random to try and time and trade,” DeShurko says. “Guessing [President Donald] Trump’s tweets and reactions to them is a fool’s game.”
Since the market is unstable and all over the map, ETFs such as VelocityShares Daily 2x VIX Short Term ETN ( TVIX) and ProShares Ultra VIX Short-Term Futures ETF ( UVXY) are a better asset to trade than stocks, says Jason Spatafora, co-founder of Marijuanastocks.com and a Miami-based trader and investor.
“Coupled with the tax-related sell-offs, it makes the VIX a great way to hedge against the broader market,” he says.
The majority of these ETFs are held for only a short period, depending on the current political news that is affecting the market.
“I’ve held some of these for five to 30 minutes,” Spatafora says. “Occasionally, I will hold them overnight, depending on the catalyst that made me initiate the trade in the first place. I don’t mess with the VIX unless there is a catalyst.”
During the election cycle, Spatafora was playing the futures market based on how well each candidate did during the debates. Now he trades on the volatility based off Trump’s tweets.
[Read: How to Choose the Best ETFs to Buy.]
“I have notifications set on his tweets and news and I will even go so far as to watch the White House briefings to see how White House Press Secretary Sarah Sanders responds,” he says. “Unfortunately, the easiest trades of the year have been based on the leader of the free world and other people in his administration putting their foot in their mouths without understanding cause and effect as it relates to global markets.”
ETFs help hedge market volatility. The market and sector ETFs have come into play recently when volatility rose. When market volatility picks up, stock correlations mirror them, says Steven Place, founder and head trader of InvestingWithOptions in Destin, Florida.
“In other words, stocks start to all move on the same conveyor belt,” he says. “It doesn’t matter how good of a stock picker you are when the entire market is going up and down 2 percent per day.”
An options trader, Place focuses on ETFs that have strong options markets attached to them. He mostly trades a kind of option trade called a credit spread, which allows him to bet on the direction of an ETF without a lot of risk.
“These credit spread trades have a holding period between two weeks and two months, with an expected return on capital of 10 to 15 percent,” Place says. “Some of his favorite ETFs are those that are ‘cash settled,’ meaning that they track an index but don’t have shares traded such as SPX, RUT and VIX.”
The SPDR sector ETFs are a great way for retail investors to choose a sector. The trade-off is that these ETFs may miss moves on individual stocks.
One example is SPDR S&P Retail ETF ( XRT), which is well off all-time highs while specialty retail stocks like Guess ( GES), Lulelemon Athletica ( LULU) and American Eagle Outfitters ( AEO) have all seen massive moves over the past few years, he says.
“ETFs are great for individual investors because it eliminates single stock risk,” Place says. “If a company gets hit on bad earnings, it will have a much smaller effect on the ETF.”
ETFs in a stable market. In a stable market, ETFs which hold 15 to 20 stocks are a better option than trading stocks because they can reduce risk and add diversification, says K.C. Ma, director of the Roland George investments program at Stetson University in DeLand, Florida.
In the current environment where the market is consolidating, eliminating the difference between ETFs and stocks, which means there is no significant benefit to trade ETFs over stocks, he says.
[Read: 4 Tips to Weather Market Volatility.]
“There is little stock selection left and different pockets of the market may be reacting more or less to the new event which drives the market in the short run,” Ma says.
Due to the daily volatility caused by the tariffs and trade talks, “it stands to reason to trade against the announcements,” he says. “If you have to trade it, you trade the news event stocks or ETFs for the duration of the news event.”
The iPath S&P 500 VIX Short-Term Futures ETN ( VXX) or TVIX are great tools to use to trade short-term news events, especially since many important ones are announced in non-U.S. trading hours, Ma says.
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