Cash — whether it’s in the form of money market accounts, bank deposits or certificates of deposit — has been the standard answer for financial advisors whenever market trouble has lurked.
While cash and its equivalents are still very much alive as alternatives to a declining stock portfolio, 2022 is completely different from any other market we’ve seen. That is, unless you were a well-heeled, active investor in the 1970s. For the other 99.99% of us (just an estimate!), the rules of navigating market volatility have changed. And financial advisors need to change with them, quickly.
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The Bears are Back in Town
It isn’t football season, so you know this has nothing to do with the Chicago squad by that name. The bears are bear markets. And as it turns out, there are two of them when you normally only see one at a time. The stock market is not technically in “bear territory” if you look at the S&P 500, Dow or Nasdaq. But a quick look below the surface, and steadily deteriorating conditions in mega-cap stocks are a sign that the proverbial wall of worry is getting steeper.
Over in the bond market, things are anything but business as usual. For over 40 years, stock investors could count on bonds as playing the role of the “anti-stock” when the stock market crossed into bear territory. This time, not so much. With rates starting at such low levels when the stock market peaked, you can’t just grab 6% yields on corporate bonds, or 3% yields on money market funds, as in days past. Instead, you have get more than a little innovative. However, as they say, it’s all for a good cause: your clients’ and yours. To get you started on your journey toward modernizing how you play defense in your portfolios, other than simply resorting to low-yielding cash accounts, here are four alternatives to consider.
— The obvious but not-so-obvious one.
— Floating-rate bond ETFs.
— Arbitrage: fancy word, simple idea.
— Long-short funds.
— The takeaway.
The Obvious But Not-So-Obvious One
When the stock market goes down, what goes up? Common answers to this question are bonds, gold and maybe silver. But those are dependent on other factors that might interfere with their defensive qualities. Bonds are going through that right now, as concerns about Federal Reserve rate increases later this year are spiking rates higher. That, in turn, drops bond prices, so the “cash alternative” feature of bonds is not working as it normally does.
Advisors tend to overthink this. What goes up when the stock market goes down? Investments built to move in the opposite direction of the stock market. Those come in many forms these days — from inverse exchange-traded funds, or ETFs, like the ProShares Short S&P 500 (SH), which moves opposite the S&P 500 Index — to the more volatile ETFs that own CBOE Volatility Index (VIX) call options. VIX, the most common measure of anticipated stock market volatility, has traditionally risen in price when markets get nervous, and prices fall. iPath B S&P 500 VIX Short-Term Futures ETN (VXX) is one example of such an ETF.
[SEE: 13 Long-Term Investing Strategies Advisors Love.]
Floating-Rate Bond ETFs
Unlike your seat on an airplane, you can’t use these as a flotation device. But with these bond ETFs you can increase your income yield over what you get on stagnant cash, if interest rates rise. Be careful here, though. If you own an ETF like the iShares Floating Rate Bond ETF (FLOT), which owns U.S. Treasurys, credit risk is only as great as that of the U.S. government. If you venture into floating-rate corporate bonds — such as via the VanEck Vectors Investment Grade Floating Rate ETF (FLTR) — you are accepting greater credit risk.
Arbitrage: Fancy Word, Simple Idea
Cash provides a very low (or zero) return, but you know what your return is. There are a variety of methods to try to squeeze out a moderate positive return above cash, while reducing the expected volatility seen in the broader stock and bond markets. Arbitrage is simply pairing up two investments, one long and one short, with the goal of profiting on the difference in their returns. So, if you believe the Dow Jones Industrial Average will outperform the Nasdaq 100 Index over the coming weeks or months, you could buy an ETF like SPDR Dow Jones Industrial Average ETF (DIA) to “own” the Dow, and buy an equal or roughly equal amount of ProShares Short QQQ (PSQ), which is an ETF that seeks to deliver the opposite performance of the Nasdaq 100. So, if the Dow dropped 10% but the Nasdaq fell 15%, DIA would be down 10%, but PSQ would be up 15%. You net a 5% gain on the arbitrage pair.
Arbitrage can also be done within a single ETF. There are listed securities for mergers and acquisitions, such as IQ Merger Arbitrage ETF (MNA) which buys a company being acquired in a deal while shorting the acquiring company.
Long-Short Funds
If you like the arbitrage concept but want to leave a bit more wiggle room to make or lose money, while keeping returns in a relatively narrow range, there are ETFs that buy and short different securities based on a theme. One example is the AGFiQ U.S. Market Neutral Anti-Beta Fund (BTAL), which shorts volatile stocks and buys less-volatile ones, aiming to profit from the outperformance of one group over the other. Another is the ProShares Long Online/Short Stores ETF (CLIX), which buys online retail stocks, while shorting traditional brick-and-mortar company stocks. Here, the trend toward online shopping at the expense of trekking to the mall is what the ETF tries to capitalize on.
With these strategies, you need to do your homework, and determine if they make sense for your clients across several dimensions. You will want to plan for how to simply explain these somewhat esoteric investments to clients who may be more used to the standard stock and bond paradigm. You also need to make sure you clearly understand just how much they can differ from cash, stock and bond returns in a volatile market.
The Takeaway
Cash interest rates are finally lifting off from zero. That’s the good news. The bad news is that they are now running much further behind the rate of inflation, which checked in at over 7% annualized in the latest monthly reading. That will not be lost on your clients, as plenty of media attention is now devoted to the wealth hurdles caused by the rising cost of living. That might be the best reason to consider to what extent you go “out of the box” to research alternatives to cash, educating clients on why the reward potential of using them may outweigh the risk.
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4 Ways To Play Defense Without ‘Going To Cash’ originally appeared on usnews.com
