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Many long-term savers still think that the market is too risky.  Unfortunately, in an inflationary environment, the purchasing power of dollars earning next to nothing erodes so quickly that the consequence of doing nothing is to lock in -10% real returns. Very few retirees can sustain that for long. Therefore, some equity investment is the prudent way to go for many of us. The time horizon and size of the nest egg have a lot to do with choices investors close to or in retirement should make. A question I hear often is how can I invest in stocks while protecting my downside.  

There are, in fact, products that temper volatility in a way designed to allow one to stay invested with one eye squarely on wealth preservation in a risk-on environment. We are still in a risk-on environment. Six months ago, I reviewed 10 such ETFs, five apiece in each of two categories. Let's see how these ETFs have continued to hold up since March after a tumultuous second quarter gave way to a six-week bear market rally followed by more investor pain.

The first half of the list includes five stock-based ETFs without derivatives that focus on stocks with low volatilities. These were:

SPLV, the Invesco S&P 500 Low Volatility ETF. It selects about 100 S&P 500 stocks with the lowest daily volatility over the twelve 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, holds an actively managed, concentrated portfolio of US-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 US-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 US 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.

XLU, the Select Sector SPDR Utilities ETF was the first Utilities ETF. It is comprised of all the utilities in the benchmark index. 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. Since the sector is the least volatile of the 11 GICS Sectors and its dividend yield is generally higher than the index, XLU has often been considered an all-weather supplemental core holding for dividend investors. Since it restricts itself to S&P 500 utilities, it does tend to be more concentrated than Vanguard’s equivalent utility index fund, VPU.

LVHD, Franklin Low Volatility High Dividend ETF explicitly aims for stable yield. Its use of technical inputs as well as fundamental factors in search of dividend sustainability. Specifically, LVHD considers the volatility of prices and earnings in addition to yield and positive earnings. The fund selects 50 to 100 stocks, then weights them subject to constraints on concentration, turnover, and liquidity. 

The second half of the list contained ETFs that are partial derivatives based and engineered to mitigate losses in equity market downturns. As such, they do not have ValuEngine reports available. Additionally SWAN, the Amplify Black Swan ETF was dropped from this update.  It was geared to give investors 30% exposure to the upside of the S&P 500 with long-dated options while holding a "riskless" basket of laddered intermediate-term treasuries. Unfortunately, the rapid rise in interest rates resulted in a steep negative return for the treasury basket while the long-term call options expired worthless. The net result was worse than 100% exposure to the S&P 500 in a down market, NOT what SWAN had been designed to provide.

The removal of SWAN from the list still leaves us with five ETFs that use derivatives to limit exposure to the downside of the market. These five are: 

ASPY, ASYMShares Asymmetric S&P 500 ETF is an indexed and rules-based alternative strategy to hedging US 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”, and ”risk-elevated.”

BJAN, Innovator U.S. Equity Buffer ETF, use 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 the 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 very different protection and buffer zone. The issuer publishes effective interim levels daily on its website. The fund must be held until 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.

QAI, IQ Hedge Multi-Strategy Tracker ETF, seeks investment results that track, before fees and expenses, the price and yield performance of the IQ Hedge Multi-Strategy Index. The IQ Hedge Multi-Strategy 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 is actively managed yet nonetheless aims to align its exposure to an index, the Advanced Research Risk Parity Index. The index diversifies across four asset classes (TIPS, US Treasury Bonds, global equities, and commodities), seeking returns similar to global equities with less risk over time. It is sponsored by LA-based hedge fund provider Evoke Aris.

SPD, the Simplify US Equity PLUS Downside Convexity ETF 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

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.

The following data table comparisons:

Key Findings:

1. XLU, the Select Sector SPDR Utilities ETF, has been the clear winner among this selection of below-average risk ETFs in year-to-date and 12-month performance. It also has the lowest Beta of the stock ETFs and the lowest expense ratio of the entire selection.  It has certainly provided better-than-expected returns with low volatility during this torrential market season cementing its historic status as an all-weather safe haven.

Going forward, however, there are some warning flags. One warning is that all but one of its holdings are rated as overvalued by ValuEngine and on a valuation basis, XLU is in our bottom decile.  With a 1 rating, XLU is rated to greatly underperform the market in the next six to 12 months.

2. DIVZ, the TrueShares Low Volatility Equity Income ETF, has been the second-best performer both year-to-date and on a 12-month basis. It is the only other of the ten ETFs measured to have a positive return during this period. It has been the top performer altogether YTD in the actively managed US large-cap category. This bolsters the point in the latest SPIVA research that the relative performance by active managers relative to benchmark index funds tends to improve in choppy and down markets.  This has especially held true in the first year or two of bear markets in the past. In the sixth decile with about half of its stocks rated as undervalued, DIVZ is closer to fairly valued according to VE valuation models in comparison with XLU. However, DIVZ and XLU are identically out-of-favor with ValuEngine’s main model with a 1 rating and are also expected to greatly underperform.

3.  As a category, the 5 low-volatility and income-oriented stock ETFs all outperformed SPY on a year-to-date and 12-month basis. Thus, for tactical investors fearing that the market was too high and overdue for a correction last autumn or winter, moving all or part of one’s core US equity allocation to these types of ETFs including the five listed here would have rewarded such investors well, especially on a relative basis. 

4. Although the three ETFs with “volatility” in the name, LVHD, SPLV, and USMV all had negative returns for the YTD period, all were considerably less negative than benchmark index ETF SPY’s returns. Moreover, the first two posted positive returns for the 12-month period ending this week with LVHD, the Franklin Low Volatility High Dividend ETF, posting superior returns to SPLV by Invesco in both periods.  

Although USMV from iShares had a negative return for the past 12 months, it was much less negative than that of SPY.  Moreover, in terms of where to reallocate now, ValuEngine’s models rate USMV 3, making it the only ETF among these five rated to perform in line with the market.

5. Moving to the derivatives-driven ETFs that represent themselves as controlling market risk, two of the five ETFs in this category, RPAR, the Risk Parity ETF, and SPD, the Simplify Low Volatility ETF failed to limit investor drawdowns relative to SPY. Thus, both failed in satisfying their stated objective functions precisely when their investors needed them to do so. 

6. In contrast, market-neutral QAI from IQ overcame a rocky first quarter to be virtually flat the past 6 months, taking its YTD number to a drawdown that was more than 700 basis points less than that of the S&P 500. 

7. Better still, both BJAN and ASPY delivered investors protection from market downturns in line with their stated investment objectives. BJAN, the Innovator U.S. Equity Buffer ETF, seeks to track the return of the SPDR S&P  ETF Trust (SPY), up to a predetermined cap, while buffering investors against the first 9% of losses over the 12-month outcome period. It has done exactly that, limiting investor 12-month losses to 8%. ASPY, ASYMShares Asymmetric S&P 500 ETF, follows a rules-based, quantitative long/short hedging strategy that seeks 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 SPY. It has performed so well that its 12-month loss of less than 4% ranks it easily the best among these five derivatives-engineered ETFs. Its year-to-date performance of -10.1% is second best to QAI’s -8.9%.  Since ASPY uses a signaling algorithm to switch from participation mode to protection mode and back again, its timing cannot be infallible. Thus far in its young life, however, it has delivered well for investors looking for downside protection while also expecting to participate in market gains.
 

Conclusion

Where this blog is concerned, the failures of RPAR and SPD to fulfill the expectations of downside protection in bear markets have led to the decision to drop these two ETFs from the next update. Going forward, the ValuEngine models doubt that the two most successful ETFs on this low-volatility list since last autumn will be able to continue their outperformance. The models prefer USMV in this category. All are prudent choices. Time will tell which will fare best in the quarters to come.

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