Since mid-January, there has been a sharp acceleration in stock correlations, which poses a severe challenge for investors who wish to minimize risk.
Given the extreme volatility of the stock market as of late, savvy investors should consider alternative exchange-traded funds, also known as ETFs, which exhibit low correlations to diversify.
Recently, WisdomTree Strategist Gaurav Sinha said in a research note “After years of low correlations in a post-QE world, we are now entering a regime where higher correlations are feeding higher volatility. In my view, higher volatility (compared to 2017) is here to stay. Increasing stock correlations within equities are additionally making it harder for investors to look for diversification by simply investing in equities. Thus, beating markets through simple stock selection is getting harder.”
Furthermore, Sinha argued that the higher correlations across equities could potentially point to spikes in the VIX as well as even greater volatility. Sinha anticipates that higher market volatility is becoming the norm with the heightened correlations among traditional stock picks, making it more difficult for investors to diversify within the equity market.
Savvy investors should consider alternative strategies that do not exhibit high correlation to traditional assets that etfs provide. Investing alternatives like etfs could ultimately provide better diversification thereby being able to defensively position a traditional portfolio mix in the currently volatile market environment.
To quantify how ETFs can serve as a solution, the Greenwich Associates 2018 US ETF Study surveyed 180 institutions participating regarding their increased use of ETFs in 20 of 21 equity and fixed-income product categories over 2017.
“As they ready their portfolios for the end of the “Goldilocks” market, US institutions are integrating ETFs more deeply into their portfolio management and investment strategies,” explains Andrew McCollum, Greenwich Associates managing director who authored of the report.
According to the study’s findings, the increased ETF use is displacing a number of other investment vehicles like stocks, bonds, mutual funds, and derivatives. ETFs are most commonly displacing active mutual funds.
ETFs are being implemented for strategic uses including obtaining investment exposures in “core” portfolio allocations, and building top-down strategies that create alpha through asset allocation instead of security selection. 70% of survey respondents cited these purposes behind their use of ETFs compared to 60% in 2016.
The findings also indicate that institutional investors are increasingly using smart beta ETFs to protect portfolios against market volatility. Study participants investing in non-market-cap-weighted/smart beta ETFs was 44% in 2017 as compared to 37% in 2016.
Meanwhile, 67% of institutions depend on ETFs as liquid, fast and relatively low-cost tool to execute a range of strategic tasks like managing cash flows and making tactical changes to their portfolios.
“Investors continue to turn to ETFs to express their views in fast-changing markets,” explains Ravi Goutam, head of iShares pensions, foundation & endowments team at BlackRock. “During volatile global equity market activity in February, clients utilized ETFs for efficient liquid market exposures through the secondary market. Investors are also creating solutions using ETFs in innovative ways to drive absolute return and positive outcomes.”
If investors are thinking about investing in ETFs, they might consider something like the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (NYSEArca: PUTW).
This ETF aims to reflect the performance of the CBOE S&P 500 PutWrite Index. It can help investors generate income by selling volatility through writing options. Investors can use PUTW to help lower portfolio beta while also minimizing downside risk. The strategy can generate higher potential income if the VIX stays elevated. The income generated can offset potential losses if equities declined, especially in a highly correlated and volatile market.
Savvy ETF investors can also try long/short strategies, such as the WisdomTree Dynamic Long/Short U.S. Equity Fund (DYLS).
This stock and the WisdomTree Dynamic Bearish U.S. Equity Fund (DYB) hedge and seek to provide market-neutral and bearish positioning, respectively. They operate in markets with deteriorating fundamentals. These alternative ETF strategies can help investors by diversifying exposure in declining markets as well as limit downside risk.