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The last several years of the bull market have seen tremendous expansion in assets under management in exchange-traded funds.  Hundreds of billions of dollars have migrated to passive, index-based strategies with transparent holdings and low-costs.  This has been a windfall for the two largest firms in the game: Vanguard and Blackrock, both of which have sterling reputations for creating vehicles with minimal expenses, excellent tracking, and deep liquidity.

The reason so much money has migrated towards products such as the iShares Core S&P 500 ETF (IVV) and Vanguard Total Stock Market ETF (VTI) is that investors know exactly what they own and why they own it.  But also, more simply, because that’s where the performance has been.  U.S. stocks have been rocketing higher over the last twenty-four months with little volatility.  Both these ETFs have gained more than 57% over that time frame. 

It’s easy to forget how dicey and uncertain investing can be with such steady and unrelenting gains.  2017 was also a historic year in that every single month notched positive returns in diversified large-cap U.S. stock indexes.  Those type of easy gains don’t come around often, and when they do, the opportunity must be seized. 

This recency bias is why so much money is now piling into the market after hesitating on the doorstep for a prolonged period.  Thus, selling legacy mutual funds, bonds, and cash for the perceived upside in stock-focused ETFs seems like the most rational course of action at this stage of the game.

The other side of this steep incline is also worth pondering as well.  Namely, where will assets flow within the ETF realm when stocks hit a speed bump? 

The easy answer of course is back to the safety of timeless risk pairing investments such as cash, fixed-income, and possibly even commodities.  These are often areas where fear brings a renewed sense of value and diversification benefits. 

It’s also highly likely that bear market and volatility-linked funds will receive an uptick in activity.  The iPath S&P 500 VIX ST Futures ETN (VXX) has become a preferred way for short-term traders and institutional investors to play a sharp downtick in the stock market.  This exchange-traded product tracks futures on the CBOE VIX Volatility Index, which essentially measures options activity and positioning.  A higher VIX is representative of fear, while a lower VIX can postulate a sense of greed or calm. 

The problem with a fund such as VXX is that it’s an extremely complicated, expensive, and ponderous vehicle to own.  It’s not the type of investment that top advisors will recommend or that is appropriate for a typical diversified portfolio. 

More attuned to that category are tactical asset allocation and trend-following funds.  ETFs that switch between cash, bonds, or stocks based on the prevailing market conditions will start to gain some headway.  I wrote last year about the Quant X Risk Managed Growth ETF (QXGG) and EquityCompass Risk Manager ETF (ERM), which are two examples of this style.  There are also countless others that offer varying risk mitigating strategies. 

The benefits to these funds is that their multi-asset style will likely create a lower volatility risk profile.  Nevertheless, they tend to be more expensive than a traditional index fund and may suffer some level of performance slippage when transitioning between varying sleeves of their portfolio model.  Such is the trade-off that investors will need to evaluate prior to making sweeping changes to their existing ETF holdings. 

Furthermore, there is always the potential for specific market verticals to act independently of the major indices.  Thematic ETFs or those that track individual sectors have the potential to buck the relative pull of a downtrend.  The difficult part is forecasting ahead of time which areas of the market are going to outperform.  No one has a crystal ball that will unveil the future. 

The Bottom Line

Timing the market can be difficult and no strategy is flawless.  Nevertheless, we are going to see ETF investors seeking out fresh alternatives to supplement their existing core holdings in the event of a prolonged sell-off in stocks.  Such an event will provide perspective on which ETF strategies thrive under those circumstances and those that don’t live up to their expectations.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.


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