Low-cost diversification and exposure to alternative investments available through ETFs.

As we watch markets grapple with COVID-19 concerns, it is worth revisiting strategies to manage volatility in an investment portfolio. Markets will always face periods of uncertainty, which is why a measured approach to investment management is important.

When we talk about volatility, we are referring to the magnitude of upward and downward movements in asset prices over a period.

Volatility tends to have negative connotations, but it can also be a positive force. Investors tend to think of volatility in terms of downward market movements, as we are currently seeing, but it can equally relate to the pace of rising markets.

Exchange-traded funds (ETFs) can be an effective tool for investors in periods of market volatility. They can assist by offering broad exposure and instant diversification in a liquid and cost-effective way. The wide range of specialised ETFs available on today’s stock exchanges also offer investors choice and flexibility in how to adapt to changing market conditions.

There are many approaches to combating market volatility and here we highlight three of the most used that can be implemented with ETFs.

1. Diversification

A simple analogy for diversifying is the old adage, don’t keep all your eggs in one basket. If all your investments are in one company, volatility may affect you more, compared to having a spread across a range of companies, countries and asset types.

Different assets, regions and sectors may react differently to market events and perform better in certain market conditions. For example, some may benefit more from more-volatile markets, while others will perform better where markets are more stable (less volatile).

If you consider this in context of the COVID-19 concerns, people still have basic food and health needs, so companies covering consumer staples such as supermarkets or fresh food suppliers, or healthcare companies producing medical vaccines or even vitamins, are likely to be less negatively affected and may even benefit.

By contrast, people are less likely to travel and go to restaurants (even aside from directions to self-isolate) so tourism-linked companies such as airlines and hotels are likely to struggle.

Even within one asset class, such as equities, diversification by using a large number of companies can be a useful method of managing volatility and risk. This is because individual companies will have individual risks that can vary based on locality, management style or a range of other factors.

A basic example would be comparing a dairy producer based in regional NSW to one based in north Queensland. The NSW producer may have been hit by bushfires while the Queensland producer was able to maintain production.

2. Incorporating more stable, less cyclical investments

While including more stable investments in your portfolio can also be considered diversification, it can also be used as a personal volatility strategy. What this might mean is factoring a certain part of your portfolio into investments that may not offer high growth but are consistent over time, regardless of market conditions.

An example is investments in infrastructure, companies that cover airports, toll roads, railways and telecommunications. These normally have monopolistic fee structures and have very high barriers to entry and predictable revenue streams. They are not expected to rise as much in good times but are less likely to be materially impacted in bad times.

A number of essential services come under infrastructure, so regardless of the economic situation they continue to be needed. For example, we are reliant on telecommunications (including internet providers) in good times and it has become even more crucial in the case of COVID-19 because many companies have enacted work-from-home policies.

From this perspective, many industries within infrastructure can be considered defensive investments.

You can see how this relates to performance through the ETFS Global Core Infrastructure ETF (ASX Code: CORE), which focuses on the 75 least volatile companies within the developed world “core” infrastructure universe. There is a clear divergence between returns and volatility of infrastructure compared with the broad spread of global equities in the MSCI World.

CORE compared to MSCI World and VIX Index over 10 years

3. Alternative investments

Alternatives are investments that try to use strategies or assets with a low correlation to stock and bond markets, to assist in neutralising negative outcomes. Low correlation means the investment’s pattern of performance should have little, no or even an inverse relationship with the rest of the portfolio. 

There are many alternative assets available to investors.  Many are quite advanced technically and, ultimately, require significant faith from the investor in the skills of the manager.  However, our belief is that one of the best, and certainly the oldest and most tried and tested alternative assets, is gold.

Gold typically has a low or even negative correlation with other asset classes. The correlation has also been known to become highly negative during events such as the global financial crisis. This has allowed gold to act as a safe haven in major financial and political events, as shown below:

Source: ETF Securities, Bloomberg data at 9 March 2020. Returns quoted are total return in Australian dollars.

There are a range of ways investors can access gold. Using a gold-backed ETF such as ETFS Physical Gold (ASX Code: GOLD) is a cost-effective and easy-to-access method allowing investors to buy gold via their share-trading platform.

Gold-backed means the physical gold bullion is stored by the fund manager in a vault on behalf of investors, and investors purchase units in that fund. In the case of GOLD, a unit represents approximately one-tenth of a troy ounce of gold and can be redeemed for the physical gold holdings.

4. Strategic tilts

Maintaining a diversified portfolio and incorporating alternative investments is an essential part of long-term portfolio construction, but investors may still consider shorter-term strategic tilts to increase or reduce exposure to certain assets during periods of volatility.

Investors may choose to buffer their portfolio by adding or increasing existing exposures to defensive assets such as gold, infrastructure or currencies for short periods.

An investor might choose to offset weakness in the Australian dollar with exposure to the US dollar via an ETF like the ETFS Enhanced USD Cash ETF (ZUSD), or increase exposure to gold through ETFS Physical Gold (GOLD) to help offset sharemarket falls.

For some investors, though, market volatility is less about defensive positioning and more about a potential buying opportunity. These investors would typically have a high growth, long-term investment strategy and aim to buy assets at market lows, hoping to benefit from any potential recovery.

They might incorporate short-term tilts towards sectors like technology that tend to be hit hard in volatile times, and use ETFs such as ETFS Morningstar Global Technology ETF (TECH) or ETFS FANG+ ETF (FANG).

For many investors, focusing on the long term rather than acting on short-term activity might be a more suitable option. Longer-term strategy should focus on an investor’s goals, investment timeframe, ability to withstand losses and other personal factors.

Conclusion

During periods of market volatility, taking a measured approach can help with deciding the right course of action for you.

Some questions to consider, either yourself or with the help of a financial adviser, are:

1. Does my investment strategy still meet my goals and needs?
2. Do the investments in my portfolio still match my overall strategy?

However you decide to manage your portfolio, it is worth stepping back to consider the what, why and how of your investments, rather than blindly following the crowds.