The behavior of utilities, consumer staples, small-caps, Treasuries and the dollar are all signs of a defensive pivot taking place; here's a look at 6 "safe haven" ETFs for an increasingly dangerous market, cautions David Dierking, editor of TheStreet's ETF Focus.
If you pay attention to what the financial markets are telling us right now, I think you have to be concerned about a correction. Utilities and consumer staples outperformed sharply last week. Small-caps continue to underperform large-caps badly. Treasury yields keep falling quickly and significantly. The dollar is strengthening. All of these are signs of a defensive pivot taking place.
When they all tell the same story at the same time, it's time to begin thinking about protecting your assets. That, of course, can take a number of different forms. Some investors will simply yank all of their money out of assets that carry any type of risk and move into cash. I wouldn't personally recommend this kind of move, but some people are still inclined.
Government bonds and gold are commonly thought of as defensive hedges. Investors looking to maintain equity exposure often land on the utilities sector to take some risk off of the table.
The ETF market offers a number of different options for getting defensive. While I'll offer up 6 funds for you to consider, I think it's important to also consider the general theme around why I'm mentioning them.
For example, gold may or may not work in an equity bear market since its long-term correlation to stocks is essentially zero. It'll be important to examine the context around the current environment to determine if it might work in today's markets.
With that being said, here are 6 ETFs to consider if you're looking to add a little protection to your portfolio.
iShares U.S. Treasury Bond ETF (GOVT)
This, of course, is your traditional risk hedge to equities. In most cases, stocks and Treasuries have an inverse relationship. When stock prices head down, bond prices tend to rise offering both a smoothing out of long-term returns and overall risk reduction benefits.
The problem is that this relationship hasn't been holding for the past few months. Since the March peak in Treasury yields, stocks and bonds have been moving in tandem.
That's made this asset class pair less than ideal from a risk mitigation standpoint, but I doubt investors have cared much since both large-caps and long-term Treasuries have gained 11% since the March rate peak. If the equity markets crack, however, expect this inverse relationship to quickly return to normal.
The other curiosity to the current environment is how Treasuries haven't been responding as you might expect given the current inflation rate. Interest rates and inflation tend to move together, so one would expect rates to be rising here. Instead, we've seen the exact opposite take place. That could be a sign that the markets do indeed view short-term inflation risks as transitory and there's no need to reset interest rates higher.
Or it could be a sign that there are bigger risks at play that's causing investors to pivot defensively. Whether that's concerns that the economic growth engine is slowing, rising COVID cases could impact future growth or the upcoming debt ceiling expiration, there's some real underlying concerns below the surface.
Either way, adding some Treasury exposure to take some risk off the table makes sense. GOVT is a more generic all-maturity bond fund, but you could choose one targeting a shorter or longer term maturity depending on your views.
SPDR Gold MiniShares Trust (GLDM)
Many investors consider gold to be a defensive hedge as well. While that may end up being true in some circumstances, it won't be in all. In reality, gold has almost a zero long-term correlation with equities.
If you're looking for a pure risk hedge for your portfolio, that makes gold ideal. If you're looking for an asset class that will rise in value if stock prices fall, it's really a 50/50 shot whether or not it will be successful.
Gold is really most effective as a hedge against 1) inflation (in some cases) and 2) real interest rates. I say "in some cases" with respect to inflation because history has shown that, like stocks, it may or may not work as a hedge.
Over history, returns for gold have been strong during periods of hyperinflation, defined as a 5% annualized rate or higher. If inflation rates are below that level, it may or may not provide a benefit.
Think of gold as an asset class that pretty much does whatever it wants. In the current environment, even though the current inflation rate is above 5%, we really haven't seen gold prices budge. That's consistent with the idea that inflation is transitory and not a long-term concern. If that narrative changes and inflation persists, I'd expect gold prices to rise.
I choose GLDM because it's more than 50% cheaper than the SPDR Gold Trust (GLD). GLD, however, is much more liquid and trades at much tighter spreads. If you're more of a long-term buy-and-hold investor, GLDM makes more sense. If you're a frequent trader, GLD may still be a better choice despite the higher expense ratio.
PIMCO Enhanced Short Maturity Active ETF (MINT)
This is another fixed income hedge against an equity portfolio, but it targets corporate bonds instead of government bonds. That makes it slightly riskier since credit risk now comes into play.
The short-term nature of the bonds being held (the portfolio has a duration of around 0.4 years) and the fact that it consists almost exclusively of investment-grade securities, it's a modest step up in risk for a touch more yield.
With the economy recovering and the government still pledging its full financial support of the markets, delving into the short-term investment-grade credit market is probably not terribly risky at the moment.
MINT, however, can come with its risks. During the worst of the COVID recession, this fund significantly deviated from its underlying NAV, a rare occurrence for the typical ETF, as investors abandoned anything associated with risk. At its low point, MINT traded at nearly a 2% discount to its NAV resulting in immediate losses for anybody trading out right at the bottom.
In this low rate environment, that would have translated into a loss of roughly two years of income from the fund. The fund is also actively-managed, which should help limit a degree of risk in the fixed income market.
Consumer Staples Select Sector SPDR ETF (XLP)
When it comes to hedging equities with equities, investors will often point to the utilities sector as the ideal landing spot, since demand is considered as everybody needs electricity and water regardless of the economic environment.
I prefer staples here, however, because consumers are flush with cash, utilities aren't exactly cheap right now and their high debt loads could become expensive when the Fed begins tightening and rates drift higher.
Staples could provide some degree of downside protection in a correction, but it's important to remember that these are still stocks. If the S&P 500 ends up dropping 20%, consumer staples may only fall 10%, but they're still falling. This isn't a downside or risk hedge in the same way that something like Treasuries would be.
I'm going with XLP as the consumer staples ETF of choice here, but it's worth noting that roughly 45% of the fund's assets are going to the combination of Procter & Gamble (PG), Cola-Cola (KO), PepsiCo (PEP) and Walmart (WMT). If that's a little too concentrated and you want to spread out your risk a bit, go with the equal-weight version of the sector, such as the Invesco S&P 500 Equal Weight Consumer Staples ETF (RHS).
Invesco DB U.S. Dollar Index Bullish ETF (UUP)
If stocks start heading down and investors pivot to Treasuries, it makes sense that the dollar would also likely rise, since they are denominated in U.S. dollars.
It's not a perfect relationship and the direction of the dollar index is dependent on many factors. However, the dollar and the Japanese yen are considered the world's primary reserve currencies and would tend to attract forex traders in the event of a risk asset pullback.
If you want to bet on the dollar, but don't want to delve into the forex or futures market, UUP is a nice alternative. It does invest in near-expiration dollar index futures contracts, but the work is done for you with UUP. Word of warning: UUP can issue a K-1 at tax time, which could make your filing situation more complicated.
iShares U.S. Medical Devices ETF (IHI)
Adding this ETF to your portfolio would be similar to the idea of adding consumer staples or utilities. The healthcare sector is also considered defensive given that the need for medicines, medical care and hospital procedures would be steady in times of economic uncertainty.
Given the advances being made in areas, such as genomics, biotech and robotics, healthcare is actually a sector that provides both defense and growth.
I'm going to offer up a more targeted healthcare play here and go with medical devices. This area of the sector has been growing quickly and it's expected that the acceptance and use of medical devices in surgeries and other procedures will soon become the norm. At a trailing P/E ratio of 47, this sector won't be cheap, but the growth story is undeniable.