How do you spell investor relief in a bear market? E-T-Fs

Even a nine-year bull market is giving some investors a nervous stomach — the ETF industry is trying to soothe that worry

Sep 8, 2018 @ 6:00 am

By John Waggoner

Nine years into a bull market with rocketing growth in stocks like Amazon and Apple, investors are wary of equities.

Providers of exchange-traded funds have played to that sentiment by rolling out ETFs that attempt to protect investors from a downturn in the stock market, using strategies that range from shorting stocks to focusing on dividends or employing multifactor approaches that emphasize defense.

Such ETFs are remarkably popular. Many advisers, however, are skeptical about how helpful the funds will be when the next downturn arrives. Their concerns range from whether defensive ETFs will work as advertised to whether they're necessary.

"We don't invest in a particular fund because it's defensive," said Jennifer Dever, financial planner for Pennington Bass & Associates. "We think a really great defensive strategy is adding something that can go up when stocks go down."

Popular worries

It's not hard to construct an argument for a stock meltdown at any given moment. The popular worries currently include:

Age. By traditional measures, the bull market began March 9, 2009, when the Standard & Poor's 500 stock index hit 677, making it the longest bull market on record.

Valuation. The Shiller cyclically adjusted price-to-earnings ratio, which looks at average 10-year P/E ratios adjusted for inflation, is just slightly lower than its level on the eve of the 1929 stock market crash.

Interest rates. The Federal Reserve has been raising rates — albeit from extraordinarily low levels — since December 2015. The yield on the bellwether 10-year Treasury Note has been rising since July 2016. Rising rates don't guarantee lower stock prices, but they do mean that stocks are less attractive relative to bonds and that interest-rate costs will cut into corporate earnings.

More important, however, is that investors remain scarred from the two massive bear markets in the past 18 years.

"There was a psychological shift that occurred during the global financial crisis and the Great Recession," said Brian Singer, head of William Blair's dynamic allocation strategies team. "As in the aftermath of the Great Depression, we're seeing behaviors that came out of the Great Recession have not changed."

One of those behaviors is a wariness of the stock market, even though the S&P 500 has soared at an annualized pace of 18.93% since its 2009 bottom.

Fear-factor ETFs

The ETF industry's response has been to roll out ETFs that play to those worries.

For example, the Principal Mega-Cap Multi-Factor Index exchange-traded fund (USMC) made its debut less than a year ago, on Oct. 11, 2017, and has already gathered $1.8 billion in assets.

The fund plays defense, not offense. Megacaps are often the bluest of blue-chip stocks: companies with strong balance sheets and robust earnings that can usually weather downturns well.

"When you allocate money to megacaps, you're going a bit more defensive," said Paul Kim, managing director of ETF strategy at Principal Global Investors.

One obvious approach to protecting against a downturn is the bear-market ETF, designed to rise when the stock market falls, and vice versa.

MicroSectors, for example, launched three inverse FANG+ exchange-traded notes, whose value is linked inversely to the value of the FANG stocks — Facebook, Apple, Netflix and Google — the four hottest stocks of the bull market. The three ETNs, which opened their doors on Aug. 1, gathered a combined $120 million in assets in less than a month, according to Morningstar Inc.

Another bear fund, AdvisorShares Dorsey Wright Short ETF (DWSH), entered the ETF landscape on July 1 and has raised $4.4 million in its brief life. The fund selects the weakest large-company stocks and sells them short, using a proprietary relative-strength formula.

You don't have to be an outright bear to be defensive. Dividends are a natural buffer against losses, and the industry has launched 32 dividend-focused ETFs in the past two years. Fidelity Dividend ETF for Rising Rates (FDRR), for example, launched nearly two years ago. It has $359 million in assets, versus $97 million for Fidelity Momentum Factor, launched on the same day.

Similarly, high-quality stocks have a reputation for weathering a bear market better than their shadier cousins; 34 quality-focused ETFs have been rolled out in the past two years.

Low-volatility funds are another popular defensive play. "In order to grow assets, you have to be in equities, so maybe you should gravitate to low-volatility stocks — you'll get a lower beta, and less of a fall when the market declines, which will allow you to sleep better," said Sam Stovall, chief investment strategist of U.S. equity strategy at CFRA.

iShares Edge MSCI Minimum Volatility USA ETF (USMV) is the 600-pound gorilla of the group, weighing in at $16 billion in assets. And that hasn't gone unnoticed: The ETF industry has trotted out 35 more low-vol ETFs in the past two years.

Multifactor funds often include defensive strategies as well. For example, value funds are supposed to fall less than a broad index in a bear market and recover more quickly — and, in a general sense, are considered a defensive strategy. But cheap stocks can always get cheaper, and some perennial favorites of value investors — industrial stocks and bank stocks — often get walloped in a bear market, no matter how cheap they are. PIMCO RAFI Dynamic Multi-Factor U.S. Equity ETF (MFUS) attempts to improve on value performance by targeting low volatility, quality, momentum and size as well as value.

The industry also is marketing defensive bond funds, said Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. "A number of products are focusing on higher quality slants and looking at the most liquid names," Mr. Rosenbluth said.

The dozens of funds launched over the past two years and the millions of dollars that have flowed into them paint a picture of an industry that's loaded for bear. Nevertheless, the question arises: Will these strategies work?


Bear markets are, by definition, nearly impossible to predict. More importantly, the last bear market ended in March 2009 — meaning that very few defensive ETFs have a track record that includes a major bear market.

Rita Lee, research director at Brouwer & Janachowski, said that when she's looking at defensive ETFs, she worries most about liquidity. You don't want a defensive ETF that rarely trades.

"Then I look at whether it's a strategy that's straightforward enough to work," she said. "Multifactor ETFs are tricky."

In fact, a white paper published in 2017 by Rob Arnott, founder of Research Affiliates, found that an investment factor's five-year performance is negatively correlated with its future five-year performance — in other words, a factor such as value or momentum that has done well over the past five years will most likely lag in the next five.

"By significantly extending the period of past performance used to forecast future performance, we can improve predictive ability, but the forecasts are still negatively correlated with subsequent performance: The forecast is still essentially useless!" he wrote along with the paper's co-authors, Noah Beck and Vitali Kalesnik.

One tricky issue is how a multifactor fund selects securities according to its various factors.

Knowing the logic behind the index isn't enough, said Feifei Li, head of investment management at Research Affiliates. For example, suppose the fund selects stocks based on three factors: price momentum, earnings growth and sales growth. It could have one sleeve of stocks that fit each criteria, a practice called mixing. It could also score all stocks on all three factors and choose the ones that score the highest on the combined factors — a practice called integrating.

"Mixing is better for smart beta," Ms. Li said.

Another issue is cost. While defensive ETFs don't have to be expensive, many advisers overlook the cost of market impact. When an ETF rebalances, it sometimes has to sell big blocks of stocks and buy others. Buying a big block of a stock pushes the price up, while selling pushes the price down.

"You have to pay attention to turnover and concentration," Ms. Li said.

Risk versus return

Ben Johnson, director of global ETF research at Morningstar Inc., said it's easier for funds to reduce risk than enhance returns, and "all of the defensive strategies have reliably done that."

"The foundation of low-volatility funds, for example, does not point to superior absolute returns but better risk-adjusted returns," he said. "We have a fair degree of confidence in the better-crafted, cost-efficient offerings."

Mr. Rosenbluth sees the defensive ETFs as a useful reassurance for skittish investors who might otherwise pull out of the market altogether.

"Over the long term, it's better to stay invested than bail," he said. "These defensive strategies, such as lower-volatility strategies, protect on the downside and have you participate in the gains on the upside. For someone who is more concerned about the downside ... these ETFs are going to cushion the blow."

The biggest question, however, is not just whether defensive ETFs will work in a bear market, but whether clients will be happy with the results. After all, most stock ETFs, no matter how cunningly constructed, are going to fall in a bear market. Telling clients they only lost 20% when the market was down 30% is rarely a happy conversation. In a bear market, no one cares about relative performance.

"When you tell people they haven't gone up as much as the market, they're fine," Ms. Li said. "When you have to tell them they're down, it's painful."


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