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5 ETFs for the Next Bear Market


 After every multi-year bull market run, investors must be cautious about protecting their nest egg from the threat of the next down turn in stocks.  Through the advantage of active portfolio management, it is possible to side step a protracted decline so that you are positioned to profit from the subsequent bull market that ensues. 

Consider that over the past 64 years, there have been 13 bear markets, lasting an average of 14 months and declining a total of 24.2% before recovering.  By contrast, the 14 bull markets since 1949 have lasted roughly 41 months on balance, each growing an average of 110.0%. (Source: Putnam Investments)

If you have the capability to preserve your capital during down cycles through the use of conservative investments, you will be able to put more money to work in the market when stocks begin their next growth phase.   Through the use of trend following and active portfolio changes, we can select investments that will allow you to sleep well at night knowing that your money is not susceptible to these pernicious declines. 

Remember that the psychology of most investors is most exuberant at market tops, and most desperate at market bottoms.  Our goal is to alleviate this roller coaster of emotion and uncertainty by shifting our asset allocation during Bull and Bear market cycles.

The following sections contain examples of investments that we select for our clients during Bear market periods.  We have organized them in order of lowest volatility (most conservative) to highest volatility (most growth oriented). 

Vanguard Short-Term Corporate Bond (VCSH)

Vanguard has long been known as the pioneer of low-cost, passively managed index funds.  The Vanguard Short-Term Corporate Bond (VCSH) continues that tradition by offering investors access to a short duration portfolio of investment grade corporate bonds with a very low expense ratio.

The benefit of owning a fund such as VCSH is that it gives you the ability to still generate a modest yield on your capital without being susceptible to a great deal of interest rate risk.  Because the fund has an average duration of only 2.9 years and investment grade credit quality, the share price should remain quite stable over the long term.

iShares Treasury Bond ETF (GOVT)

Throughout nearly every Bear market you see a trend of investors fleeing stocks for the safety of Treasury and investment grade corporate bonds.  This phenomenon is known as a “flight to quality” as investors leave the risk of equities for the relative safety and security of high quality fixed-income investments.  This shift of capital has the effect of driving up the prices of Treasury bonds and consequently driving down interest rates. 

One such ETF that can benefit from strengthening Treasury bond prices is the iShares Treasury Bond ETF (GOVT).  This fund is designed to access the entire U.S. Treasury yield curve in a single trade.  This diversification and liquidity is a very attractive quality which is why we have identified this fund on our short list of Bear market investments. 

The benefit of owning a fund like GOVT is that you don’t have to select a specific maturity of Treasury bond in the hopes that you access the right section of the yield curve.  While this fund will be more susceptible to price fluctuation than VCSH because of its higher average duration, it will also give you an excellent capital appreciation opportunity if we do see that flight to safety in U.S. Treasuries. 

PIMCO Total Return Fund (BOND)

When Bill Gross launched the first actively managed bond ETF in 2012, no one could have known how successful it would be in swiftly gathering billions of dollars in asset.  However, we were early adopters of this fund because we believe in the research, investment strategy, and active philosophy of the world’s largest bond manager.  Year after year PIMCO has proven themselves by consistently beating their benchmark indices and creating value for investors by outperforming their peers. 

The advantage of owning an actively managed exchange-traded fund such as BOND is that the portfolio manager will shift their asset allocation in response to changing global macro-economic trends.  They will increase or decrease their allocation to different sectors of the fixed-income market that include Treasury bonds, mortgage backed securities, corporate bonds, international bonds, municipal bonds, and more. 

With BOND you are getting access to a fund that has just the right mix of credit quality and duration to generate a healthy dividend yield while keeping overall volatility low.

iShares Conservative Allocation ETF (AOK)

Maintaining a conservative portfolio during a Bear market does not mean that you have to eliminate your stock exposure altogether.  iShares has solved this problem with their asset allocation products that allow you to select an investment with just the right mix of stocks and bonds to suit your risk tolerance and time horizon.  The fund that makes the most sense to preserve capital during a protracted down-trend in the market is the iShares Conservative Allocation ETF (AOK).

This exchange traded fund is essentially a “fund of funds” that purchases a basket of other iShares stock and bond ETFs.  AOK has an asset allocation that is approximately 71% domestic bonds, 17% domestic stocks, and 12% international stocks.  The high allocation of bonds in the portfolio act as a shock absorber when paired with a modest exposure to stocks so that you get a fund that has a smooth price trend. 

Think of AOK as a way to ratchet down your exposure to stocks while still maintaining a minimal amount of correlation to the stock market to achieve your long-term goals. 

iShares MSCI U.S. Minimum Volatility ETF (USMV)

For those investors who still want to have a fully invested stock fund, even during periods of economic contraction, I would recommend the iShares MSCI U.S. Minimum Volatility ETF (USMV).  This fund holds a basket of stocks that is made up of 125 historically low volatility companies in its index.  Generally these companies are more concentrated in the Health Care, Consumer Staples, Utilities, and Financial sectors.  What you are left with is a unique portfolio of stocks that typically have very steady returns and smaller price fluctuations.

All things being equal, you should see this low volatility fund decline less than its fully loaded index peers during periods of price decline.  For trend followers and active managers this type of fund may give us the ability to stay invested during periods of short-term market corrections instead of getting stopped out of a position.

USMV can make an excellent large-cap core holding for investors that still want to have a portion of their portfolio correlated to stocks so that they don’t miss out on the next growth phase.   It can also make for a great starter position for the portfolio that is lacking stock exposure. 

Summary Analysis

Each of these funds can be used as single investments to add to your existing holdings or as a comprehensive portfolio strategy using a balanced asset allocation mix.  The key to any good investment strategy is timing and discipline.  In order to be successful, you must actively monitor the global investment markets and make adjustments to your holdings in order to side step large losses.  Like a well-built home, your portfolio needs to be constructed to provide for the needs of your family and withstand adverse situations.

In addition to tailoring your asset allocation to the current investment climate, we also recommend that you employ risk management techniques on each position in your portfolio.  This can take the form of a trailing stop loss to protect your portfolio from large losses in the event that an investment does not perform as expected.   If a stop loss is triggered, the investment will be sold and moved to cash so that you can reevaluate the opportunities in the marketplace. 

Why Not Just Short the Market?

In my experience the single worst investment decision I have ever seen chosen and implemented are to short stocks, bonds or commodities.  For those of you that are new to the term, being “short” the market means that you profit when stocks fall.  Conversely you will lose money when stocks rise. 

When you are short the market you are fighting the entire system.  You are fighting the Fed, you are fighting the banks, and you are fighting your friends and neighbors retirement accounts.  It’s like the equivalent of a bicycle trying to stop a moving freight train.  Unless you are a very short-term, disciplined, and aggressive trader, you will almost always get run over. 

Wouldn’t a more sound investment philosophy be to just move your portfolio to cash or one of the bond funds mentioned in this report and wait for a better buying opportunity?

We believe that you never want to take too much risk in your portfolio by betting all of your chips on one outcome.  That is why we build balanced portfolios that incorporate active management to avoid large losses. 

Success requires planning, and planning for success is what we do at Fabian Capital Management. We are a fee-only wealth management firm that helps clients achieve their goals by providing a clear investment plan—and implementing it decisively. In doing so, we help you take the steps necessary to get your portfolio on the right track.

Note:

The information expressed by Fabian Capital Management is for informational purposes only and should not be construed as a recommendation to buy, sell, or hold any specific security.  Investing involves the risk of loss and further risk disclosure can be obtained by reading the fund’s prospectus.  Fabian Capital Management clients may own securities mentioned in this report.  This commentary does not constitute individualized investment advice. 

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Comment   |  6 years, 7 months ago from Irvine, CA