When explaining the impressive rise of the ETF industry, most are quick to note the major cost differentials and potential tax efficiencies as the primary advantages of exchange-traded products over traditional actively-managed mutual funds. While these factors have certainly been instrumental in growing ETF assets in recent years, there are some other distinguishing aspects of ETFs that make them more appealing than mutual funds to more active investors. ETFs trade like stocks, which to most means that they can be bought and sold throughout the day at a price determined on the open market, instead of at the end of the session at net asset value. But it also means that they can be sold short, thereby significantly increasing the depth and complexity of trading strategies available to ETF investors (see Five Advantages Of ETFs Over Mutual Funds).
Lingering concerns about the stability of Europe and fresh worries about a conflict in Korea have hammered equity markets over the last month, as virtually every corner of the globe and every sector has tumbled. But that doesn’t mean that every investor has lost his shirt over the last four weeks; many who bet on a downward correction have turned a nice profit as asset prices have crumbled. Investors who amplified short exposure through leveraged ETFs have made a killing thanks to the recent wave of risk aversion (see Three Leveraged ETFs Up 50% During The Correction).
Short selling and leveraged ETF investing are, of course, for those investors with an above average appetite for risk. But there are ETF plays all along the risk tolerance spectrum that can be useful in a bearish environment. In recent weeks, we outlined two “market neutral” ETF trades designed to profit from weakness in the euro zone relative to the rest of the region:
- Long HEDJ, Short EFA
- Long GXF, Short EZU
An argument can be made that such a market neutral strategy is even more risky than a simple short strategy; if the long asset deteriorates while the short asset soars, losses can be amplified. But because the ETFs in these trades tend to be highly correlated, such a scenario is rather unlikely. Below, we take a look at how each of these strategies have performed in recent weeks (specifically, since the S&P 500 touched its 2010 high on April 23).
The Currency Hedged Play
Many U.S. investors have rejoiced in the euro’s slide, which has both given a boost to their national pride and made a European getaway much more affordable. But it has also eroded returns on international investments denominated in the common currency, a concept not all investors have grasped. The vast majority of equity ETFs available to U.S. investors do not hedge out currency exposure, meaning that the bottom line depends on both local returns and exchange rate movements.
The WisdomTree International Hedged Equity Fund (HEDJ) is an exception. This ETF offers exposure to the EAFE region, but also hedges out currency exposure. It may seem like a minor distinction, but this nuance has translated into a major return differential over the last month; HEDJ has outperformed the otherwise similar MSCI EAFE Index Fund (EFA) by a wide margin (see HEDJ vs. EFA: A Better EAFE ETF?):
Betting On Non-Euro Europe
In recent weeks, Europe has been split into two in the eyes of many investors: the euro zone and economies that use a non-euro currency. One of the best ways to bet against the former is by shorting the iShares MSCI EMU Index Fund (EZU), which includes stocks of EU members that have adopted the euro as their currency (see EZU holdings). One of the best ways to bet on the latter is the Global X FTSE Nordic 30 ETF (GXF), which offers exposure to Sweden, Denmark, Norway, and Finland (of the group, only Finland has adopted the euro).
Although most major currencies have slipped relative to the dollar in recent weeks, the “euro drag” has weighed heavily on EZU. The EMU fund has lagged behind its Nordic rival over the last month, delivering a positive return to those who shorted EZU and bought GXF:
Disclosure: No positions at time of writing.