ETF Ideas For A Flat Market

by on August 16, 2010 | ETFs Mentioned:

This year has been a frustrating one for investors, as equity markets came racing out of the gate only to lose steam as much anticipated job creation failed to materialize and much of the developed world found itself facing a massive credit crunch. Every development that seemingly indicates a robust recovery–such as the impressive earnings season–is quickly followed by more discouraging news to keep markets in check.

Major U.S. indexes have spent part of 2010 well into positive territory while also dipping deep into the red, currently standing about even on the year. As the summer months draw to a close, many investors are beginning to predict that more sideways movement is in the forecast. There is a growing feeling that while there is not enough fuel for a upside rally, the situation is also not so bleak as to bring on a double dip recession. That creates a unique and often frustrating trading environment. “Stock investors can be forgiven if they feel like they have traveled great distances to go nowhere” writes Ben Levisohn. “A range-bound market doesn’t have to be an unprofitable one, however. There are…trading strategies that, when used properly, can help investors make money in the short term.”

As a result of horizontal trends, many have turned to fixed income funds. The first seven months of 2010 alone saw cash inflows of $23 billion to fixed income ETFs, reflecting the  increasing confidence that investors have found in achieving their fixed income exposure through ETFs [see 2010: Year Of The Bond ETF]. With volatility plaguing traditional markets, it is not uncommon to see even the most daring investors currently hold half of their portfolio in fixed income safe havens.

But besides fixed income funds, there are more creative ways for investors to profit in sideways markets. the gains they are looking for in equity securities. One of Levisohn’s ideas comes from leveraged ETFs; shorting these funds is an intriguing–albeit risky, way of generating returns in the short-term.

Because many leveraged ETFs reset exposure on a daily basis, the return to these securities over multiple trading sessions depends not only on the change in the underlying benchmark, but the path taken by that index during the relevant period. In oscillating markets–where gains are often followed by losses and vice versa–both bull and bear leveraged daily ETFs can see their values erode over a multi-day holding period [see more in the Leveraged ETF Center]. So shorting both a bear and bull fund has the potential to profit when markets jump back and forth, but ultimately finish near where they started. The example Levisohn uses includes shorting both Direxion’s Daily Large Cap Bull 3x Shares (BGU) and Daily Large Cap Bear 3x Shares (BGZ), although this strategy could be implemented with any of the funds found in the Leveraged Equities ETFdb Category.

Obviously, any strategy utilizing leveraged ETFs involves significant risk–and this one is no exception [also see ETF Ideas For Deflation Defense].

BuyWrite ETFs

Another intriguing option during sideways markets involves implementing a “covered call” strategy that consists of establishing a long position in the market and simultaneously writing call options. If markets move sideways, investors in this strategy can enhance returns through the receipt of the premium on options written. Moreover, if markets sink this strategy provides some down side protection, as the premiums received serve to offset some losses. The downside in this strategy comes if markets make an upside rally; the position as a writer of call options means that gains will be limited if the underlying index surges higher.

There are multiple ETFs offering exposure to a covered call strategy. Invesco Powershares’ PBP follows the CBOE S&P 500 BuyWrite Index, which is designed to measure the total rate of return of a hypothetical “buy-write”, or “covered call”, strategy on the S&P 500 Index. The fund employs a strategy of a hypothetical portfolio consisting of a “long” position indexed to the S&P 500 Index (i.e. purchasing the common stocks included in the S&P 500 Index) and the sale of a succession of one-month, at- or slightly out-of-the-money S&P 500 Index call options that are listed on the Chicago Board Options Exchange [see more at PBP's fact sheet]. iPath offers a similar product; the CBOE S&P 500 BuyWrite ETN (BWV) implements the same strategy, but is structured as an exchange-traded note.

PowerShares also offers the NASDAQ-100 BuyWrite (PQBW), which implements a similar strategy on the NASDAQ 100 Index [see also Do You Need A Covered Call ETF?].

One Man’s Junk Is Another Man’s Treasure

One last ETF option for investors expecting sideways markets comes in the form of high yield bonds. If conditions stay stable–not materially improving or deteriorating–the current return on these securities begins to look pretty good. Take a look at the SPDR Barclays Capital High Yield Bond ETF (JNK). Most of the underlying holdings pay a coupon rate of at least 8%, and the current yield on the fund sits north of 9%. If markets move sideways, most investors would be thrilled to stand by and collect a current yield that approaches double digits. The risk here comes if market sink; JNK carries significantly more downside risk than most fixed income ETFs, and could lost a big chunk of value if markets head lower and default risk climbs higher.

JNK tracks the Barclays Capital High Yield Very Liquid Index, a benchmark that includes publicly issued U.S. dollar denominated, non-investment grade, fixed-rate, taxable corporate bonds that have a remaining maturity of at least one year. The fund’s underlying assets consist primarily of debt with credit qualities of BB and below [see all of JNK's holdings here].

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Disclosure: No positions at time of writing.