Controlling Risk with ETFs

by on September 23, 2014

When making any investment decision, one of the first things that comes to mind is how much risk you are willing to take on. With each decision, there is a risk/return tradeoff that is unique to each investor, meaning this profile identifies how much an investor is willing to risk to capture a larger profit. No matter which corner of the market you are looking to invest in, there will always be some type of risk associated with each investment, whether it’s with fixed income, which is generally considered low-risk, or with equities, which tend to be riskier securities.

Thanks to the evolution of the ETF industry, there are a wide range of unique funds that are designed to help mitigate various types of risk. 

Market RiskThe Bears and Bulls Are Duking It Out On Wall Street

Market risk is the most common type of risk investors encounter. Also called systematic risk, market risk refers to the risk that affects all securities in the same manner. This type of risk cannot be mitigated by conventional means, meaning it is caused by some factor that cannot be controlled by simple diversification. Investors witness this type of risk often; for example, during the financial crisis, equities across the board suffered major losses, no matter how “safe” a particular industry seemed to be. 

There are several ways investors can track this type of risk: beta, correlation, standard deviation, and historic volatility are all viable tools to use when identifying and measuring a particular security’s risk relative to the market (i.e. its sensitivity to fluctuations in the broader market). 

Several ETFs aim to identify those securities that are least sensitive to market volatility. These low volatility funds offer access to both domestic and international markets, as well as targeted exposure to different capitalization sizes. Many of these ETFs use the metrics mentioned above, such as standard deviation, beta, or historic volatility, to identify stocks that exhibit the least sensitivity to market swings. Some of the most popular low volatility ETFs include [see also 3 Things You Need To Know About Low Volatility ETFs]:

  • S&P 500 Low Volatility Portfolio (SPLV)
  • MSCI USA Minimum Volatility Index Fund (USMV)
  • MSCI Emerging Markets Minimum Volatility Index Fund (EEMV)
  • MSCI All Country World Minimum Volatility Index Fund (ACWV)
  • MSCI USA Size Factor ETF (SIZE)

Since many of these are broad based funds, investors might find these low volatility ETFs as more compelling options for a core portfolio holding. 

Inflationary RiskGold

Inflationary risk occurs when the value of an asset or income decreases as the rising costs of goods and services (inflation) shrinks the purchasing power of a currency. Since inflation can negatively impact every asset class, there are several ways investors can hedge against rising prices, depending on the composition of their portfolios.

One way to hedge against inflation is to invest in a “one-stop-shop” ETF, which attempts to mitigate the negative impact of rising prices. These real return ETFs invest in multiple asset classes, and place hedge positions in Treasuries or TIPS to combat inflation. 

Investors can also utilize this strategy themselves, investing in Inflation-Protected Bonds. TIPS are the most popular inflation-fighting tool since they are extremely low-risk, given that they are backed by the U.S. government, and since their par value rises with inflation (as measured by the Consumer Price Index). Investors can also choose foreign inflation-protected bond funds such as the SPDR DB International Government Inflation-Protected Bond ETF (WIP).

For those that have a higher tolerance for risk, investing in certain commodities can also provide great inflation hedges. Gold and other precious metals, for example, are some of the most most popular inflation hedges because precious metals (especially gold) have historically shown strength when the dollar encounters weakness (devaluation), and physical exposure also serves as a store of value that tends to perform well in inflationary environments. The SPDR Gold Trust (GLD) is by far the most popular option for gold exposure [see also Inflation ETF Special: 25 ETF Ideas To Fight Rising Prices].

Currency RiskCurrencies

Currency, or exchange rate, risk arises from the change in price of one currency or a basket of currencies against another. When you buy a foreign security, your dollars are converted to the currency that the security is denominated in, essentially making you long a stock and long a foreign currency. Therefore, when the U.S. dollar weakens you will benefit, but if the dollar strengthens, the investment will lose its value. 

Since these securities (which include ETFs) are quoted in U.S. dollars, there is a common misconception that investors believe they do not have currency exposure, when in fact they are directly impacted by fluctuations between the U.S. dollar and the given foreign currency. 

There are two ways investors can hedge this risk with ETFs. One way is to utilize currency ETF products, which reflect a specific currency versus the USD or a basket of currencies against the USD. Another, less hands-on approach is to invest in currency-hedged ETFs, as these funds mitigate the impacts of currency fluctuations via currency futures. Essentially, currency-hedged ETFs are for investors that are bullish on the U.S. dollar; those that believe the dollar will be weaker, may want to remain unhedged. 

Interest Rate Risk

Interest rate risk occurs when a fixed income security declines in value as a result of a rise in interest rates. Interest rates can  have a significant impact on the demand (and therefore the market price) of existing fixed income securities: when rates rise, existing debt loses a bit of its luster since investors can purchase new debt with a more attractive cash flow profile.

The simplest solution to avoiding interest rate risk is to invest in short, ultra-short, or zero duration bonds, which are least sensitive to rising interest rates.

Another viable option is to add exposure to floating rate bonds, which invest in investment grade debt with a floating interest rate. These floating rate funds make interest payments that are based on the value of a specified reference rate. Essentially, these funds strip out interest rate risk while still capturing the component of returns associated with investment grade corporate debt risk. There are currently only three ETFs that offer this exposure, the most popular being the Floating Rate Note Fund (FLOT).

Bank loans are another type of floating rate debt. These securities are privately arranged debt instruments issued by a bank that provide capital to a company usually with a below investment-grade credit rating.

Lastly, Floating Rate Treasuries, a new type of U.S. security, can also be used to hedge against interest rate risk. 

Credit RiskBonds

One of the primary risk factors of bond investing relates to the creditworthiness of the issuer and the duration of the fund. The concept of credit risk is fairly straightforward: the less likely an issuer is to repay its obligations, the higher yield investors will demand. 

The most popular go-to fixed income security investors choose for its creditworthiness is U.S. government securities, as these are considered to be the safest investments in the market. Certain foreign government bonds are also viable options, though investors should choose their exposure wisely as not all countries have as sound credit as the U.S.

In corporate bonds, investors will want to look for ETFs that invest in Investment Grade debt, which typically hold an S&P rating of BBB and higher. Issuers with credit ratings below BBB are considered to be below investment grade, or junk bonds, which are issuers that have a higher probability of default. 

The Bottom Line

No matter what type of investment you make, there will always be some risk associated with it. But with the wide range of ETF options, investors can easily and cost-effectively hedge against these different types of risks. 

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Disclosure: No positions at time of writing.