Five ETF Strategies For A Sideways Market

by on June 10, 2011 | Updated July 9, 2014

Most investors have a pretty good idea which ETFs will perform well in bull markets (generally any type of risky asset, including equities and commodities) and which will perform well in bear markets (low risk bonds and inverse equity ETFs, among other asset classes). But finding products that have the potential to deliver meaningful gains when equity markets are moving sideways can be a more challenging task.

The very nature of such an environment eliminates the vast majority of equity ETFs, and bond funds are also unlikely to show much  movement when equities move along sideways. A 0% return on a portfolio is obviously preferable to the losses many experienced in 2008, but no growth can be tough to swallow. No one sets up a portfolio expecting it simply to tread water, and those with little in the way of patience may be frustrated by investments that simply spin their wheels without generating income. A “Flat market” essentially translates into a delayed retirement, lower-than-expected discretionary cash, or reduced financial security.

Just as there are ETFs that are likely to perform well in up markets and down markets, there are a number of ETPs that can deliver nice returns when markets simply more sideways. Below, we profile five ETPs that may be able to deliver impressive returns when equity markets stall and flatten out for extended periods of time [for more ETF ideas, sign up for our free ETF newsletter]:

1. VelocityShares Daily Inverse Short-Term ETN (XIV)

This ETF seeks to deliver daily inverse exposure to an index comprised of short-term VIX futures contracts. The VIX, a widely-watched measure of anticipated equity market volatility, isn’t an investable asset. But innovations in financial markets have given investors options to access the “fear market” through exchange-traded futures contracts.

While most VIX ETPs offer long exposure to various indexes, XIV is designed to deliver short exposure. And as a result of both moderate volatility and the structural nuances of the VIX market, this fund has consistently delivered huge gains during its relatively short history [see Inverse VIX ETN: Free Money?].

If equity markets are flat for an extended period of time, there is a high likelihood that the VIX stays flat as well, as this “fear index” generally exhibits a strong negative correlation to equity markets. But a flat VIX doesn’t necessarily mean translate into flat performance for XIV; the performance of this ETN depends not on the movement in the spot VIX, but on the performance of an index comprised of VIX futures. Because that market is often in steep contango, most VIX benchmarks tend to lag far behind the spot VIX. XIV allows investors to play the role of the house, exploiting the structural phenomenons that often cause abysmal performances from the ETPs in the Volatility ETFdb Category.

XIV will thrive when the VIX plummets. But because this ETN has the winds of contango firmly at its back, it is also likely to perform quite well when markets move sideways–as long as VIX futures markets remain contangoed.

2. PowerShares S&P 500 BuyWrite Fund (PBP)

This ETF offers a unique twist on one of the most widely-followed indexes in the world, the S&P 500. PBP is linked to the CBOE S&P 500 BuyWrite Index, a benchmark designed to measure the performance of implementing a “covered call” or “buy-write” strategy on the S&P 500 Index. Such strategies, which have been used for decades, are relatively straightforward: the portfolio consists of a long position in the index (i.e., the S&P 500) and the sale of a series of call options on the same benchmark (in the case of PBP, a series of at- or slightly out-of-the-money options on the S&P 500).

This strategy has limited upside potential, since a big appreciation in the S&P would be offset by the value of the obligations related to the writing of the call options (as the S&P 500 increases, those options become in-the-money to the holder, or an obligation to the writer). But it also has the potential to soften the blow if the S&P declines or enhance returns in a flat market. That’s a result of the premiums earned from writing call options; if the underlying benchmark holds steady or declines, those options are worthless to the holder (meaning the writer–in this case PBP–earned a profit on that activity).

Covered call strategies have long been popular among investors expecting markets to move sideways. Innovation in recent years has made these techniques readily available through the exchange-traded structure; in addition to PBP, iPath offers an ETN (BWV) linked to a similar strategy [Do You Need A Covered Call ETF?].

3. 2x Monthly Leveraged Business Development Company ETN (BDCL)

Recommending a leveraged ETP in a flat environment may seem like lunacy. As many investors are well aware, the daily reset mechanism on many leveraged ETFs can lead to adverse impacts of compounding when markets oscillate between gains and losses. So first of all, it’s important to note that BDCL resets exposure to the related index on a monthly basis, not a daily one. While it is still very much subject to return erosion or enhancement from compounding, the impact of this phenomenon is not nearly as severe as it is in daily reset products.

The potential appeal of BDCL in a flat market relates entirely to the hefty distribution yield. In order to maintain certain favorable tax treatments, BDCs must pay out almost all of their earnings–making this asset class a source of juicy dividend yields. BDCL adds leverage on top of this current return, resulting in an effective yield that blows all other ETPs out of the water. As of June 2011, the annual leveraged yield on BDCL was a whipping 14.6%–considerably higher than most ETFs that sought to deliver handsome dividend yields could achieve at the time [see Dividend ETF Special: 25 Attractive Opportunities].

Because BDCL is a leveraged product, it is obviously a risky bet. But if market stay flat, this ETN can deliver some solid returns. Dividends are your friends when stock prices are sticky, and few ETPs offer a yield that comes anywhere close to BDCL.

4. Short BGU / Short BGZ

Perhaps the most common use of leveraged ETFs involves a short-term bet on a certain asset class, whether it be a broad-based equity fund or a resource-specific commodity ETP. But leveraged ETFs can be tremendously useful tools in a number of different environments, and in particular can be used as a way to generate positive returns in sideways markets.

In this case, we’re talking about the breed of leveraged ETFs that resets on a daily basis, resulting in a compounding effect that can enhance returns in trending markets (i.e., where markets post a string of consecutive gains or losses) but erode them in seesawing markets (i.e., where gains are followed by losses and vice versa). If equity markets move back and forth but fail to move considerably higher or lower overall, it’s pretty likely that daily leveraged ETFs linked to those indexes–both long and short varieties–will lose ground [see a detailed explanation of compounding and leveraged ETFs].

So going short both components of a pair of leveraged ETFs–such as the Direxion Large Cap Bull 3x Shares (BGU) and Bear 3x Shares (BGZ)–has the potential to exploit the adverse impact of oscillating markets on daily leveraged ETFs. If markets see and saw but finish up right around where they started, leveraged ETFs will face some potentially stiff headwinds from compounding. That, of course, translates into gains from a short position in these assets.

Here’s a recent example: between March 11 and June 3, the iShares Russell 1000 Index Fund (IWB) gained about 0.4%. BGU and BGZ lost 0.2% and 3.8%, respectively, during that same stretch.

If this strategy sounds risky, that’s because it is. A lot can go wrong with a pair of short positions in products that have a tendency to exhibit significant short-term volatility, and the eruption of a trending market can leave investors with big losses in a short period of time [Five Facts Every Investor Should Know About Leveraged ETFs].

5. Spread ETPs

Most of the 1,200 ETPs on the market today seek to deliver returns that corresponds to the change in price of a single asset class over a specified time horizon–whether it be mid cap Brazilian stocks, gold bullion, or Italian Treasuries. In flat markets, most of these funds can be expected to turn in relatively flat returns.

Innovation in the ETF industry has given investors a suite of tools that offer exposure to asset class spreads, the differentials in returns between two asset classes, over single trading periods. Spread trading, which has been employed through various strategies for decades, is relatively straightforward; returns realized depend not on the absolute movement of a single asset, but on the relative performance of one asset class relative to another.

FactorShares recently debuted a suite of “spread ETFs” that include both long and short exposure to a number of assets, including gold, oil, U.S. equities, bonds, and the dollar:

  • 2x S&P 500 Bull/T-Bond Bear (FSE)
  • 2x T-Bond Bull/S&P 500 Bear (FSA)
  • 2x S&P 500 Bull/USD Bear (FSU)
  • 2x Oil Bull/S&P 500 Bear (FOL)
  • 2x Gold Bull/S&P 500  Bear (FSG)

[see more on the methodology behind these ETFs]

Unlike some of the other ideas on this list, the FactorShares ETFs won’t necessarily turn in gains in flat markets–the performance all depends on the relative strength of the relevant asset classes. But these tools certainly have the potential to deliver both gains and losses in any type of environment: up, down, or flat.

Disclosure: No positions at time of writing.