Investors who suspect that the stock market may be about to decline can take action to reduce the risk in their investment portfolios. Rather than simply selling out of the market, which may trigger adverse events, such as tax liability, investors can remain invested while generating protection for their portfolios from market declines.
Below, ETFdb.com will discuss the various ways investors can reduce risk in their ETF portfolios and list 10 different ETFs that can help do just that.
10 ETFs to Help Reduce Risk
|(SH )||ProShares Short S&P 500|
|(SPXU )||ProShares UltraPro Short S&P 500|
|(GLD )||SPDR Gold Shares|
|(LQD )||iShares iBoxx $ Investment Grade Corporate Bond ETF|
|(TLT )||iShares 20 Year Treasury Bond ETF|
|(VXX )||iPath S&P 500 VIX Short-Term FuturesTM ETN|
|(VIXY )||ProShares VIX Short-Term Futures ETF|
|(VIG )||Vanguard Dividend Appreciation ETF|
|(XLU )||Utilities Select Sector SPDR Fund|
|(VNQ )||Vanguard REIT ETF|
It is possible to reduce risk by investing in ETFs that increase in value when the market declines. This is done with inverse ETFs. There are several inverse ETFs that take positions against the entire market or a specific sector.
One example is the ProShares Short S&P 500 (SH ), which seeks to produce returns that are inverse the returns of the S&P 500 Index. But there are even more aggressive inverse ETFs that magnify returns, such as the ProShares UltraPro Short S&P 500 (SPXU ), which seeks to return daily investment results that correspond to three times the inverse of the daily performance of the S&P 500. If the market rises, these inverse funds will not perform well. But if the market declines, they will rise in value, as they did in 2008 when the market crashed.
Beta measures how much a stock or ETF is expected to move on a daily basis in relation to how the overall market moves (generally, the S&P 500 Index is used as a benchmark). A fund with a beta of 1.0 moves in line with the overall market, so that a 1% rise or fall in the S&P would be matched by a 1% rise or fall in the fund. The lower the beta value, the less volatile the underlying instrument is in comparison to the market.
There are many securities with beta values of 0.50, or lower. For example, the SPDR Gold Shares (GLD ) has a five-year beta value of 0.12; that means that if the S&P 500 increases 1%, the gold ETF is expected to rise only 0.12%. Separately, fixed-income ETFs tend to have lower beta values. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD ) is a bond ETF that invests in investment-grade corporate bonds. It has a five-year beta value of just 0.07. Lastly, there are U.S. Treasury bonds, which are very low-beta instruments. The iShares 20 Year Treasury Bond ETF (TLT ) fund invests in 20-plus-year U.S. Treasury bonds and has a five-year beta of -0.60. A negative beta means that the stock or fund, generally, has performance that is opposite to the market.
An alternative way to measure volatility is through the VIX, otherwise known as the Volatility Index, and often called the fear index. When volatility increases, particularly to the downside, volatility funds do well. Popular VIX-related ETFs are the iPath S&P 500 VIX Short-Term FuturesTM ETN (VXX ) and the ProShares VIX Short-Term Futures ETF (VIXY ). These ETFs provide exposure to the S&P 500 VIX and are designed to provide access to equity market volatility through volatility index futures. These ETFs should not be held for long periods of time unless the investor is expecting a prolonged period of high volatility.
Dividends are a meaningful source of risk reduction because they are a real return and provide downside protection. The Vanguard Dividend Appreciation ETF (VIG ) invests primarily in dividend growth stocks and has a 2.2% yield.
A specific asset class with high dividend yields is the utility asset class. Utility stocks are ideal choices for risk-averse income investors because they generate reliable profits, which are returned to shareholders through high dividend yields. The best utility ETF is the Utilities Select Sector SPDR Fund (XLU ). XLU has a beta of 0.18 and a 3.3% dividend yield.
Another investment vehicle that typically has high dividend yields is the real estate investment trust, or REIT. These trusts are required to distribute at least 90% of their distributable cash flow to investors through dividends. This results in high yields across REITs. One of the most well-known ETFs that invests in REITs is the Vanguard REIT ETF (VNQ ). This fund has a 3.8% dividend yield.
The Bottom Line
In order to reduce portfolio risk, investors can utilize inverse ETFs, low-beta ETFs, VIX ETFs, dividend ETFs, or a mixture of all of them. The broader goal is to reduce exposure to any potential market declines. The 10 ETFs listed above can help a risk-averse investor accomplish this.