ETFs are often regarded as useful price discovery tools as they are able to deliver liquid access to previously difficult-to-reach markets, but that’s not the only way to utilize them that doesn’t involve making a transaction.
Traders and investors often look to ETFs as a means to gauge risk appetite levels across the investable universe for a variety of reasons.
See also How to Spot a Style and Sector Rotation with ETFs.
Why Risk Appetite Matters
Let’s dive into what this means and how it can help you make better decisions.
What Is Risk Appetite
Risk appetite simply refers to investors’ willingness to take on risk in the market at any given moment. The higher the investor’s risk appetite is, the more bullish price action we’re likely to see in the market; the lower the risk appetite is said to be, the more likely we are to observe weakening momentum – if not altogether a downtrend in the market.
Put another way, risk appetite is your tolerance for loss while still keeping in mind your investment objective; as such, a higher risk tolerance implies a greater willingness to take chances, and vice versa.
How to Utilize Risk Appetite Information
You might be wondering why gauging the overall risk appetite in the market matters in the first place. Let’s assume you have a great sector-momentum trading strategy with a solid track record, but after time you notice that your success rate and profit levels are deteriorating. What gives? Your strategy hasn’t changed. Ah, but the market environment has, and so too has investors’ risk appetite.
It pays to be aware of decreasing risk appetite levels in the market as this is likely to challenge many swing-trading and momentum-focused strategies; for instance, in a choppy market with weak risk appetite levels, it’s not uncommon to observe breakout trades failing quickly after triggering. Also, this sort of environment is ripe for quick changes in direction and known for kicking people out of trades too early, despite proper risk management.
Remember that having a great strategy is only part of the battle; the harder step is knowing when to apply it, and more specifically when to be aggressive or conservative with it. If you have a good sense of risk appetite levels, it could help your conviction on both entry and exit.
5 Ways to Gauge Risk Appetite With ETFs
Here are some of the most popular ways that investors might look to ETFs, and especially relevant pairs, in order to gauge risk appetite levels across the broad market, or zoom-in on a specific asset class:
- How are stocks trading relative to bonds? This longstanding comparison has been skewed in recent years thanks to the unprecedented intervention on the part of central bankers. The historical rule of thumb is that equities and fixed income will move inversely of each other. Simply put, if stocks are outperforming bonds, you can bet that risk appetites are probably strong.
- Are the major indexes trading above/below their 200 day moving averages? This is another way to gauge whether we are in a bull or bear market aside from the more traditional definition (losses upwards of 20%). Keep an eye on these tickers for a quick read of the S&P 500 (SPY ), NASDAQ (QQQ ), (DIA ), and the Russell 2000 (IWM ).
- Are Emerging Markets leading Developed Markets? Compare EFA (or SPY) to EEM for a quick gauge; if the latter is stronger, it’s fair to say that risk appetite is strong, although you have to be careful and see if this applies broadly or is geography-specific.
- Which sectors are leading/lagging? Sometimes when you can’t read the whole market, it pays to look at risk appetites on a sector or even industry level. Strong risk appetites are often characterized by cyclical sectors like consumer discretionary (XLY ) and technology (XLK ) leading in lieu of more defensive ones like utilities (XLU ) or staples (XLP ).
The Bottom Line
ETFs can be utilized in countless ways that don’t involve transacting them. One popular approach is to look to ETFs and relevant pairs as a means of gauging risk appetite levels in the market. This can be useful because it gives you better insight as far as what strategies in your arsenal may have a higher chance of success given the environment.
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