Are ETFs best in a downward trending market?

by , 28th November 2018

The longest bull run in history could be nearing its end as volatility rises and major US stock markets correct, wiping out their gains this year. But how will ETFs fair when the tipping point comes?

Despite their many attractive qualities, including liquidity, transparency, low costs and ability to access markets where other products can’t, there are still critics of the wrapper and some who go so far as to label them dangerous.

Jim Cramer at CNBC labelled some ETFs “totally abusive, moronic, horrible,”. He adds that while ETFs can be useful for day traders normal investors pay a terrible price because it makes the whole business of stock picking much more difficult and more futile that it should be.

They have faced criticism by various market watchers and during February’s volatility suffered severe outflows for two consecutive months – the first time since 2008. At this time volatility hit 30 – the highest level since 2011 – and market watchers largely conceded that the outflows from ETFs at the time was a result of the volatility as opposed to ETFs driving the volatility.

Flows into and out of ETFs during more recent corrections have been a mixed bag. In November and October 10th – when the S&P 500 fell 3% – European Equity ETFs suffered outflows, while US ETF flows remained in positive territory, according to BlackRock.

Regardless of which way the market is now going, there is no doubt more volatility than last year and investors are beginning to get a bit twitchy.

At the time of writing the VIX was trading just below 20, nearly double the price it was twelve months ago reflecting an increase in volatility in the markets.

The 10-year treasury yield also hit its highest level this year on the 8th November when it reached 3.24%. This was significant as it reflects a drop-in investor confidence and points to higher interest rates. This shows that investors are moving into bonds, which are considered safe assets. Movements from the 10-year treasury yield are heavily scrutinised against historical patterns as they enable investors to compare historical rates with ones they see today.

The bear issues

Christopher Gannatti, head of research at WisdomTree, explains that in 2017 there was truly no downturn and the VIX was at its lowest for years.

“By definition we are not in a bear market yet because that requires markets falling 20% from the high point; at the moment we are 8% from the last high….At this point you want to be looking at your strategy and whether it’s the right one for the way you think the market will move. For example, including defensive stocks or dividend paying ETFs is one possibility that could help reduce any losses, similarly a fixed income strategy is another option.”

There are many ways to access defensive strategies, for example, consumer stocks come in ETFs, index trackers, individual stocks, while dividend paying (or income) stocks can be accessed by ETFs, segregated mandates, individual stocks or trackers, among others.

It’s fair to say that ETFs have helped revolutionise investing in the bond markets, their low costs and ability to purchase in low unit size have meant that all investors are now granted access.

Despite this, how ETFs fair in bear markets remains to be seen.

In some cases, ETFs are not always the cheapest option and for those investors who are happy to buy and hold it may make more sense to be in an index tracker, which may not have the same trading capabilities as an ETF, but in many cases is cheaper.

For example, Vanguard’s FTSE 100 ETF costs 0.09%, while its FTSE 100 Index Unit Trust is 0.06

Jack Bogle told CNBC earlier this year that traditional index funds are better than ETFs because they don’t encourage bad market-timing behaviour.

Stacey Ash, director and investment managers at iFunds, also says: “On a like-for-like basis in a downward trending market you want to look at cost and therefore perhaps a low-cost OEIC is preferable to an ETF.”

However, he explains that there are a lot of other factors to consider, such as efficiency using a swap, greater revenue lending out securities. “The market spreads on the ETFs can also get wide, so it may not make sense to use them as a long-term tool – you don’t want to be penalised when selling. There is no clear-cut answer and it does depend on your strategy. Typically, we find that passives (trackers) are used as our core and ETFs are used for tactical trading and exposures.”

This is of course where ETFs shine, they can be a useful active management tool in a downward trending market to make asset allocation moves.

However, even with this there are things to look out for such as trading costs and whether the platform you are using has the ETFs you need access to and this may be the difference between a tracker and an ETF.

Ash says: “Platforms do have a bearing on what products we use, sometimes we are backed into a passive route because a platform won’t have an ETF we want to use.

Gannatti also argues that it almost doesn’t matter which wrapper you use, it’s about what is in it.

So, which way is the market headed?

Gannatti says: “Forced to take a view, I would say that even if we have seen a correction in the US stock markets – the earnings behaviour from firms has been quite strong – and there aren’t enough other indicators to suggest we are heading for a recession, yet.  The downdraft we are feeling at the moment might well be viewed as a potential opportunity as opposed to a signal that a recession is coming.”

However, it might be the months to Christmas that are more telling of which way things are going to go.

Ash adds: “We are seeing that all the short-term trends are now negative, but it’s most likely that the recent sell offs were corrections as opposed to signs of a recession. Instead, the markets feel a bit directionless at the moment, it will be the months between now and Christmas that will be the turning point.”