4 Ways to Play Defense Without ‘Going for the Money’ | Financial advisors

Cash – whether in the form of money market accounts, bank deposits or certificates of deposit – has been the standard response from financial advisers whenever market problems have arisen.

While cash and its equivalents are still very much alive as alternatives to a declining stock portfolio, 2022 is completely unlike any other market we’ve seen. Unless you were an active, well-heeled investor in the 1970s. For the remaining 99.99% of us (just an estimate!), the rules for navigating market volatility have changed. And financial advisors need to move with them, fast.

The bears are back in town

It’s not football season, so you know it has nothing to do with the Chicago team that goes by that name. Bears are bear markets. And it turns out there are two of them when you normally only see one at a time. The stock market is not technically in “bearish territory” if you look at the S&P 500, the Dow or the Nasdaq. But a quick peek below the surface and steadily deteriorating mega-cap stock conditions are a sign that the proverbial wall of worry is getting steeper.

In the bond market, things are anything but business as usual. For more than 40 years, equity investors have been able to rely on bonds to play the role of “anti-equity” when the stock market has gone into bear territory. This time, not so much. With rates starting at such low levels when the stock market peaked, you can’t just get returns of 6% on corporate bonds or 3% on money market funds, like in the past. Instead, you got more than a little innovation. However, as they say, it’s for a good cause: that of your customers and yours. To help get you started on your journey to modernizing the way you play defense in your portfolios, instead of just resorting to low-yielding cash accounts, here are four alternatives to consider.

  • The obvious but not so obvious.
  • Floating rate bond ETFs.
  • Arbitration: fancy word, simple idea.
  • Long-short funds.
  • The take-out sale.

The obvious but not so obvious

When the stock market goes down, what goes up? Common answers to this question are bonds, gold, and perhaps silver. But these depend on other factors that could interfere with their defensive qualities. Bonds are going through this right now, as concerns about Federal Reserve rate hikes later this year are pushing rates higher. This, in turn, causes bond prices to fall, so the “cash alternative” feature of bonds does not work as it normally does.

Advisors tend to overthink it. What goes up when the stock market goes down? Investments built to move against the direction of the stock market. These come in many forms these days – from inverse exchange-traded funds, or ETFs, like the ProShares Short S&P 500 (SH), which trades opposite the S&P 500 Index – to the more volatile ETFs that own the call of the CBOE Volatility Index (VIX). options. VIX, the most common measure of anticipated stock market volatility, has traditionally risen in price when markets get jittery and prices fall. iPath B S&P 500 VIX Short-Term Futures ETN (VXX) is an example of such an ETF.

Floating Rate Bond ETFs

Unlike your seat on an airplane, you cannot use them as a flotation device. But with these bond ETFs, you can increase your income return relative to what you get with stagnant cash, if interest rates rise. Be careful here, though. If you own an ETF like the iShares Floating Rate Bond ETF (FLOT), which holds US Treasury bonds, the credit risk is no higher than that of the US government. If you venture into floating rate corporate bonds – such as through the VanEck Vectors Investment Grade Floating Rate ETF (FLTR) – you are accepting greater credit risk.

Arbitration: fancy word, simple idea

Cash offers very little (or no) return, but you know what your return is. There are a variety of methods to try to achieve a moderate positive return above cash, while reducing the expected volatility seen in the broader stock and bond markets. Arbitrage simply involves combining two investments, a long and a short, with the aim of profiting from the difference in their returns. So if you think the Dow Jones Industrial Average will outperform the Nasdaq 100 Index in the coming weeks or months, you can buy an ETF like the SPDR Dow Jones Industrial Average ETF (DIA) to “own” the Dow, and buy an equal or roughly equal amount of ProShares Short QQQ (PSQ), which is an ETF that seeks to offer the opposite performance of the Nasdaq 100. So, if the Dow Jones fell 10% but the Nasdaq fell 15 %, DIA would be down 10%, but Le PSQ would be up 15%. You net a 5% gain on the arbitrage pair.

Arbitrage can also be done within a single ETF. There are listed securities for mergers and acquisitions, such as IQ Merger Arbitrage ETF (MNA) which buys a company being acquired in a transaction while selling short the acquiring company.

Long-Short Funds

If you like the concept of arbitrage but want to leave a little more leeway to make or lose money, while keeping returns within a relatively tight range, there are ETFs that buy and sell different securities according to a theme. An example is the AGFiQ US Market Neutral Anti-Beta Fund (BTAL), which shorts volatile stocks and buys less volatile stocks, with the aim of profiting from the outperformance of one group over the other. Another is the ProShares Long Online/Short Stores ETF (CLIX), which buys retail stocks online, while shorting traditional stocks of brick-and-mortar companies. Here, the ETF is trying to capitalize on the trend of shopping online at the expense of walking to the mall.

With these strategies, you need to do your homework and determine if they make sense for your customers across multiple dimensions. You’ll want to plan how to simply explain these somewhat esoteric investments to clients who may be more accustomed to the standard stock and bond paradigm. You should also make sure you understand how much they can differ from cash, stock and bond returns in a volatile market.

Takeaway meals

Cash interest rates finally take off from zero. That’s the good news. The bad news is that they are now much further behind the rate of inflation, which came in at over 7% annualized in the latest monthly reading. This will not be lost on your clients, as much of the media attention is now devoted to wealth hurdles caused by the rising cost of living. This is perhaps the best reason to consider how far you think outside the box when researching alternatives to cash, telling customers why the reward potential of using them may outweigh the risk.

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