The best ETF hedges in a rising market

Gold and senior loans can bring more than balance to your portfolio – while also helping it grow

Andrew Willis 24 April, 2019 | 2:00PM

With ongoing uncertainty and an extended bull run, it makes sense to balance an equity approach with something less correlated to market movements. Defensive moves for a late-stage market cycle can involve using other types of equities as a strategic play for stability and income. But defensive equity plays are still tied directly to equity risk.

One way to capital preservation could be through targeted fixed income and tailored gold ETFs. ETFs opened efficient avenues for sophisticated and specific targeting of investment goals, often seen in with equities in strategic beta products. ETFs have also enabled strategic income solutions to emerge that operate at a fraction of the cost of their mutual fund counterparts.

Fixed income ETFs – a senior loan strategy

Senior loans are an alternative to equity that are less correlated to markets and fixed-rate bond markets. They’re a bet on the credit of a company and backed by collateral if it goes bust, and they aren’t exposed to interest rate risk like equities.

“With Senior loans you are taking on credit risk, not interest rate risk like you would in traditional fixed income,” says Karl Cheong, Head of ETFs for First Trust Portfolios Canada which oversees the bronze-medalist First Trust Senior Loan ETF (FSL) (CAD-Hedged). “Senior loans have a negative correlation with the Barclays Agg [Bond Index], mortgages and treasuries. When rates increase, core bonds and treasuries fall, but senior loans tend to benefit.”

The payoff for senior loans can be tied considerable equity risk, cautions Alex Bryan, Director of Passive Strategies Research, North America at Morningstar. They’re not something you’d want to do if you think a recession is coming. He says most senior loans are issues by borrowers below investment grade. When business is good, they repay their debts. “The converse is true during recessions.” He also points out that there is still some correlation to equity risk, noting how the Invesco Senior Loan ETF (BKL) had a 0.71 correlation with the S&P 500 from April 2011 through March 2019.

Cheong contends that corporate fundamentals are healthy and banks that issue loans aren’t over extended like they were in 2007 and 2008. And investors concerned about the sustainability of equity appreciation in this late cycle shouldn’t have to give up gains in their fixed income play.

With the recent yield curve inversion, investors may have gravitated to passive, broad-based fixed income exposures. But Cheong says the cost-benefit analysis of holding the passive aggregate benchmark doesn’t make mathematical sense. You’re looking at a duration of around six years and a yield around 3%– where a lot can happen in today’s volatile markets – and you’re getting little income for the risk taken.

Cheong cites the increasing bond-stock correlations in 2018 as a future potential risk. “Investors need to look very carefully at their fixed-income holdings,” says Cheong, “they may not be acting like a traditional hedge to equity market declines. Overall, we believe senior loans, given their senior secured position in the capital structure, floating interest rate, attractive income and low default rate are well positioned for this part of the economic cycle,” says Cheong.

For another niche for diversification and growth that is an alternative to equities, you could consider gold.

Gold can grow, too

“Gold doesn’t correlate with anything,” says George Milling-Stanley, Vice President and Head of Gold Strategy at State Street Global Advisors. It’s a bet on its status as a capital preserver for the last few thousand years – and its ability to grow.

“If you look at the performance of gold since 1971 [when the link between gold and the dollar was severed – opening up the free market], it’s been appreciating at a compound AGR of 7.5%,” says Milling-Stanley.

The payoff for gold shouldn’t be seen through a potential play against slumping stock prices, however. “The performance of gold is uncorrelated with stocks,” Bryan cautions on this approach, “there’s no rule that says gold goes up when stocks go down. Gold benefits from a weak dollar and inflation (or an increase in inflation expectations), both of which could be triggered by easy monetary policy if you want to make that play.” But in the meantime, Bryan contends it’s hard to value and doesn’t yield anything, which can make it speculative.

Kristoffer Inton, equity analyst at Morningstar also notes that a rise in gold prices from rising inflation is more of a store of value approach than a growth approach. He finds many factors to be a potential risk but feels that a combination of cultural importance and higher incomes in China and India should lead to more gold purchases. He adds that in India, currency instability and a lack of investment alternatives can also drive the demand for gold.

This demand keeps this asset highly liquid, an important aspect for wealth preservers.

“Gold as a source of return is a byproduct of the positive correlation that exists between economic growth and gold demand in the form of jewelry, technology, and long-term savings,” says Juan Carlos Artigas, Director of Investment Research at World Gold Council, adding that gold is scarce, and mine production has for many years not been enough to satisfy all demand, which has lead to recycling of the precious metal.

Milling-Stanley says more than a $100 billion US worth of physical gold changes hands over the counter every month. Easier-to-hold gold ETFs already top $100 billion US in market cap, with State Street’s SPDR Gold Shares (GLD) ETF holding the largest AUM at over $30b. This approach to holding gold is highly efficient with fees of 0.40%, considering the logistics required to store and secure gold, in additional to appraisal costs, says Milling-Stanley.

A word of caution

A recurring commonality between both senior loans and gold is the element of uncertainty that remains. Investors should be aware that both a hedge with ‘senior’ loans and the ‘gold’ standard is not without risk, and the time span of the investor’s allocation plays a big part.

Recessions aren’t the right time to get into senior loans. Gold’s complex set of growth drivers mean you could be waiting for gains or face unexpected short-term losses from an increasingly complex set of factors.

Investors with a shorter-term time horizon and absolute adversity to risk should look at other options.

About Author

Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.