Etfs In A Down Economy: Invest Or Avoid?

Exchange-traded funds (ETFs) are a great way to diversify your portfolio and can be used to prepare for a recession. They are a collection of stocks, bonds, commodities, or a combination of these, and each share you purchase gives you a slice of all of them. This makes them a safer option than investing in individual stocks.

ETFs are also a good option for beginners as they are relatively inexpensive and tend to be less risky. They are also simple to invest in and have lower expense ratios than mutual funds.

However, there are some disadvantages to ETFs. They may be subject to commission fees, and there is a risk that the ETF will close, forcing investors to sell sooner than intended and potentially at a loss.

Overall, ETFs can be a strategic way to position your portfolio during a down economy, but it is important to carefully consider the advantages and disadvantages before investing.

The benefits of investing in ETFs

Exchange-traded funds (ETFs) are a popular investment vehicle for both active and passive investors. They are similar to mutual funds but trade like stocks, providing investors with a low-cost, diversified portfolio. Here are some advantages of investing in ETFs, especially during a down economy:

Diversification:

ETFs offer instant diversification by providing exposure to a basket of stocks or bonds from various sectors, industries, or countries. This diversification can limit your risk, as poor performance in a few stocks will not drastically affect your overall portfolio.

Low Cost and Tax Efficiency:

ETFs are known for having low expense ratios compared to actively managed funds. They also tend to be more tax-efficient, as they realize fewer capital gains, and dividends are automatically reinvested. Additionally, many online brokers offer zero-commission trading in ETFs.

Flexibility and Liquidity:

ETFs trade like stocks during market hours, allowing investors to buy and sell throughout the day. They also provide flexibility in terms of investment options, such as margin trading and short selling. The most popular ETFs have high liquidity, ensuring a constant pool of buyers and sellers.

Access to Various Asset Classes:

ETFs give investors access not only to equities but also to other asset classes such as bonds, currencies, and commodities. This allows for further diversification and the ability to invest in specific sectors or industries.

Strong Performance During Down Economies:

During economic downturns, certain sectors like healthcare, information technology, consumer staples, and utilities tend to remain stable or even thrive. ETFs focused on these sectors can provide downside protection and help mitigate risk during turbulent economic times.

Strong Track Record:

ETFs that track broad market indices, such as the S&P 500, have a strong track record of pulling through volatile periods and economic downturns. This can provide investors with peace of mind, knowing that their investments are likely to recover even in challenging economic conditions.

The risks of investing in ETFs

Like all investments, Exchange-Traded Funds (ETFs) come with a number of risks that you should be aware of before investing. Here are some of the key risks to consider:

Underlying Asset Risk

ETFs invest in a range of underlying assets, such as stocks, bonds, commodities, and currencies. As a result, they are exposed to the same risks as these underlying assets. For example, a bond ETF may be exposed to credit, default, and interest rate risks. It's important to carefully review the prospectus of an ETF to understand the specific risks associated with its underlying investments.

Market Risk

The value of the underlying assets of an ETF may fluctuate, and the ETF's value will move accordingly. Broad market index-tracking ETFs, such as those following the S&P 500, are generally less volatile than those tracking specific industries or sectors. However, it's crucial to understand the underlying risks associated with the particular index or sector an ETF is tracking.

Liquidity Risk

Liquidity refers to how easily an investment can be converted into cash without impacting its market price. ETFs with low liquidity may have wider bid-ask spreads, leading to higher trading costs and difficulties in buying or selling. To assess the liquidity of an ETF, consider factors such as average bid/ask spreads, average trading volume, and how closely the ETF trades to its net asset value.

Tracking Error Risk

ETFs that track an index may not always deliver the exact same returns as the index due to factors such as management fees, tax treatment, and dividend timing. This is known as tracking error risk. Physical replication ETFs tend to have larger tracking errors than synthetic replication ETFs, which use financial engineering to replicate the returns of an index.

Counterparty Risk

Counterparty risk arises in securities lending and synthetic replication. In securities lending, this risk occurs when holdings are lent to another investor for a short period. In synthetic replication, counterparty risk is associated with swaps used to track indices. While collateral requirements can minimize this risk, it's still important to consider, especially in the case of exchange-traded notes (ETNs), which are unsecured debt notes issued by banks.

Tax Risk

While ETFs are generally considered tax-efficient, this doesn't apply across the board. Actively managed ETFs, international ETFs, those using derivatives, and commodity or currency ETFs may be taxed differently. It's important to understand the tax treatment of a particular ETF before investing.

Closure Risk

On average, about 100 ETFs close each year, and when this happens, investors may incur capital gains taxes, transaction costs, and other expenses. It's advisable to sell an ETF as soon as its issuer announces its closure to minimize potential losses.

Trading Risk

Trading an ETF incurs costs such as commissions, sales charges, market impact costs, and direct trading costs like the bid-ask spread and management expense ratio. These costs can add up, especially for actively traded ETFs, and impact overall investment returns.

Composition Risk

Even ETFs tracking the same sector or index may have different underlying holdings, leading to performance differences. It's important to review the specific holdings and weightings of an ETF to understand its composition and the associated risks.

Hype Risk

With the growing popularity of ETFs, there is a risk of getting caught up in the hype and chasing the latest trends. It's important to stick to your investment strategy and carefully evaluate each ETF's methodology and documentation rather than following the crowd.

How to choose the right ETFs

Exchange-traded funds (ETFs) are a low-cost strategy to build an optimal portfolio. As of November 2023, there were over 3,000 ETFs listed on U.S. exchanges, with combined assets exceeding $7.6 trillion.

• Investment Objectives: Understand your investment goals and risk tolerance. Are you looking to diversify your portfolio, invest in specific sectors or industries, or find a lower-cost alternative to mutual funds? Knowing your objectives will help guide your ETF selection.
• Time Horizon: Consider how soon you will need the money you plan to invest. Generally, it is advised not to invest money that you will need within the next five years.
• Asset Class: ETFs can hold various asset types, including stocks, bonds, commodities, currencies, and alternative investments. Choose an ETF that aligns with your desired asset class exposure.
• Geography: Determine the desired geographic focus of the ETF. Some ETFs invest globally, while others focus on specific regions, countries, or states.
• Segment: Consider the size of the companies (large, mid, small, or micro-cap) or the specific industry sectors (technology, energy, financials, etc.) you want to target.
• Investment Style: ETFs can align with specific investment strategies, such as values-based investing, growth or value-based investing, or active fund management.
• Holdings: ETFs are typically based on indexes, and you can review their holdings to ensure they align with your desired investments.
• Expenses: Compare expense ratios among ETFs. This represents the annual cost of investing in the fund as a percentage of assets managed. Some ETFs may have higher fees, impacting your overall returns.
• Performance: While past performance doesn't guarantee future results, it's important to understand how the ETF has performed relative to its benchmark.
• Liquidity and Closure Risk: Assess the ETF's liquidity by evaluating its trading volume and bid-ask spread. Also, consider the potential risk of the ETF closing down due to insufficient assets.
• Issuer: Evaluate the reputation and track record of the company offering and managing the ETF.
• Ratings: Many ETFs receive ratings from independent firms that analyse their cost, efficiency, and management relative to their peers.

Using these criteria, you can narrow down the vast array of ETF options to those that best fit your investment objectives and risk profile.

How to invest in ETFs

• Open a brokerage account: You will need a brokerage account to begin buying and selling securities like ETFs. If you don't already have one, you can open one online with many brokers offering accounts with no minimum balance requirements, transaction fees, or inactivity fees.
• Find and compare ETFs: Use screening tools provided by brokers to narrow down the thousands of ETFs available based on criteria such as asset type, industry, trading performance, fund provider, etc. Look for ETFs with low expense ratios, no commissions, strong historical performance, and a diverse range of holdings.
• Buy your chosen ETF: Navigate to the "trading" section of your brokerage account and purchase the ETF using its ticker symbol, specifying the number of shares you wish to buy. You can use different order types, such as market orders, limit orders, stop orders, or stop-limit orders, depending on your preferences.
• Monitor your investment: Congratulations! You've bought your first ETF. While there's no need to constantly check its performance, you can access that information through your brokerage account or by searching for the ticker symbol online.

Additional Considerations:

• Diversification: ETFs are a great way to diversify your portfolio as they offer exposure to a variety of assets, sectors, and markets. This helps to reduce risk, as poor performance in one area may be offset by gains in others.
• Costs and Fees: While ETFs are known for having low fees, consider all potential costs, including expense ratios, commissions, and broker fees. These can eat into your returns over time.
• Risk Management: ETFs can provide risk management through diversification, but it's important to understand the underlying risks associated with the specific ETF and its holdings. Some ETFs, such as those focused on a single industry, may carry more risk.
• Robo-advisors: If you'd prefer a more hands-off approach, consider using a robo-advisor, which will build and manage an investment portfolio for you, often using ETFs. These services typically charge a low annual fee and can be a good option for beginners.

How to hedge against a market crash with ETFs

Exchange-traded funds (ETFs) are a useful tool for retail investors to hedge against a market crash. ETFs are passively managed and include a basket of stocks. They are a great investment vehicle for small and large investors alike, as they provide low-cost access to a variety of asset classes, industry sectors, and international markets.

Focus on defensive securities

ETFs that invest in defensive equity sectors such as consumer staples, healthcare, and utilities can help protect against sharp drawdowns, corrections, and crashes. These sectors tend to be resilient during market downturns as they include products that are always in demand, such as soap, toilet paper, and healthcare services. Examples of defensive ETFs include:

• The Consumer Staples Select Sector SPDR ETF (XLP)
• The iShares US Healthcare Providers (IHF)
• The Vanguard Health Care Index Fund ETF Shares (VHT)
• The Utilities Select Sector SPDR ETF (XLU)

Invest in non-correlated assets

ETFs that specialize in non-correlated assets such as bonds, precious metals, and commodities can also stabilize a portfolio during a crash. Historically, gold has been a popular hedge against stock market crashes, inflation, and economic or geopolitical turmoil. Examples of non-correlated ETFs include:

• Vanguard Short-Term Bond Index Fund ETF Shares (BSV)
• SPDR Gold Shares (GLD)
• Invesco DB Commodity Index Tracking Fund (DBC)

Choose sector-based funds

ETFs that focus on sectors that weather economic downturns can also be a good choice. In addition to healthcare, consumer staples, and utilities, information technology is another sector that tends to be stable during recessions. Examples of sector-based ETFs include:

• The Invesco Food & Beverage ETF (PBJ)
• The Vanguard Consumer Staples ETF (VDC)
• IShares Residential and Multisector Real Estate ETF (REZ)

Consider inverse ETFs

Inverse ETFs are designed to go up when the stock market goes down. For example, the Direxion Daily S&P 500 Bear 3X Shares (SPXS) seeks to return three times the inverse performance of the S&P 500 on a daily basis. However, investors should be aware that these ETFs are highly aggressive and can be a significant liability when the market turns around.

While ETFs can be a useful tool for hedging against a market crash, it is important to remember that no investment is completely risk-free. It is always a good idea to monitor your portfolio and consult a financial professional for guidance.

Frequently asked questions