The puck stops here: Use ETFs as a portfolio’s last line of defence

This is the third article in a series.

Portfolio managers can learn from hockey. Previously, we’ve discussed balanced and aggressive attacks for neutral and positive markets, and the neutral-zone trap as to defense defend against a potentially hostile markets. This month, we address the “chip and chase” and the last line of defence, goaltending.

Low-volatility chip and chase

Playing the puck deep into the opponent’s end and quickly pursuing it involves risk. Giving up control may award your opponent with possession. Some risk is mitigated by the fact that it happens positioning so deep in the opponents’ end. A low-volatility market is perfect for taking such risks. But you need good speed and solid fore-checking.

Gordie Howe and Bobby Hull rarely employed this approach; Jagr, Malkin, and Crosby use it infrequently. However, the Canuck’s line of Alex Burrows and the Sedin brothers [DASH] who don’t mind banging bodies in the corners [DASH] are extremely effective in frustrating and wearing down opponents with their “cycle”-type offence.

The “cycle” approach is like identifying uncorrelated asset classes [DASH] some will do well, while others won’t. Equities, commodities and bonds are three good examples (see, “Equities, commodities, bonds,” this page). Someone should always be open for a shot or a pass.

Yet asset correlations aren’t static. The relationship between stocks, bonds and commodities will change over time and must be watched carefully, particularly when volatility is high or rising. Other aspects of the chip and chase are similar to the 2-1-2 structure described in the first article of this series (see, “ETF tips from the rink,” advisor.ca/etf-hockey).

Last line of defence

Recent market volatility has shown that cash or short-term fixed-income instruments are occasionally the only safe havens. Diversification simply fails to control risk during periods of high volatility. In a low-interest-rate environment, this is an even more painful realization. If investing time horizons are long [DASH] 10 years or more [DASH] trying to rebalance to a fixed mix may pay off. For some individual investors, however, there is no guarantee asset-class returns will approach the long-term averages that underpin their financial plans in time to skate them back on side. Sometimes, we must rely on that last line of defence [DASH] goaltending.

Goaltending has evolved, as have the choices in short-term fixed-income offerings. Today, most goalies use the “butterfly” technique. They spend lots of time on their knees with legs splayed outwards to maximize ice-level net coverage. Glove, blocker and stick skills deflect everything else, making superior mobility and quickness important. Glenn Hall and Tony Esposito were early proponents. One risk is the so-called “five hole” between the legs. Like credit or liquidity risk for a bond fund, this is not normally a concern, but occasionally causes gnashing of a coach’s teeth.

So how should we deal with money-market funds in low-interest-rate environments? Forget about them. iShares Premium Money Market ETF (CMR) has an MER of 0.27%, compared to major banks’ money-market mutual-fund MERs of about 0.55%, a bargain if your client has $25,000 or more to park.

However, it is difficult to justify with annual returns of around 1.0%. Like a vulnerable goaltender on the blocker side (the Leafs’ Jonas Gustavsson) or on the glove side (James Reimer or Ben Scrivens), low net-of-fee returns from money-market funds suggest looking elsewhere for protection and yield income.

Marty Brodeur, Tim Thomas and Dominik Hasek have successfully used hybrid goaltending styles. Likewise, other ETF vehicles can be used effectively as money market substitutes but with more risk. Short-term fixed-income ETFs are the obvious first choice, but short-term laddered-fixed-income government and corporate ETFs, and short-target-maturity ETFs, give advisors even more flexibility (see “ETF vehicles,” this page).

In low-volatility environments, diversification helps most. Consider equities, commodities and bonds. When volatility increases, stronger defence may be needed. Short-term fixed-income choices, other than money-market, are available to enhance yield; but watch out as costs become more important considerations. AER

Table 1

HED: Equities, commodities, bonds

Broad-based equities	Broad-based commodities	Broad-based Canadian bonds
iShares MSCI World (XWD)	iShares Broad Commodity (CBR)	Vanguard Canadian Aggregate Bond ( VAB)
Vanguard MSCI US Broad Market (VUS)		iShares DEX Universe (XBB)
iShares S&P/TSX Capped Comp. (XIC)		BMO Aggregate Bond (ZAG)

Table 2

HED: ETF vehicles

Short-term fixed income	Symbol	Mgt. Expenses
Vanguard Canadian Short-Term Bond	VSB	0.15%
BMO Short term Federal Bond	ZFS	0.22%
iShares DEX Short-Term Bond	XSB	0.25%
iShares DEX Short-Term Corporate	XSH	0.25%
BMO Short Provincial Bond	ZPS	0.27%
BMO Short Corporate Bond	ZCS	0.32%

Short-term laddered	Symbol	Mgt. Expenses
iShares 1-to-5 yr Laddered Government	CLF	0.17%
Powershares 1-to-5 yr Laddered Investment Grade Corporate	PSB	0.25%
iShares 1-to-5 yr Laddered Corporate	CBO	0.28%

Short-term target maturity	Symbol	Mgt. Expenses
BMO 2013 Corporate Bond Target Maturity	ZXA	0.30%
RBC 2013 Target Corporate Bond	RQA	0.30%
RBC 2014 Target Corporate Bond	RQB	0.30%