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%

The neutral-zone trap: Positioning  ETFs to counteract volatile markets 

 

This is the second in a series. Next month: the chip and chase for rotational markets and goaltending styles for the last line of defense. 

In the previous issue, we discussed the need for a balanced and aggressive attack during neutral and positive markets. This month, we examine the neutral-zone trap for protecting against a potentially hostile market.

Setting the trap

When the opposition controls the puck in its own end, the neutral-zone trap can be used to counteract the rush before it develops into a major threat. In recent years, capital markets have appeared unpredictable for extended periods. They seem to react to one crisis after another, while dominating investors by keeping them off balance. Current events, rather than longer-term disciplines, seem to be most important.

Both Jacques Lemaire (Devils and Wild) and Guy Carbonneau (Canadiens) have leveraged the trap effectively to thwart attacks. Randy Carlyle, too, used it to coach Anaheim to the 2007 Stanley Cup (Leaf fans can dream on!). It was so effective that the NHL moved to strictly enforce obstruction rules, while allowing the two-line pass to make the trap less useful (see “Two-line passes,” this page).

Meant to disrupt momentum, players space themselves in the neutral zone in a 1-2-2 formation with one fore-checker looking to take advantage of a turnover. In a portfolio, this checker can be an aggressive equity fund like a small-cap or an emerging-markets fund that will respond quickly if the market trend suddenly turns positive (see “Fore-checker: aggressive small cap and emerging markets,” this page).

Two forwards block any attack lanes along the boards forcing the play toward the centre. These players must be ready to strike if they create a turnover. Broadly-based equity positions would serve this two-way function well, perhaps one domestic like XIC or VCE and one global/international like XWD, VEF or ZIN. (See “Forward: Canadian Equity,” and “Forward: global/international equity,” this page).

The two players on defence delay attackers while their forwards reposition to defend if no turnover can be forced. In a portfolio, these positions will depend on the risk tolerance of the investor. In a low-interest-rate environment, some return potential is important, but defence is the primary objective. High-yield or convertible bonds are risky, but offer better upside. Pairing with a defensive offset, like a short term/duration or laddered ETF, would provide the right mix of defence with offensive potential.  (See “Defence: high yield and convertible bonds,” and “Defence: short-term or laddered bonds,” this page).

Mounting a defence in the face of a powerful market onslaught can be a challenge. When volatility picks up, there are few tactics [DASH] other than cash or high-quality short-term bonds [DASH] that can preserve capital. Whether or not you have a sense about the kind of market threats ahead, ETFs can be useful players in positioning you correctly to defend and attack. AER

Thanks again to Dr. Jim Sugiyama, hockey savant, for his input.   

NOTE TO ART: This will likely be two pages

BOX

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SIDEBAR 1

HED: Two-line passes

SIDEBAR 2

HED: Fore-checker: aggressive small cap and emerging market funds

Exchange traded fund	Symbol	Mgt. Expenses
iShares Russell 2000 Index Fund (CAD hedged)	XSU	0.35%
Vanguard MSCI Emerging Markets Index	VEE	0.49%
iShares S&P/TSX SmallCap Index Fund	XCS	0.55%
BMO Emerging Markets Equity Index	ZEM	0.57%
Claymore BRIC ETF	CBQ	0.67%
Claymore Broad Emerging Markets ETF	CWO	0.71%
iShares MSCI Emerging Markets	XEM	0.82%

SIDEBAR 3

HED: Forward: Canadian Equity (broad lowest cost)

Exchange traded fund	Symbol	Mgt. Expenses
Horizons BetaPro S&P/TSX60 Index (swap)	HXT	0.07%
Vanguard MSCI Canada Index	VCE	0.09%
BMO Dow Jones Titans 60 Index	ZCN	0.16%
iShares S&P/TSX 60 Index	XIU	0.17%
iShares S&P/TSX Capped Composite Index	XIC	0.25%

SIDEBAR 4

HED: Forward: Global/International equity

Exchange traded fund	Symbol	Mgt. Expenses
Vanguard MSCI EAFE Index (CAD hedged)	VEF	0.37%
iShares MSCI World Index	XWD	0.45%
BMO International Equity Hedged to CAD Index	ZIN	0.50%

SIDEBAR 5

HED: Defence: High yield and convertible bonds

Exchange traded fund	Symbol	Mgt. Expenses
Claymore Advantaged Convertible Bond	CVD	0.45%
iShares DEX HYBrid Bond Index	XHB	0.45%
Claymore Advantaged High Yield Bond	CHB	0.56%
iShares U.S. High Yield Index	XHY	0.60%
XTF Canadian Convertible Liquid Universe	CXF	0.65%
Powershares Fundamental High Yield Corporate Bond	PFH	0.65%
BMO High Yield Corporate bond	ZHY	0.69%

SIDEBAR 6

HED: Defence: Short term or laddered bonds

Exchange traded fund	Symbol	Mgt. Expenses
Claymore 1-5 year Laddered Government Bond	CLF	0.17%
BMO Short Federal Bond Index	ZFS	0.22%
iShares DEX Short Term Corporate Universe + Maple	XSH	0.25%
Powershares 1-5 year laddered Inv. Grade Corp. Bond	PSB	0.25%
iShares DEX Short Term Bond Index	XSB	0.25%
Claymore 1-5 Year Laddered Corporate Bond	CBO	0.28%
BMO 2013 Corporate Bond Target Maturity	ZXA	0.30%
RBC Target 2013 Corporate Bond	ROA	0.30%
BMO Short Term Bond	ZCS	0.32%