By Lance Humphrey, CFA, Portfolio Manager of Global Multi-Assets
Much of the media coverage of last week’s stock market drop has focused on a pair of exchange-traded products that allowed investors to bet against stock volatility. Both of these ETPs quickly lost nearly all of their value when market volatility spiked — one of them will have to close, while the other is a fraction of its former size.
The news stories fed into a negative narrative about ETFs that some investors have long promoted. Basically, this viewpoint is that ETFs, which are a fast-growing part of the investment world, may do well when markets are climbing, but when times get tough, their structure could cause them to be a driver of market volatility.
Last week was perhaps the biggest test of that theory to date, and our observation is that ETFs on the whole behaved essentially the way they were designed to behave. The decline of the largest ETFs benchmarked to the Standard & Poor’s 500, the Nasdaq 100 and the Dow Jones Industrials¹ nearly matched the decline of those respective indexes last week, even in the face of significant selling by investors in those ETFs.
Even the inverse volatility products mentioned earlier largely did what they were supposed to do when volatility suddenly rose nearly 100% — these products fell by close to 100%.
In general, we are proponents of ETFs — we use them alongside traditional mutual funds and individual securities to get diversification in a number of our asset-allocation portfolios. We like that we are able to get tax-efficient exposure to desirable asset classes at a relatively low cost, which can assist in our tactical asset allocation and risk management processes.
We are, however, wary of the risks attached to some of what we consider exotic ETFs in the marketplace. This would include products betting on or against volatility, as well as ETFs that offer two or three times the leverage on or against a specific index. In the case of the former, investors may be subject to sudden price swings, as we saw last week. In the case of the latter, the effect of compounding could lead to ETF performance that varies greatly from the performance of the underlying index.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are suited for you based upon your individual goals, objectives, risk tolerance and time horizon.
¹The index consists of the 30 largest publicly traded firms in the United States.
This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.
Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
Asset allocation does not protect against a loss or guarantee that an investor’s goal will be met.
Exchange-Traded Funds (ETFs) are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost systems.
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Standard & Poor’s 500 Index and S&P are registered trademarks. The S&P 500 Index is an unmanaged index of 500 stocks. The S&P 500 focuses on the large cap segment of the market, covering 75% of the U.S. equities market. S&P 500 is a trademark of the McGraw-Hill Companies, Inc.
NASDAQ-100®, NASDAQ-100 Index®, and NASDAQ®, are trade or service marks of The NADAQ Stock Market, Inc. (which with its affiliates are the “Corporations”) and have been licensed for our use. THE CORPORATIONS MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO THE USAA NASDAQ-100 Index Fund. The Fund is not sponsored, sold or promoted by The NADAQ Stock Market, Inc. and The NADAQ Stock Market, Inc. makes no representation regarding the advisability of investing in the Fund. • Index products incur fees and expenses and may not always be invested in all securities of the index the Fund attempts to mirror. It is not possible to invest directly in an index.
The NASDAQ-100 Index is a capitalization-weighted index composed of 100 of the largest nonfinancial securities listed on the Nasdaq Stock Market. Sector funds are non-diversified and may be more volatile than other funds. A non-diversified fund may invest a greater percentage of its assets in a single issuer or a limited number of issuers. Such a focused investment strategy may increase the volatility of the fund’s investment results because this fund may be more susceptible to the risks associated with a single issuer, or economic, political, or regulatory event than a diversified fund.
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