What is an ETF?
An ETF is an exchange traded fund, which is a fund that tracks indexes like the S&P 500 and Dow Jones. When you buy shares in an ETF, you are buying shares in a portfolio that tracks an underlying index.
It is important to remember is that it is not possible to invest directly in an index. The easiest and quickest way to do this is by investing in ETFs.
Over the last ten years, ETFs have grown in popularity. In fact, financial firms have been issuing so many of them that it is not easy for the retail client to make a careful selection.
ETFs are divided into categories and subcategories, and their increase in flexibility has brought with it an increase in complexity.
In this article, I have done the hard work for you by selecting a very good strategy for ETFs to invest in, And if you keep visiting this blog, I will publish many others in the future.
My choice fell on smart beta ETFs. If you want to know more about these, just read my previous article.
As a benchmark for the following strategy, I have used the famous iShares Core S&P 500 that we have all had at least once in our portfolios. It just replicates the S&P 500 by accumulating dividends.
iShares Edge MSCI World Minimum Volatility
It tracks the MSCI World Minimum Volatility.
It has physical replication with optimized sampling.This method of approximation selects only some of the securities that have the greatest influence on the index’s performance. As a result, commissions are lower than what would have been achieved using the normal physical replication method where all the components are bought in order to replicate the index.
It can deviate from the index, but this is not a major issue. In this example, my goal is to invest in a portfolio that has some characteristicsof the selected index, not to replicate it perfectly.
It reinvests dividends, and the net assets of the fund are $4 billion USD.
By investing in the less volatile companies from a basket of blue chips, we cannot expect great returns. Indeed, in three years, it did just29%, while the benchmark did 46%. Making more money by risking less is usually not possible.
I still prefer this strategy over the benchmark because the risk-adjusted return over the last three years has been 1.66 vs 0.64for the iShares Core S&P 500.This means that for every unit of risk, the return has been much better.
By investing in the low-volatility index over the last five years, you would have an annualized volatility of 8% vs 15% for the vanilla one, and the return would have been just slightly lower: 58% vs 66%.
This is a two-words investment strategy: buy it.
Of course, you need to know when to enter, but that is ultimately your choice. By selecting this ETF, you would have done better in terms of risk than if you had bought any vanilla ETF on the S&P 500.
Because I am talking about investment and not trading, entry timing also depends on factors that are not under your control, such as the moment when you have saved enough money to make an investment.
This is why an investment strategy is always a function of your personal life situation and cannot be defined as if it was a trading strategy.
High-return and low-risk strategies
If 58% in five years was not enough, you could have used leverage to buy more MSCI World Minimum Volatility until the absolute risk was the same as the benchmark. Then you would have returned more.
With $10,000 USD to invest, you could have invested in the benchmark at a volatility of 12% a year, or you could have bought in leverage, $17,000 USD of MSCI World Minimum Volatility while risking the same (its risk with no leverage is 7.5%). By doing that, the return would have been 98% in five years instead of 66% with the benchmark.
You can now argue that five years ago, we did not have the data we are now using to come to that conclusion. But the relationship between risk and return for these ETFs have been pretty stable over the years. Therefore, it should also hold in the future, and we would have arrived at the same conclusion if we had used data from 2012 to 2015 to invest in it from 2016 until today.
If you want more return or less risk, the World Minimum Volatility ETF represents a superior choice over the vanilla one.
Fees are slightly higher at 0.3%to be a passive ETF with a cheap replication method, while many vanilla ETFs are at 0.1% or less. But transaction costs have little influence on the investment strategy.
How to overcome high-volatility markets
I am a mainly a trader, but as I wrote in a previous article, every trader should know how to invest his savings.
The problem that you’ll have when making any investment in stocks is that, when volatility is very high, like in 2008, diversification won’t save you.
The more violent the market fall, the greater the correlation across every financial asset.
In other words, gold, fixed-income and anything else you can think of will fall with your portfolio instead of hedging it.
The only sensible way to hedge portfolio against fat tail events and high-volatility regimes is by using options.
Warning: There is a risk of loss in trading. It is the nature of commodity and securities trading that where there is the opportunity for profit, there is also the risk of loss. Commodity trading involves a certain degree of risk, and may not be suitable for all investors. Derivative transactions, including futures and forex, are complex and carry the risk of substantial losses. Past performance is not necessarily indicative of future results. Please read additional risk matters on our web site www.londontradinginstitute.com
It is important you understand all the risks involved with trading, and you should only trade with risk capital. This communication is intended for the sole use of the intended recipient and is for informational purposes only. It is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument.