An investment should generate good financial returns — it is the Holy Grail of the financial world. Volatility is a constant feature of the stock and bond markets and investors have always been grappling with strategies to cope with the capriciousness of the markets. When traditional investments start taking a beating, the quest begins for newer modes of investment and investors increasingly turn to alternative investment strategies to mitigate risks and assure good returns. The urgency for exploring such strategies increased over the past decade ever since the aftershock of the Global Financial Crisis (GFC), which threw the markets into a tizzy.
ETF — the new kid on the block
Exchange Traded Funds (ETFs) are the new exciting investment alternative that has caught investor attention. An ETF is a pooled investment vehicle, like a mutual fund. The pool can comprise different asset classes such as stocks, bonds, commodities, or other assets. However, unlike mutual funds that trade at a single price based on Net Asset Value (NAV), ETFs trade at a market-determined price on an exchange throughout the day, just like shares, and are thus called exchange-traded funds. Furthermore, investors buy or sell ETFs through brokers unlike mutual funds, which transact directly with the investors.
ETFs have emerged as one of the most popular investment alternatives and with good reason. Valuations of almost all financial assets are high. Coupled with this, volatility has been the dominating feature of the market in recent times. Volatility caused by geopolitical events, economic surprises, and investor sentiment can erode the value of a portfolio and it would take years to recover from a market downturn. One of the worst fears of many investors is that a downturn may hit them at a time when they are particularly vulnerable—such as when they are about to retire.
ETFs can help overcome market volatility
ETFs can help alleviate the impact of market volatility through diversification. Let us take the example of what happened, after the GFC, to investors who were overweight on financials. Such investors had to endure a much higher downside than investors who were diversified across multiple sectors. Low-cost, tax-efficient ETFs are the most efficient way for investors to achieve this objective easily. Further, investors can hedge their positions and profit from a falling market with short-term investment strategies such as inverse ETFs. Thus, with ETFs, investors can make a profit in a bull as well as a bear market. Some believe that ETFs not only help in overcoming volatility, but they could possibly be the reason for reducing volatility in the markets.
Yet another factor that makes ETFs a good choice is the protection they offer through ‘correlation diversification’. Correlation refers to the degree of relationship in the movement of prices of the assets in a portfolio. Given that a less correlated pair decreases overall risk, a portfolio based on stock correlation strategy contains the fall in the stock and the overall portfolio. In a scenario of increasing global correlation and rapidly changing market conditions, sector diversifications through ETFs is considered an effective investment strategy. Further, the intraday liquidity provided by ETFs allows investors to change strategies rapidly or hedge the risk profile of the portfolio intraday. ETFs not only provide investors with higher diversification options, but they also provide transparent exposure to diverse asset classes. Furthermore, they are a low-fee investment vehicle. For average investors who are interested in seeing their investments grow alongside the economy, an investment vehicle such as an ETF is certainly a boon.
