Deep into the darkness peering, long I stood there, wondering, fearing,
Doubting, dreaming dreams no mortal ever dared to dream before.
Edgar Allan Poe – The Raven
With the stock market sitting near all-time highs, often times ETFs that have languished fly under the radar as investors focus on the euphoria of unrealized gains. The natural inclination is to keep pouring new money into stocks that are performing well, which is exactly what recent data suggests has been happening. So far this year investors have added more than $277 billion into stock ETFs and mutual funds. That is the single biggest year of inflows to stock funds since 2000, which suggests that optimism is high despite the risks of a correction.
With Halloween upon us and the end of the year rapidly approaching, I thought it would be prudent to focus in on investment themes that have been persistently frightening all year long. Many of these sectors have been consistently trending downward with no bottom in sight, but when the tide turns they may be ripe for a sharp rebound.
1. What fear? The iPath S&P 500 VIX Short-Term Futures ETN (VXX) is designed to provide access to equity market volatility through CBOE Volatility Index futures. Simply put, this exchange-traded note offers investors the ability to capitalize on the CBOE VIX Index which is a widely recognized measure of fear in the marketplace. Throughout 2013 that fear has largely been replace with greed for stocks, which is why VXX has fallen precipitously.
This ETF is down over 60% year-to-date and most shockingly has attracted over $1 billion in new assets according to Index Universe. Clearly there is still a great deal of demand for institutional investors to hedge their bets using an easy to access ETN such as VXX in their portfolios.
While this fund has fallen out of favor now, it could quickly bounce higher if we see a flight to quality that includes heavy selling pressure from stocks. It can be used as an alternative method of shorting the market in the event that a correction ensues. However, this fund can be volatile and I recommend that novice investors thoroughly research the index methodology before entering a new position and use a tight stop loss to guard against further downside risk.
2. Breaking the Buck. The PowerShares US Dollar Bullish Index (UUP) is one of the most well-known proxies for tracking the US dollar index. This ETF recently hit fresh 2-year lows as a result of continued strengthening in foreign currencies and a commitment to loose monetary policy by the Federal Reserve. A falling greenback can be good for international corporations that derive the majority of their profits from overseas operations. It can also benefit precious metals prices such as gold as investors seek to diversify their exposure away from paper assets.
There is nothing to suggest that the recent trend of a falling dollar will subside any time soon. I am continuing to advocate avoiding this space in favor of more traditional asset classes such as stocks and bonds. Although a breakdown in international markets might send investors fleeing to purchase the dollar as a safer alternative to foreign currencies.
3. Miners are starting to dig in. One of the more unimpressive sectors this year has been gold miners, which are tracked by the MarketVectors Gold Miners ETF (GDX). These stocks have been hit hard by falling gold bullion prices which squeezed profit margins and depressed prices. Despite the fact that GDX has lost more than 42% this year, investors have been undeterred from the chart and have added over $2.3 billion in 2013.
This unrelenting demand is a sign that gold mining stocks may soon regain their former glory. From a technical perspective they are probably in the best shape of this group, having already put in a low this year and may be coiled to spring higher. A combination of rising commodity prices and a falling US dollar will likely help lift this sector higher. However, I am still wary about the volatility associated with mining stocks and consider them suitable for more aggressive investors looking for a value opportunity.
4. Shorting stocks has been painful. The actively managed Ranger Equity Bear ETF (HDGE) has been a tough place to hang out this year as stocks have grinded relentlessly higher. I have noted several portfolio managers who have tried to call a top in the market and recommend a short strategy, only to get punched in the stomach by the bulls. HDGE has lost approximately 24% this year, which is on par with the inverse performance of the SPDR S&P 500 ETF (SPY).
It really comes as no surprise that a dedicated short ETF has had a rough year, and this fund may ultimately see strong inflows once a sustainable correction begins to materialize. The advantage of an ETF like HDGE is that you get the expertise in security selection by the fund managers’ who have a great deal of experience in that arena. Another alternative ETF to consider in a falling market is the ProShares Short S&P 500 ETF (SH) which will more closely correlate to the daily inverse performance of the S&P 500 Index.
I typically prefer to sidestep a decline in the safety of cash by reducing my position sizes or adding bonds to offset stock volatility. However, using a short ETF as a hedge can be a valuable short-term trading tool for a portion of the portfolio. Especially if your goal is to protect highly appreciated stock positions that you want to hang onto.
While I am avoiding all of these themes at this time, there will ultimately be a day when these ETFs come back into favor. The shifting trends of the market dictate that investors are prepared to actively swing their asset allocation to take advantage of new opportunities when conditions improve. I prefer to wait for a tradable bottom to develop instead of trying to catch a falling knife.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management.
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