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Wed, April 1 at 7:00PM ET

Don’t Ignore the Defensive Signals – Buy These 2 ETFs

The market is flashing defensive signals, so don't get stuck in small-cap ETFs

Exchange-traded funds come with the benefit of being more transparent than other asset classes. You know exactly what you own at all times, and a variety of online sources are available to help you track fund metrics.

etfs-to-buy-small-capWhile screening asset statistics at recently, I noticed that the top 10 largest recipients of new fund flows this year are skewed towards small-cap and international equity funds.

The iShares Russell 2000 ETF (IWM) is the largest recipient of new money, posting a net gain of $2 billion in 2014. Its more aggressive sister fund, the leveraged ProShares Ultra Russell 2000 (UWM), was a few spots down with an additional $1.6 billion in new money.

It’s not surprising to me that investors are continuing to add to high-beta areas of the economy after a run like we experience in 2013. That kind of risk-on behavior is pretty typical in the midst of impressive resilience in domestic stocks. Adding exposure to international stocks also makes sense, considering that foreign equities haven’t had the same move higher as the U.S. and may present a pocket of value or diversification strategy.

However, it’s worth noting that successive highs in the equity markets appear to be slowing perceptibly, and we are starting to see signs of defensive posturing in key areas. The iShares 20+ Year Treasury Bond ETF (TLT) and SPDR Gold Shares ETF (GLD) are both areas that have come on strong this year as defensive hedges.

Both of these sectors have been established safe havens at one time or another during periods of equity volatility. TLT has gained 5.1% and GLD has gained 13.5% year-to-date. IWM has only managed a 2.5% gain in the same time.

Interestingly, we have yet to see a significant return of asset flows in these defensive areas. Both GLD and TLT have added approximately $600 million in net new money, which is just a fraction of the tens of billions they lost in 2013. That leaves a great deal of room for additional upside if we start to see fear in the marketplace.

What this data points to is the fact that that investors are more likely to chase recent performance than to look for areas of value or hedge their equity bets with non-correlated positions. It’s an old tale, and one that is likely to be repeated with every market cycle.

This year, we are going to witness how the markets react to the Federal Reserve’s exit from its quantitative easing efforts, and how that reaction will translate to equity, bond, and commodity prices. The release of stimulus as a bid for the economy will give us a better sense of whether this market can sustain its upside momentum or if we will experience additional volatility. Further upside gains in stocks need to be fueled by positive economic statistics and earnings reports that support higher prices.

I am more inclined to put new money to work at these levels in low-volatility sectors or broad-based ETFs that offer more security than small-cap stocks. Two funds that come to mind are the iShares MSCI U.S. Minimum Volatility ETF (USMV) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV). These defensive funds still offer upside participation if stocks continue to rise, and may insulate your portfolio from a more pernicious decline if momentum wanes.

No matter how things shake out this year, I recommend that you stay flexible, diversified, and balanced with your portfolio. The ability to side-step volatility while still taking advantage of attractive opportunities will serve you well this year.

David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. Learn More: Why I love ETFs, And You Should Too.

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