Boy, is this market ever going to stop? The Nasdaq Composite recently reset all-time highs thanks in large part to a Google (GOOG, GOOGL) post-earnings reaction that sent the mega-cap up 16% in a day.
Meanwhile, the S&P 500 is sniffing its own high-water mark, and it knows it’s close. “Sell in May and go away” proponents once again look misled.
However, while I don’t think the market is necessarily “due” for a correction (I never do), one might be coming regardless.
The second-quarter earnings season could get particularly ugly, as FactSet is looking at a blended earnings decline for the S&P 500 of 3.7% — the first time the index would report negative earnings since 2012. The “good news is bad news” dynamic is still in play, as better economic data increase the likelihood of a 2016 rate hike. And depending on who you ask, contagion from Greece is still a real possibility.
Never fear. Index funds are here.
Whether you want to dive into something safe and sturdy, or hedge your portfolio against a potential correction, these are some of the best index funds to cover your behind.
Best Index Funds for Safety: PowerShares S&P 500 Low Volatility Portfolio (SPLV)
Expenses: 0.25%, or $25 annually for every $10,000 invested
People like to say that the market doesn’t like uncertainty, but let’s be more clear: Investors don’t like uncertainty. When volatility rears its ugly head, many would-be bulls turn into calves.
PowerShares S&P 500 Low Volatility Portfolio (SPLV) is among a few index funds that directly tries to combat the forces of volatility and uncertainty.
SPLV’s index “consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months.” The index is also “equal weighted” — not perfectly equal, but no one component represents more than 1.4% of the fund currently, which means a sudden dip in any one holding won’t send SPLV into the ground.
That makeup results in an utterly boring set of holdings that includes several insurers, such as Chubb (CB) and Progressive (PGR), as well as Stericycle (SRCL) — a healthcare waste disposal service. As we’ll discuss later, you can get a lot of protection out of healthcare.
SPLV hasn’t been an outstanding performer in its few years of life, barely being edged out by the S&P 500 index since 2011 (13.46% for the index vs. 13.29% for SPLV). However, those returns have come during a raging bull market. SPLV’s worth is meant to come in downturns, when its sturdy holdings should maintain their strength better than the broader market at large.
Meanwhile, SPLV is very cheap at just 0.25%, and it also yields a decent 2.1% thanks to its numerous blue-chip holdings.
Best Index Funds for Safety: Vanguard Dividend Appreciation (VIG)
If you’re looking for a great dividend fund, the Vanguard Dividend Appreciation (VIG) isn’t for you. At a yield of just 2.2%, you’ve got plenty of better options for income.
But if you’re looking for a quality fund that can hold up in a storm … that’s where VIG can be useful.
Vanguard Dividend Appreciation is merely a compilation of dividend achievers — stocks that have increased dividends for at least 10 consecutive years. But while growing their dividends doesn’t necessarily translate into high yields, it does speak to a certain amount of quality in the companies themselves.
So with VIG, you’re getting a lot of blue-chip companies — like Microsoft (MSFT), Johnson & Johnson (JNJ) and IBM (IBM) — that can stand on their own merits regardless of what the rest of the stock market is doing.
The best example of the VIG’s strength in downturns is 2008, when it declined just 27% to the S&P 500’s 37%. Sure, that’s still a 27% loss … but most people would happily take 10 percentage points of protection in that situation.
VIG also is absurdly cheap — in fact, it’s the cheapest of these funds — at just 0.1%.
Best Index Funds for Safety: Market Vectors Preferred Securities ex Financials ETF (PFXF)
Preferred stocks — a kind of stock-bond hybrid that yield hunters love — are far from bulletproof. During the massive market collapse we saw in 2008-09, the iShares U.S. Preferred Stock ETF (PFF) took its lumps with the rest of the market.
However, during most normal times, preferred stocks hardly move in one direction or the other — the PFF has traded in a range between $41 and $36 for the past five years. Preferred stocks just sit there and throw off yield.
Of course, some of the pain from that 2008-09 collapse came because many of the preferred stocks in the PFF were from financials — the hardest-hit sector in that wide bear move.
The Market Vectors Preferred Securities ex Financials ETF (PFXF) takes out that part of the equation as well.
The PFXF is summed up in its name: It’s preferred stocks from companies outside the financial space. PFXF’s holdings instead cover real estate investment trusts, electric utilities and telecom companies. Top holdings are preferred stocks from Southwestern Energy (SWN), Tyson Foods (TSN) and ArcelorMittal (MT).
PFXF throws off 6.1% in yield while charging merely 0.4%*, and while it’s fair to worry about the interest-rate-sensitivity of such a bond-like investment, remember that it would take one heck of a move in rates to bring Treasuries anywhere near the yields offered by PFXF. Even 30-year Treasuries are only yielding just north of 3%.
U.S. debt is hardly a replacement for the high yield of preferreds, and that fact is unlikely to change anytime soon.
*Note: PFXF’s net expenses are limited to 0.4% until at least Sept. 1.
Best Index Funds for Safety: iShares Barclays 1-3 Year Treasury Bond Fund (SHY)
Why on earth would anyone jump into Treasuries when the Federal Reserve is expected to raise rates within the next year (thus driving up yields and driving down prices)?
For one, short-term bond funds are actually the least vulnerable to interest-rate hikes, as there are fewer coupon payments that will be less than the prevailing interest rates. So bond funds like the iShares Barclays 1-3 Year Treasury Bond Fund (SHY) would be the least at risk anyway.
There’s also the fact that bond funds don’t perform nearly as badly as you’d think when the Fed lets rates tick back up. Dan Burrows sums up the results from a Charles Schwab report about bonds during the past three rate-tightening cycles:
“Losses were not, however, a foregone conclusion. In fact, four main categories of bond funds — short term, intermediate term, long term and multi-sector — collectively generated positive cumulative returns far more often than negative ones through the last three cycles.”
So, what is SHY good for?
Investors who want to store dry powder for a buying spree once a correction brings stock prices down could go to cash, but funds like SHY will at least provide a little bit of return in the form of yield — it’s better than the nothing you’ll get from greenbacks. And many investors tend to use SHY as a cash alternative when the markets get choppy, so that should help keep the ETF’s price propped up.
Best Index Funds for Safety: ProShares Short S&P500 ETF (SH)
While the funds discussed so far are focused on protective holdings, the ProShares Short S&P500 (SH) is actually designed to help you make money as the market heads lower.
The SH is a simple hedge on the market. The ETF essentially seeks to return the opposite of the S&P 500 on a daily basis — when the S&P 500 goes up, the SH ETF should fall by the opposite amount, and vice versa.
Think about it. Even if you don’t hold, say, a broad index fund like the SPDR S&P 500 ETF (SPY), you’re probably still long a number of stocks — stocks that could be pulled lower in a market decline. So, sure, you could sell those positions and collect the cash, but you’re out all those transaction fees, not to mention you could be triggering some taxable events.
An alternative? Buy into SH and claw back some of the losses that way.
It’s also worth pointing out that there are leveraged funds that seek to provide 2x to 3x the returns of the inverse of the S&P 500’s performance, but while those can do very well in a market decline, a wrong guess — and a continued bull run — will leave you licking some nasty wounds. SH is a much safer hedge in the event that the market doesn’t correct.