Defensive positioning with exchange-traded products

Reading time: 4 minutes

The S&P/ASX 200 Index hit an all-time high in late July, finally breaching the previous record set before the global financial crisis. The following two months were mixed, with a weak August followed by a strong September. With the outlook uncertain, many investors are of the view that further gains are likely to be limited, and are looking to position their portfolios more defensively.

In this article we’ll take a look at three possibilities offered by exchange-traded products that may be of interest to the pessimistic investor.

Bear Funds

Short, or Bear exchange-traded products are designed to be negatively correlated with the performance of a specified index. If the index falls, the value of the Fund should generally rise, and if the index rises, the value of the Fund should generally fall.

Bear Funds are primarily used for two purposes:

• Profit-seeking, where the investor is looking to profit from a decline in the market, or
• Hedging, where the investor holds investments such as shares, and is looking to protect the value of that investment. In this strategy, the aim is that a fall in the value of the underlying assets will be offset, at least partially, by a rise in the value of the Bear Fund.

BEAR Australian Equities Bear Hedge Fund aims to provide returns that are negatively correlated to the performance of the S&P/ASX 200 Index.

The fund invests in cash, and sells ASX SPI 200 futures. The short futures positions can generally be expected to generate a positive return when the market falls, and a negative return when it rises.

It’s important to note that a Short Fund such as BEAR will not provide returns that are the exact ‘mirror image’ of the index. BEAR’s exposure will generally vary between 90% and 110% short on any given day, meaning that a 1% fall in the sharemarket can generally be expected to produce an increase in the value of the fund of between 0.9% and 1.1% (and vice versa).

Some Bear Funds are both short and leveraged. BBOZ Australian Equities Strong Bear Hedge Fund  aims to provide magnified returns that are negatively correlated to the S&P/ASX 200 Index. BBOZ aims to maintain gearing of between 200% and 275% short.

BetaShares also offers a fund that provides leveraged short exposure (currency-hedged) to the US market under BBUS U.S. Equities Strong Bear Hedge Fund – Currency Hedged .

While gearing means that capital can be employed more efficiently, it adds an extra layer of risk and may not be suitable for all investors.

Exchange-traded products that incorporate option strategies

Some exchange-traded products incorporate the use of option strategies into their investment approach. Most commonly, these funds hold a portfolio of shares and write call options.

Call option writers (sellers) typically have the view that the underlying shares are likely to remain around their current price, and enter the strategy in order to earn the premium income and gain some downside protection. The premium income acts as another form of income, beyond the dividend income and any franking credits associated with the shares themselves.

BetaShares has two exchange-traded products offering such a strategy:

YMAX Australian Top 20 Equity Yield Maximiser Fund (managed fund) holds a portfolio of the top 20 stocks listed on the ASX and writes call options over those stocks.

UMAX S&P 500 Yield Maximiser Fund (managed fund) accesses a portfolio of stocks in the US S&P 500 Index and writes index call options.

Both funds aim to generate an enhanced yield as a result of the dividends paid on the stocks and the premiums received from writing the call options. The option premiums provide a partial hedge against a decline in the value of the stocks in the portfolio, and typically reduce the volatility of equity returns.

Both funds would generally be expected to outperform a strategy of holding the underlying portfolio alone, in falling, flat and gradually rising markets – but would be expected to underperform in strongly rising markets.

Managed Risk Funds

Managed risk funds adjust exposure according to market conditions as measured by a specified indicator. For example, the fund may adjust its exposure according to volatility levels – following the theory that high volatility readings are correlated with falling equity values.

AUST Managed Risk Australian Share Fund (managed fund) holds a passively managed portfolio of Australian shares, and sells ASX SPI 200 futures when volatility rises, with the aim of reducing exposure to shares in falling markets. When volatility is low, the short futures position is reduced, with the aim of the portfolio being able to benefit from rising markets.

This type of fund may suit investors who want to retain exposure to the upside potential of the sharemarket, but who also seek to reduce their risk in falling markets.

Please note: The Bear Funds’ strategies of seeking returns that are negatively correlated to market returns is the opposite of most managed funds. Also, BBOZ and BBUS have strategies that are both short and leveraged. Gearing magnifies gains and losses and may not be a suitable strategy for all investors. Investors in geared strategies should be willing to accept higher levels of investment volatility and potentially large moves (both up and down) in the value of their investment. Geared investments involve significantly higher risk than non-geared investments. Investors should seek professional financial advice before investing, and monitor their investment actively. An investment in any of the Bear Funds should only be considered as a component of an investor’s overall portfolio. The Bear Funds are actively managed and do not track a published benchmark.