Markets have shown they can crash unexpectedly – for example, most major share markets have fallen by 50% or more 3 times in the first 10 years of the 21st century. That’s far more than expected by traditional investment theory, which is built around the concept that time in the market is the key to long term wealth accumulation. The intense volatility that we have been experiencing over more recent times has spurned a new investment approach known as the ‘risk on/risk off’ strategy – and ETFs are powerful tools to implement this approach.
Long term investment advocates say ‘time in the markets’ is far superior to ‘timing the markets’. That’s supposedly because major share price increases can happen quickly and unexpectedly – so to be exposed to these upticks requires constant investment (even when markets are highly volatile/risky).
The problem of sequencing risk
The obvious criticism of this ‘time in the markets’ approach is that, for many investors, the risk of loss outweighs the benefits of potential gains from being a long term investor. Australia’s last Treasury Secretary, Dr. Ken Henry, has coined the phrase “sequencing risk” to highlight this problem.
Sequencing risk recognises that it’s not just the occurrence of market crashes that hurts: it’s the time and sequence of a crash that does the real damage. To explain this concept further: a market crash that occurs in the early stages of an investor’s lifecycle will generate losses which may be recouped over time. This will be far less damaging than a crash which occurs later in life.
In a crash, the investor’s capital base is eroded, meaning there are less assets available from which investment returns and income can be generated. If the crash occurs in the pension phase, the investor may be forced to sell assets to live on, further depleting the size of the income-generating asset pool. The investor also may not live long enough to fully experience the (hoped for) recovery.
Dynamic asset allocation
The ‘risk on/risk off’ approach seeks to overcome the problems of sequencing risk, and the downside risk of market crashes generally, by timing the entry and exit of assets in the portfolio with higher levels of risk, like shares, property, and even fixed income.
‘Dynamic asset allocation’ (or DAA) is the term which describes this process. DAA aims to reduce and increase risk by either selling assets (and placing the proceeds into a liquid cash instrument) or, when markets are deemed to be improving, by using the money in that cash instrument to buy back into the investor’s chosen risky assets.
When markets are deemed to be highly risky, DAA investing can reach the point where 100% of the investor’s money is held in cash – and the opposite also holds (where 100% of the investor’s money is invested back into riskier assets).
DAA proponents recommend a range of filters or indicators to guide this process of buying and selling assets. Without delving too heavily into the detail, factors like rising volatility (measured by the so-called ‘VIX Index’), falling price momentum, as well as falling asset prices are all used by DAA proponents.
ETFs are suitable for DAA investing
Liquidity is a key ingredient for the DAA approach, as it relies on being able to sell assets quickly and at a price which is close to the fair value of the asset. Blue chip shares are considered the most suitable for DAA investing, compared to small cap stocks which are less liquid, or traditional managed funds, where liquidity is only available at the end of each business day.
ETFs can also be a powerful tool for DAA investing, especially where the ETF itself references liquid underlying assets. That’s because ETFs can be traded continuously during their trading hours, just like shares themselves. ETFs can also make assets that are traditionally inaccessible for DAA investing – for instance, gold or agriculture – accessible, through providing liquid exposure to these assets in easily tradeable units.
In essence, ETFs are, by design, a vehicle for investors to quickly trade into and out of assets. They allow for rapid reaction to market conditions, which is the essential element of the DAA strategy.