The overwhelming return of volatility on the markets places investors in front of many questions. Staying positioned in equities? And if so, how do you reshape your portfolio? The turbulence of the markets, with Nasdaq and S&P 500 that in the short span of a few weeks entered correction phase (i.e. over -10% from the maximums), they bring out pitfalls that many investors do not consider. Pitfalls also due to distortions present in indices where the Tech giants have reached a weight never seen before.
The Big Tech dictate the law on the main indices
Just look at the photograph of the Nasdaq Composite Index, made up of over 3,000 stocks and which sees a small group of just 10 stocks making up over 50% of the entire weighting of the index (52.5% to be exact). The first two – Apple and Microsoft – alone account for nearly 21%. The same goes for the Nasdaq 100, while in the S&P 500 the top seven stocks by weight are all in the technology sector and account for almost a quarter (23.6%). Expanding the speech to the MSCI World, the dominance of Big Tech is certainly more diluted, but undeniable even there as US equities accounted for 69% of MSCI World at the end of 2021 and the seven Tech sisters (Apple, Microsoft, Amazon , Alphabet, Tesla, Meta and Nvidia) account for around 17.6%.
This means that when giants such as Apple and Microsoft have a little cold on the stock market, the whole market is affected. When the Big Techs rose to the sound of records, the indices benefited everyone, now that the sell-off involved them in the first place, the sensitivity of the indices to the mood of these stocks becomes a dangerous weapon.
Possible ‘smart’ countermeasures
Phases of uncertainty such as the current one must therefore lead investors to focus even more on what they can control. And among the main elements to best monitor is the diversification of your portfolio, together with the risks associated with volatility.
How should investors behave in the face of spikes in risk? When volatility suddenly comes back to bite, an effective antidote is to balance the search for yields with a good defensive strategy. A dynamic portfolio that allows you to stay on equities but with the appropriate countermeasures. In these situations, some types of smart beta ETFs come in handy, suitable for a partial reshaping of portfolio allocations quickly and economically, as well as guaranteeing immediate diversification given by the large number of securities present in the underlying assets.
In particular, in recent years, in times of market turbulence, substantial inflows on the strategie low volatility. Low volatility ETFs, also called ‘minimum volatility’, which fall into the category of smart beta, do nothing but replicate indices in which the weighting of the individual stocks does not follow the market capitalization but the volatility of the securities thus allowing greater exposure to more defensive sectors and consequently a containment of the drawdown in the correction phases. There are also ETFs that combine the low volatility factor with the high dividend factor, allowing concentrated exposure even on high dividend stocks, an important element in low interest rates.
Looking at performance, the S&P 500 Low Volatility Index has recorded -5.2% since the beginning of the year, compared to -7.27% for the traditional S&P 500 (data at the close of 24/01/2022). Greater resilience in the short term makes them suitable for tactical use in certain market phases, even if in the medium term their performances are still interesting (+ 14.4% at 12 months, in line with what the S&P 500 did).
Then there is the option of another type of factorial ETF, the equal weight, which provide for a equal weighting for all stocks in the index. For example, in the NASDAQ 100 Equal Weighted Index, if your name is Apple ($ 2.640bn market cap) or Seagen ($ 2.2bn), the weight in the index is 1% for both stocks. In the case of the S&P 500 Equal Weighted Index the performances are -5.3% YTD, + 17% at 12 months and + 73% at 5 years.
Defense and attack
When nervousness peeps in the markets, defense castling can also be enacted with ad hoc instruments linked to the volatility expressed by the VIX index. The VelocityShares Daily 2x VIX Short Term ETN, which offers two leveraged exposure to the VIX futures market, has jumped 45% year-to-date. Reserving a small percentage of the portfolio for replicants on the VIX can therefore act as an effective hedge, a sort of insurance of the portfolio against the unexpected in the markets. A product that with well-directed markets tends to lose value over time (-88% annualized performance of the VelocityShares Daily 2x VIX Short Term ETN), but able to act as a buffer when there are declines in other exposures.
A different function, on the other hand, is that performed by ETFs that go short, including leverage, on stock indices thus allowing you to speculate on the descent of the markets. These are instruments suitable for qualified investors accustomed to constantly monitoring the performance of the underlying assets in order to seize very short-term opportunities.
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