Low-cost option makes money as prices retreat

This article is part of
Multi-Asset Investing - December 2015

Volatility returned with a vengeance in 2015 after several years in which investors had enjoyed relatively benign conditions.

Bonds, which for more than a decade had proved a one-way bet for investors, were buffeted in the first half of the year with the volatility of gilts reaching a five-year high.

Equities then ran into significant turbulence after a sustained period of relatively low volatility. Fears about slowing economic growth in China triggered a sharp August sell-off in global equity markets, which quickly became known as the ‘great fall of China.’

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The news was no better in commodities, which continued their downward trajectory.

With global growth faltering, geopolitical tensions mounting and concern about the timing and impact of US and UK interest rate rises, there are plenty of reasons to expect further volatility across asset classes in 2016.

Clearly the challenge for multi-asset managers is how best to navigate such conditions.

For unconstrained investors, the answer in the past would have been to hold a substantial proportion of their portfolios in cash. But the explosion in exchange-traded fund (ETF) growth means there is now another alternative.

The universe of more than 5,500 ETFs and other exchange-traded products (ETPs) now available includes a growing array of inverse ETFs, which allow investors to effectively short a wide range of individual asset classes.

Inverse ETFs are comparatively low-cost, continuously priced and easily traded vehicles, allowing investors to hedge against volatility or to generate a positive return from a falling asset price.

For example, if you take a negative view on the outlook for the FTSE 100 index there is the db x-trackers FTSE 100 Short Daily Ucits ETF, which has an ongoing charges figure of 0.5 per cent and is designed to produce a positive return when the blue-chip index falls.

There is the effect of daily resetting to be taken into account, but if your investment process tells you the FTSE 100 is going to fall then it will perform the essential task asked of it, allowing you to make money from that retreat in prices.

For those looking for more specialist exposure, the array of inverse ETFs and other ETPs now track dozens of more niche assets, ranging from lean hogs and soyabeans, to currencies and real estate.

As with any investment, it is essential to understand the complexities and risks associated with these products, as well as the opportunities. Most inverse ETFs are reset on a daily basis, so they are only designed to provide the inverse performance of the underlying asset on that day.

It is also important to understand exactly how the product is structured and how derivatives such as swaps are employed to achieve the desired return.

They can be a very useful tool and as well as allowing investors to generate a positive return from falling asset prices, inverse ETFs – used alongside regular ETFs – open up broader opportunities for investors in terms of the strategies they can employ.