Defensive position for investors in hard times

PUBLISHED : Monday, 05 December, 2011, 12:00am
UPDATED : Monday, 05 December, 2011, 12:00am

With markets gyrating on overnight news and optimism in short supply, retail investors can see the writing on the wall. Central bankers are grappling with the debt crisis, experts are struggling to explain, and for many 'ordinary' people that means one investment strategy makes most sense: keep it simple and hold on to what you've got.

Sometimes that is easier said than done. Inflation, for instance, eats away at cash savings when almost no interest accrues, and even property values can tumble in a matter of months.

That helps to explain why investors are now seeing new attractions in Exchange Traded Funds (ETFs). As an instrument, they were never designed to dazzle, instead falling squarely in the 'safer and steadier' category of investment.

As open-ended funds, each is set up to track the performance of an underlying benchmark, perhaps Hang Seng constituents or a commodity like gold. This can give investors what Hong Kong Exchanges and Clearing describes as 'cost-efficient exposure' to a wide range of markets or themes, while still able to sell ETFs quickly and easily through the usual brokerage channels.

Volatility remains a risk. It should, though, be mitigated by the diversity of the underlying holdings or the essentially conservative nature of the fund.

'In most cases, ETFs are 'passively managed', investing in a variety of assets across particular markets or indices,' says James Jones, Asia managing director for FE (Financial Express), a company which specialises in providing investment data and performance analysis for the financial services sector. 'The basic aim is to replicate the performance of those markets/indices. However, ETF managers are responsible for keeping tracking errors low - that is close to the price of the underlying assets/indices - through trading consistently in the relevant exchange.'

Summarising the attractions for investors in the current rocky environment, Jones is not short of suggestions. He points first to the relatively high liquidity and transparency, compared to some narrower index tracking funds. Then there is the low level of minimum investment, low transaction costs - helped by the absence of subscription fees - and the convenience that comes from most ETFs being traded on a stock exchange.

While regulations necessarily apply on a case-by-case basis, the chance for Hong Kong-based investors to have easy access and diversified exposure to overseas markets is also seen as a plus.

As a result, Jones sees ETFs as a logical component in any well-balanced portfolio, offering a defensive position, yet with good upside potential on any sustained market rally.

'The individual risk inherent to single securities can be well diversified,' he says. 'However, investors should still be cautious as far as allocation of ETFs within a portfolio is concerned, to ensure the asset mix there is also balanced.'

Preferring not to comment on past - or possible future - performance of individual ETFs, Jones nevertheless highlights the ready availability of information giving average results per sector.

'Our database currently tracks more than 2,500 ETFs in all parts of the world to help compare and choose,' Jones says.

Taking things a step further, cautious investors are also advised to consider not just the underlying market risk. They should question such things as potential tracking errors and liquidity risk for specific funds, as well as whether the asset price of an ETF can trade at a discount or premium to its NAV (net asset value).

Regarding the latter point, Hong Kong Exchanges and Clearing explains that price discrepancies can result from supply and demand factors, especially in more volatile markets. In certain cases, for instance, investors might buy in at what turns out to be a premium.

On a more technical level, it may also be worth knowing if an ETF engages in stock lending. This obviously entails risk, notably if the borrower in such an arrangement runs into difficulties of their own.

'Compared with other structured investments such as options and futures, ETFs offer relatively lower risk for investing money in commodities,' Jones says. 'However, investors should be aware that some of these funds are still subject to counterparty risk as they are 'synthetic', using derivatives instead of holding [equivalent physical assets] or underlying securities.'

David Pinkerton, chief investment officer of Falcon Private Bank, similarly notes the current attraction of ETFs. In particular, he sees them as an effective way to rapidly rebalance market exposure to a variety of asset classes. And some funds, he says, allow for short exposure on certain instruments, thereby providing a hedge against risk.

'Generally, investors should stay with the ETFs that have larger market capitalisation or ample daily trading volumes,' Pinkerton says.