By Philip Moskie
One of the best ways to give yourself some level of insulation from a bear market is by trading ETF’s. Specifically, an ETF that tracks with a major stock index such as the S&P 500 or the Nasdaq are better choice in tough times. This is because buying an ETF of a major market index represents an immediate diversification of the risk amongst all the stocks that make up that index. The indexes will still trade down in a bear market, but you eliminate the risk of bad news or an earnings report missing analyst expectations and your stock dropping 15% to 30% immediately and then staying there for months or even years.
Table of Contents
- Introduction
- What is an ETF?
- Why are ETFs better than stocks in a bear market?
- What type of ETFs should you trade?
- Leveraged vs. Non-Leveraged ETFs
- Conclusion
Introduction
As of the writing of this post, the stock market is currently in throes of a bear market. This is being caused by very tough economic conditions in our post COVID world. In this post we will explore the relatively new world of exchange traded funds or ETFs as they are referred to. We will explore what an ETF is, why they are a better choice in a tough market and then which types will be most relevant in a difficult market like we are experiencing now.
What is an ETF?
ETF stands for exchange traded fund and is an equity that trades on the stock market just like a stock. However, rather than correlating to a specific stock, the ETF tracks with the price of a group or “basket” of stocks rather than just one. They are designed to follow things like the Nasdaq Composite Index or the S&P 500 for example. They can also represent specific sectors of the market like Pharma or Technology.
Why are ETF’s better than stocks in a bear market?
Diversification of risk
In a bear market bad news becomes magnified. Any bad news or economic event can send a stock tumbling 10% to 20% or more. Currently Carvana (CVNA) is a good example. In March of 2020, the stock traded around $26 per share. By August of 2021 it hit a high of just over $360 per share. It was an amazing run and Carvana became one of the darlings of the market. Then the bear market began, and it started to sell off. The stock recently hit new lows of $3.55 a share! It’s one year price performance was down 98% while the Nasdaq Composite was down just 30%. With an index ETF your risk is diversified. If a single stock from the Nasdaq reports bad news, the effect on the overall Nasdaq (and corresponding ETFs) will most likely be minimal.
Reduction of risk in certain sectors
If a stock sector has been very hot for a long period of time, it is highly likely that it will sell off in a very aggressive manner when a bear market hits. In addition, certain sectors are chock full of smaller young companies that can have liquidity issues when markets get tough. By picking an ETF that is not in these types of sectors you reduce some this risk. When market conditions improve you can go back and revisit these sectors, but for now use the ETFs.
Additional Safety in certain sectors
Studies have shown that certain sectors of the market are somewhat immune from the effects of the bear market. Sectors like that are more stable are somewhat safer in a bear market. That being the case, an ETF that targets one of these more stable sectors may be safer and easier to make money in than just a single sto
What types of ETF’s should you trade?
Now that we have discussed what an ETF is and why we think you should trade them in a bear market, we will discuss the two types of ETFs we think you should choose from. They are Index ETFs and Sector ETFs. These two types can further be broken down by the amount of leverage they are designed to provide.
Index ETF: an index-based ETF is an ETF whose movement tracks with the movement and price action of a major market index. Currently there are ETFs that track the Nasdaq and the S&P 500. There is no ETFs that track with the Dow Industrial average. The reasons we choose to trade these in a bear market are numerous. We have already discussed the diversification that comes with buying this type of ETF. However, there are other ETFs that can be considered in this difficult market.
Sector based ETF: is an ETF that tracks with a “basket” of stocks within a certain sector. History has shown that certain market sectors act better in poor market conditions. These sectors include the following:
*Communication Services
*Consumer Staples
*Health Care
*Utilities
*Banks
*Pharmaceuticals
Trading ETFs that represent these market sectors can provide a certain amount of protection again very large drops in price.
Leveraged vs. Non-Leveraged: there are ETFs that are designed to trade at multiples of the underlying equity price. For example, there are ETFs tracking the S&P 500 that provide returns 2X and 3X the S&P. If the S&P is up 2% in a day, the ETF will be up 6%. Now while these can provide nice returns when you are right, they also represent much larger risk when you are wrong. Proceed with caution of you decide to use leveraged ETFs.
VettaFi has a great list to start your education on the large array of ETFs available to you. PLEASE MAKE SURE TO READ ALL OF THE RISK DISCLOSURES THAT ARE PROVIDED FOR EACH ETF AS MANY, ESPECIALLY THE LEVERAGED ONES, HAVE RISK SPECIFIC TO THEIR FUND THAT YOU MUST UNDERSTAND.
Here is the link: https://etfdb.com/compare/volume/
Conclusion ETFs have been around since the 1990’s and have become an important part of the stock market. In this post we have discussed how they can be used for diversification, safety, and to provide leverage to those that choose to use them wisely. They should be considered by beginners and advanced traders alike. We advise traders to study the myriad of different ETFs available to them and identify those that are likely to fit with your trading style and risk tolerance.