During major market downturns, various kinds of investments can often move in similar directions – typically downward – no matter their expected behavior. In practice, because of this while low volatility ETFs are generally effective, they might not all the time protect a portfolio from losses if the general market falls sharply.
Remember the COVID-19 market crash in February and March 2020? ZLB’s maximum drawdown – the most important drop from peak to trough during a given period – was almost as significant as that of XIU. As a result, even ETFs which can be typically considered less volatile can experience large losses in value during widespread market downturns.
The concept of a “free lunch” in risk management refers to the flexibility to cut back risk without significantly affecting returns. It was the American economist Harry Markowitz who said: “Diversification is considered the only free lunch in investing.” So when you could reduce risk by one unit, ideally you’ll want your return to diminish by lower than half a unit and even doesn’t sink.
However, achieving this balance relies heavily on maintaining low correlations between assets – where one asset zigzags while one other zigzags. Unfortunately, this equilibrium is short-lived because during severe market downturns, correlations between different asset types often approach a beta of 1.0, meaning they’ll all lose value at the identical time.
Additionally, the few assets that reliably pay out when markets collapse, corresponding to put options and long-volatility derivatives, will not be suitable for long-term holders because maintenance costs can exceed payouts in most scenarios.
Many fancy hedge fund-like alternative ETFs promise to supply this balance, but often include high fees and a survival advantage. Survivorship bias is the tendency to only consider successful examples in an evaluation and ignore people who failed – a very important aspect to concentrate to when reviewing funds.
For most Canadian ETF investors, a realistic investing approach involves “diversifying your diversifiers.” This means integrating quite a lot of asset types, each reacting otherwise to different market conditions while compensating for one another’s weaknesses. Together, your team forms the last word fantasy sports team.
For example, in case your portfolio includes global stocks, adding high-quality bonds can provide a buffer during economic recessions, since bonds are inclined to perform higher when stocks falter. To further protect against inflation and rising rates of interest when bonds could also be underperforming (like in 2022), some may add commodities to their mix. Finally, holding some money equivalents provides liquidity and stability if all else fails.
