During a major market downturn, different types of investments tend to move in the same direction—usually down—regardless of how they behave. Roughly speaking, this means that low-yield ETFs, while generally performing well, may not always protect a portfolio from losses when the rest of the market declines significantly.
Remember the COVID-19 market crash in February and March 2020? The steep decline—meaning the steepest decline from peak to trough over a period of time—of ZLB is almost as significant as that of XIU. So even ETFs that are often considered less volatile can still experience significant declines in value during broader market downturns.
The concept of a “free lunch” in risk management refers to the ability to reduce risk without significantly affecting returns. It was the American economist Harry Markowitz who said: “Diversification is known as the only free lunch in investing.” So, ideally, if you can reduce your risk by one unit, you would want your return to be reduced by less than half a unit or not at all.
However, achieving this balance depends heavily on maintaining a low correlation between assets—when one asset jumps where another jumps. Unfortunately, this balance is fleeting because during severe market downturns, the correlation between different types of investments tends to converge to a beta of 1.0, meaning they can all lose value simultaneously.
In addition, the few assets that pay reliably when the market tanks, such as put options and long-term volatility, are not suitable for long-term owners as maintenance costs can exceed payments in many cases.
Many popular hedge-fund-like ETFs promise to provide this balance, but often come with high fees and survival bias. Survivorship bias is the tendency to consider only successful examples in an analysis while ignoring those that have failed—an important thing to be aware of when evaluating funds.
For many Canadian ETF investors, an effective investment strategy involves “dividing your dividers.” That means combining different asset classes that react differently under different market conditions, each offsetting the other’s weaknesses. Your outfit team together creates a Fantasy sports team.
For example, if your portfolio consists of global equities, adding high-quality bonds can provide a buffer during economic downturns, as bonds generally do better when stocks are volatile. To further protect against inflation and rising interest rates when the bonds may not perform well (like 2022), some may add assets to their mix. Finally, holding cash equivalents provides cash and stability if all else fails.
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