Bear Market Marketing

During and after a bear market, interest in investments aiming to hedge against volatility or play off the bear market’s themes tends to spike. Wall Street often obliges by proffering a range of products to meet demand. While some of these may be fine depending on your circumstances, we think it is important to understand what is driving the hype—emotions and, in some cases, marketing. In our view, investors benefit from cutting through it all and rationally weighing the pros and cons.

First up: Low-volatility exchange-traded funds (ETFs), which contain stocks with less measured volatility—typically based on the average daily move up or down over some past time period. Since these purport to ensure a smoother ride, investors often flock to them in turbulent times. But this strategy has a critical flaw, in our view. Like past prices, past volatility doesn’t predict. One month’s (or quarter’s, or year’s, or decade’s) placid stocks could be the next period’s bounciest. Hence, low-volatility ETFs’ composition is necessarily backward-looking.

In one case, a recent low-volatility ETF rebalance shifted its holdings away from Utilities and Real Estate and towards Health Care, Consumer Staples and Technology, on the grounds that the latter had become relatively less volatile. We think this highlights how shedding (recently) bumpier stocks for (recently) calmer ones is just a twist on heat-chasing—a decision hinging on past performance metrics of one form or another. Moreover, since volatility and market returns aren’t correlated, low-volatility strategies can—and often do—lag broad markets. This can include stretches when stocks are falling—ostensibly low-volatility ETFs’ time to shine.

Speaking of heat-chasing, thematic ETFs target less timid investors by aiming to capitalize on potential COVID-related trends and profit opportunities. Recently, we have seen some ETFs focusing on biotech firms with FDA-approved drug therapies; “companies at the forefront of R&D, vaccines, therapies and testing technologies;” and firms offering technologies or services that facilitate remote work.^[i] The practice of building ETFs based on widely discussed economic or societal trends has been ongoing for years as ETFs exploded in popularity. Some of these ETFs may indeed offer exposure to companies that share a competitive advantage, and many may enjoy superior returns for a time. But don’t confuse flashy marketing pitches and name-checking popular trends with an investment that fits in with your overall strategy, goals and needs. The COVID theme may be novel, but the risks aren’t, in our view. Piling into potential “coronavirus winners” amounts to trading on widely known information based on recent returns—and can skew your portfolio towards just a few sectors.

Up next is gold—in headlines currently as prices hover around all-time highs. Year-to-date inflows into gold-related ETFs through May also surpassed the previous annual inflow record.^[ii] Why all the buzz? Many fear aggressive monetary measures will spur hot inflation. Others fear the rally since March 23 is a headfake with much more downside ahead. Gold, conventional wisdom holds, will retain its value in both scenarios, making it a “hedge.” 

But history doesn’t support this view. When markets fall, gold frequently does, too. Since the mid-1970s, when American investors could legally own gold, there have been six global equity bear markets, this year’s included. In the bear market that ran from November 1980 – August 1982, gold prices fell -46.9%.^[iii] During the 2007 – 2009 bear market, gold finished up 25.5%—but endured a -29.4% plunge from March – November 2008.^[iv] Year to date, gold has directionally tracked stocks. In our view, anything that moves with stocks so often during bear markets isn’t much of a hedge.

Meanwhile, aside from a brief period in the late 1970s when gold prices surged alongside spiking inflation, the two have little relationship. Gold’s climb to new highs from late 2008 through 2011 came alongside historically low inflation. It then entered a multi-year bear market that came alongside very similarly tepid inflation, and its recent surge came as inflation plunged. Perhaps at one point gold was a fine hedge against inflation. But if so, we think the data suggest that faded long ago.

From stocks and commodities, we turn to insurance products. During bear markets, sellers of fixed annuities—insurance contracts that offer a fixed return based on prevailing interest rates—frequently tout these products’ purported safe haven status. They often remind would-be buyers that the product can pay “guaranteed” income at a fixed lifetime rate in retirement. While recent annuity sales figures aren’t available yet, historical US data suggest sales spike after stocks fall. Anecdotal reports out of the UK also hint at an uptick in a similar instrument.

We are no fans of most annuities in any market environment, but fixed annuities’ allure—and potential downsides—are unfortunately heightened in a downturn. For one, the way you earn interest on these contracts is from the insurer investing the principal into various portfolios of (usually) fixed income assets. This means the annuity’s fixed rate of return depends largely on prevailing interest rates—which are currently near record lows.

To compound matters, insurers often pay annuity holders less interest than they earn—that is the primary way they make money on these products. Many times, they offer teaser rates that seem great but last only a year. When they expire, the lasting yield is far, far lower. Buying an annuity now would lock in those minimal returns. In our view, this is dangerous for investors needing growth, especially given the potentially astronomical exit fees (called surrender charges) should you decide to make a change after owning the contract for a while. If you are an investor needing equity-like growth for some or all of your portfolio, we think you should be very, very careful if you are considering an annuity.

The financial industry offers investments and advice that can help you achieve your long-term goals—and investments and advice that cater to folks’ fear and greed. During bear markets, the latter seem omnipresent and hard to resist. In our view, investors are best off tuning out their siren song.