Exchange Stocks Providing Hedge Against Market Worry
When stock markets decline, they tend to carry most stocks in tow. Exchange stocks can behave a little differently, and can be an attractive option when the market is declining.
Regardless of what investing strategy we use, and what we choose to invest in, managing the risk of our investments plays a significant role in where we may end up, whether we pay enough attention to this or not.
Managing risk plays a big role in investing, even though individual investors and what they tend to invest in may not employ it very much, if at all. Compared to the way some large institutions approach risk, individuals tend to operate on the kindergarten level versus the PhD style approach that the big guys use, with their very sophisticated techniques versus perhaps some poorly thought out rule of thumb such as keeping a certain percentage of your funds in bonds that individuals limit themselves to typically.
Even big hedge funds and other large institutional investors who have the latitude to choose among a variety of other approaches still struggle a lot of the time to manage risk, because the size of their investments present a much bigger challenge than anything an individual with their much more modest sized portfolios would ever see.
There are two main ways to manage risk, with the first one being simply choosing to be in situations that have reduced risk, and getting out of them when their risk levels become too high, and the other being to stay in investments when they get riskier and look to offset this risk through other investments.
This is not about choosing one approach or the other, as we often will do both, move assets around and also pay attention to risk balancing. The two function together actually, as we reduce exposure to riskier positions and replace them with ones that reduce our portfolio risk overall.
A good example of this would be an investor who, in times like the one we are in right now with the stock market, selling some of his stocks and buying bonds with the money. In May, for instance, stocks have come down a fair bit while bonds have been increasing in value. This does happen together quite a bit, even though we still want to look closely at the markets of both types of assets to ensure we have a reasonable expectation that this will happen together this time.
Doing Nothing is the Riskiest Strategy of All
This sort of approach is a long way from what your average investor likes to do, and they will very often be daunted by the very idea of managing our portfolios actively like this, but what they don’t realize is that doing nothing is generally the worst thing we can do. Although we may be an amateur at all of this, risk management is too important to just be ignored, as this will leave us exposed to the full measure of the risks, and doing a little something to help ourselves will leave us a little helped rather than not at all.
The prerequisites for this are pretty simple ones actually, and being sensible about this is the main one. Does it make sense to hold stocks when they are going down instead of buying something else that is going up instead? We won’t be right about every move of course, but as long as we’re more right than wrong, we will benefit.
We also need courage to pull this off, although ironically enough, it should require more courage to just sit back and watch your portfolio keep dropping in value and not do anything, especially when these moves are not a surprise at all.
We’ve known that there have been some real issues that have perplexed the stock market lately, with the slowing economy and the current trade war both casting a dark cloud over our 2019 recovery. While the market has performed well during the first four months of the year, it is no secret that the risk of a significant pullback is fairly high, high enough that it should command our attention.
We could just stick with our stock positions and wait until the actual rain comes, which is not a bad approach really, and surely beats just standing out on the street and getting hit with whatever amount of rain comes. This does not have to be an all-or-nothing thing though, and ramping down our exposure during times of uncertainly like this can be wise.
Big investors have to do these things gradually, as there is no other good option. They cannot just move billions of dollars around with a few mouse clicks, so their techniques need to involve scaling out and in, and when this scaling is done right, it is in harmony with changing circumstances.
Since risk isn’t just black and white, 1 or 0, and instead moves more like a wave, it makes sense to use a scaled approach to risk management. We don’t know that we’ll get a big pullback soon, but we might, and as this risk increases, our exposure to it should decrease in accordance.
Few investors are up for picking stocks, and this is not exactly completely intuitive, although it is more so than we usually realize. A stock is doing well, that’s one you want to be in, and later it’s not doing so well but something else is, and we should want our money in better performing assets over lesser ones to the extent that we can direct this.
Exchange Stocks Can Provide a Nice Haven During Market Pullbacks
A lot of investors may not have heard of the approach of holding stock exchange stocks such as ICE, the Intercontinental Exchange, which operates the NYSE, NDAQ, the Nasdaq, CME, the Chicago Mercantile Exchange, or CBOE, the Chicago Board Options Exchange to hedge against overall market pullbacks, but this can be a good strategy indeed when used at the right time. Some think that this works because business remains good at stock exchanges even during pullbacks, but the most important reason is because people buy exchange stocks more when this sort of thing happens.
It doesn’t really matter why though, as long as this happens, and we are seeing a movement toward exchange stocks as we speak. In particular, the months of April and May have been very good ones for exchange stocks, who did not join the downward party this month and actually performed very well.
Indexes bounced around quite a bit in March, ending the month a little higher than it started, but March was not a particularly good month for exchange stocks. It really depends on the circumstances, but for the most part, these exchange stocks do not track the market all that closely, and are almost an entity in themselves when it comes to the way they behave.
During the 20% market pullback from October to December of last year, exchange stocks held up very well. While there still were some losses, as we would expect with a move like this, the losses that the exchange stocks suffered were much smaller, with CME even eking out a small gain. CME has performed a little better than the others generally over the last while, and if we had to pick just one, this would be the one.
CME is up 19% over the last 2 months, where stock indexes are now in the red over this time from its poor performance in May. Of the $30 that CME has risen in April and May, $20 of it has been since May 3, since the indexes have taken a pretty big hit.
Just because the market is going down doesn’t mean that there aren’t some stocks that are doing well, even hot, but there are a lot of stocks in the market and many of them don’t have enough liquidity to make them tempting. With the massive number of stocks in the market, finding these stocks can be a daunting process for many, and although individuals now have access to software to help them a lot in doing this, this is not something that many investors use, and is more of a tool of traders.
Exchange stocks can provide an easy go-to strategy during market pullbacks, without having to pore over countless stocks to find a good needle in the haystack.
Aside from CME’s impressive performance lately, the other major exchange stocks are also doing pretty well over this time. CBOE is up 10% in the last 2 months, ICE is up 8%, and NASDAQ is up 4%.
We don’t want to just go all in with this approach though, as this is all about picking the right spots, and the right spots involve modest declines in the indexes. These stocks all got clobbered in 2008 for instance, but this was a time where being in stocks period was a very bad idea due to the massive selling that went on.
We never want to do something with our eyes closed though, and anyone who was in these stocks in late 2007 when both the market and these stocks hit the skids and rode them down only has themselves to blame. We usually blame the market or fate but when we do, we need to have a mirror handy to reveal the real culprit.
This is not so much about being rewarded for being bold as much it is for simply being wise. In fact, it’s much bolder, and foolishly so, to refuse to modify our risks when the need to do so should be pretty clear.
The investment industry does a great job at dumbing us down though, telling us to just hang on because things have always come back and the like, but we owe it to ourselves to step up and think about these things a little more than a sheep would when being led around by their shepherd.
It’s hard to say how these exchange stocks will hold up over the coming months, but they are certainly holding up better now, and that may be enough. If we do use this tool though, we need to keep our eyes well on it because the strategy will not work if we start getting stubborn with it and remain in a position past the time it would make sense to.
Being more sensible rather than less should definitely be preferable overall though, and going with exchange stocks or other strategies designed to both reduce our risk and ultimately improve our returns are always worth considering.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
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