The best ASX ETFs to help protect and grow your portfolio

String of recent daily headlines: “ASX 200 closes at another record high.”

This is fantastic news for investors, after all, who doesn’t love all-time market highs to fatten our portfolio balances and help gloss over one or two poor stock selections! But, knowing that some of the worst market conditions followed soon after the best, doesn’t it also make you a little nervous?

I’m thinking about the 1987 stock market crash here, the dot-com boom and bust, and the GFC. Each major market downturn ultimately started amidst positive headlines exactly like the one above.

They say to be forewarned is to be forearmed. In other words, if you’re aware of a potential problem in advance, you’ll be better able to deal with it when it eventually arises. See the chart below of the current Nasdaq bull market, set to the same time scale as the one above for the dot-come crash. Notice any similarities?

The good news is we’re not trading anywhere near as vertical as we were back in 2000, and possibly, the period before the 2021 top better resembled the dot-com peak. But, we have had a very good run since the October 2022 lows – let’s hope it continues!

If it doesn’t, the aim of this article is to forewarn you of the dangers of complacency at market tops, but also to equip you with knowledge of the tools you can use to protect yourself from the inevitable downturns which are part and parcel of long term investing.

Beware the bear

The typical bear market slices around 30% off the value of stocks and lasts for just over 11 months. The bad ones can be considerably worse, though. The worst bear market in terms of losses over the last 80-years, according to First Trust Advisors LP, was the GFC bear market which saw stock prices on the S&P 500 crumble by more than half. The longest bear markets were caused by the Energy Crisis in the 1970’s and the 1981-82 recession. Each of these lasted 1.7 years.

The first rule of investing is: Know your exit strategy. Just like when James Bond walks into the Monte Carlo Casino, what’s the first thing he looks for? Is it the bar where he’s going to get his martini? Is the mysterious and curvaceous brunette sitting at that bar? Or is the baccarat table where his arch nemesis, intent on ruling the world, is seated?

Nope! It’s the EXIT sign! Just in case one of his arch nemesis’s goons jumps out of a broom closet with a machine gun, 007 will know exactly how to extricate himself safely from the situation!

When it comes to investing, you have two major exit options should a bear jump out of the proverbial stock market broom closet! They are 1. Go to cash, and 2. Hedge yourself. Let’s investigate each of these options in detail.

Go to cash

Going to cash is perhaps the original and simplest method investors have used through history to protect their portfolios. Cash is king, as they say, but this is particularly true in falling markets. The greater the decline in prices, the greater the buying power held by cash in the bank.

An added benefit of going to cash is there’s typically very little risk associated with cash balances versus capital stability (this is assumed to be as reliable as the creditworthiness of the entity you’ve parked your cash with). The table below shows the returns and volatility of returns of the major asset classes since 1980, along with their respective performances over the last ten years.

It’s clear that since 1980 cash delivered a 7.2% p.a. average return with a class leading low average volatility of 5.3% p.a. This compares to 10.8% p.a. and 20.2% p.a. respectively for Australian Shares, and 10% p.a. and 16.7% p.a. respectively for Australian Property. 

Lack of volatility is cash's main drawcard. At around one-quarter of the volatility of Australian shares, it also failed to deliver even a single negative annual return. On the other hand, Australian Shares delivered 12 negative annual returns with the worst being -40.4% in 2008 during the GFC. 

This speaks to cash's supreme stability compared to shares, and on first pass it might be the clincher for many risk averse investors to chose to only invest in cash. One might even think the returns on cash and shares seem similar. They're not.

Consider that over long periods of time, a 3.6% per annum compound return will likely mean many tens, and possibly even hundreds of thousands of dollars difference to the average retirement account. Investing only in cash will also lock an investor out of those outlier positive years for other asset classes, which as the table shows, could mean missing out on returns in excess of 60%.

It is clear then, that going to cash is not without risk. Every time an investor goes to cash they're vulnerable to opportunity cost risk. Opportunity cost is the difference in return between holding a particular asset versus the returns of the best performing assets over the same period which aren’t being held.

For example, if you decided to go to cash just last year, your opportunity cost of holding cash compared to say US Shares, was an eye-watering 21.6%. This implies you want to be quite certain prices of other assets are about to fall, and not rally, when you choose to go to cash.

It is true that timing is everything when it comes to going to cash, and a misstep could cost you dearly. For this reason I’ll discuss a simple timing strategy to assist you with making better decisions on when to go to cash at the end of this article.

For now, note that going to cash is as simple as selling your shares and transferring your money to your favourite savings account. But there are also a few options for going to cash if you wish to use ASX exchange traded funds (ETFs) which specifically focus on cash-style investments.

Cash ETFs can be purchased and sold just as easily as any ASX-listed share. Holders of ASX cash ETFs earn a monthly dividend which reflects the earnings on the fund’s capital over the period. These dividends are typically unfranked.

The major advantages and disadvantages of using ASX ETFs compared to bank accounts and term deposits are explained in detail in this earlier Listed Series article. In short, ASX cash ETFs can provide a superior, unconditional return compared to more conventional cash investments. If you are thinking of using ASX ETFs to go to cash, listed below are your options.

ASX Cash ETFs

• BetaShares Australian High Interest Cash ETF (ASX: AAA)
• iShares Core Cash ETF (ASX: BILL)
• iShares Enhanced Cash ETF (ASX: ISEC)
• Betashares Australian Cash Plus Fund (ASX: MMKT)

Hedge yourself

One way to mitigate the impact of the potential opportunity cost associated with going to cash is to use a technique called hedging. Hedging simply means making an investment whose return is expected to be positive when the return on your main portfolio is expected to be negative.

The positive return on your hedge is therefore expected to offset the losses on your main portfolio, giving you a degree of protection against a market downturn.

Hedge yourself by going short

Most hedges involve going short. Going short simply means selling an asset one doesn’t already own first and buying it back later. Short trades deliver a profit when the initial sale price is greater than the eventual repurchase price and deliver a loss when the eventual purchase price is greater than the initial sale price.

Professional investors utilise asset lending facilities to short assets they don’t already own. They may also use derivative products like options, futures, and contracts for difference to gain short exposure. For the average investor, however, arguably the simplest and easiest way to go short to hedge your portfolio is to use ASX short selling or “bear” ETFs.

Bear is simply the term applied to an ETF which is designed to profit when the prices of the assets targeted by the fund fall in value.

ASX Short Selling & Bear ETFs

• BetaShares Australian Strong Bear (ASX: BBOZ)
• BetaShares Australian Equities Bear (ASX: BEAR)
• BetaShares US Equities Strong Bear Currency Hedged (ASX: BBUS)
• Global X Ultra Short Nasdaq 100 Hedge Fund (ASX: SNAS)

The above ETFs typically rise in value when the assets upon which they’re based fall in value. So, for example, BBOZ and BEAR will tend to appreciate when the Australian share market falls, and BBUS and SNAS will tend to appreciate when the US share market falls.

Put simply, if you’re concerned the Australian and US share markets are about to suffer a severe downturn, investing in ASX short selling and bear ETFs could help you earn a profit should this occur. Your short selling and bear ETF hedges will help offset the losses in your main portfolio.

The opposite is also true, though. Short selling and bear ETFs will usually fall in value when the assets they’re based on appreciate. This highlights the main potential risk of ASX short selling and bear ETFs: When your main portfolio is appreciating, there’s a very good chance your hedge is going to lose you money.

In this way, hedging is considered by professional investors as a form of insurance. Insurance is a way of life for most of us when it comes to our homes, our cars, our health, and even our lives. We might grumble about the cost of insurance, but we’re always glad it's there to protect us when something unexpectedly bad happens.

The chart comparison above between BBOZ and the benchmark S&P/ASX 200 Index (XJO) demonstrates the relationship between an underlying asset and an ASX short selling and bear ETF. We can see that when the XJO is falling, the price of BBOZ is typically rising, providing a useful hedge. But, when the XJO is rising, when it’s only trending sideways, and sometimes even when it is falling only gradually, the price of BBOZ tends to be falling.

Top Tip: ASX Short Selling & Bear ETFs utilise derivatives, many of which are subject to time erosion. This time erosion is built into the pricing of short selling and bear ETFs which means their value tends to decline by default over time. It also means that holding these ETFs for long periods could result in substantial losses under the following scenarios:

• The price of the underlying asset rises
• The price of the underlying asset goes sideways
• The price of the underlying asset declines only gradually

Hedge yourself using the covered call strategy

Another common strategy used by professional and sophisticated retail investors is covered call writing. The detail of the entire strategy is beyond the scope of this article, but just know for now it provides a partial hedge against the fall in the price of an underlying asset.

The major benefit of the covered call strategy is it can provide hedging benefits as well as extra income in the event the underlying asset price remains stable or only moves moderately higher. Unlike short selling and bear ETFs, time erosion works in favour of the covered call strategy and they can be set up with zero initial outlay.

The trade-off is that the covered call strategy only provides limited protection from a downturn in the underlying asset, and therefore is usually viewed as an income strategy rather than a dedicated hedging strategy.

ASX Covered Call ETFs

• Global X S&P/ASX 200 Covered Call ETF (ASX: AYLD)
• Global X Nasdaq 100 Covered Call ETF (ASX: QYLD)
• Global X S&P 500 Covered Call ETF (ASX: UYLD)

The chart comparison above between AYLD and the XJO demonstrates the relationship between an underlying asset and an ASX covered call ETF. In most cases, the XJO and AYLD are typically moving in the same direction. Note though, due to the income and hedging advantages associated with the covered call strategy, AYLD was able to occasionally deliver a positive return when the XJO was falling.

Timing is everything

A common theme throughout this article is the nagging reality that going to cash or hedging is best done immediately prior to a major market downturn, otherwise there are the inevitable opportunity costs and hedging costs respectively to contend with.

Unless you’re very good at reading micro and macroeconomic conditions to predict when the next major crash is about to commence (even then it wouldn’t have helped you predict the COVID-19 pandemic!), I suggest there’s a simpler and easier way to try to time the market.

Investors have been using moving average strategies to help understand when a market downturn has already started for decades. Already started is the key phrase here, because by definition, changes in moving average prices lag any change in the price of the underlying asset they’re measuring.

The most popular moving average strategy is the 50-day (50 MA) and 200-day (200 MA) moving average crossover model. This involves plotting these two moving averages on a chart of a benchmark index, for example the XJO or the S&P 500. At its most basic level, the model suggests that while the 50 MA is above the 200 MA, an uptrend in the benchmark is in place, and while the 50 MA is below the 200 MA, a downtrend in the benchmark is in place.

Investors often view a downtrend in the 50 MA as an early warning signal not all is well with the benchmark. They may look to implement modest hedging strategies or begin to move a portion of their holdings to cash at this time.

The key signal the uptrend has ended is when the 50 MA crosses below the 200 MA, also known as the dreaded “Death Cross”. At this time, investors may choose to either move predominantly to cash or to fully hedge their portfolios.

Similarly, the 50 MA / 200 MA model may also signal when to reduce or abandon hedge positions, or to move out of cash and back into the market. If the 50 MA begins to trend higher, this is usually a good sign the benchmark is recovering, and investors may look to reduce their hedge positions or begin to move a portion of their cash back into the market.

If the 50 MA subsequently crosses above the 200 MA, therefore delivering the famous “Golden Cross”, investors will look to close their hedge positions or move back to a fully invested position.

The 50 MA / 200 MA isn’t perfect, no technical or fundamental strategy is. It can be prone to false signals and often detrimental lags compared to sudden and large moves in the underlying benchmark. However, the 50 MA / 200 MA strategy is a simple, and most importantly, objective determination of when an investor may choose to implement or eliminate a hedge position.

For now, I'll just leave you with this nugget: Imagine if you knew about this strategy in October 2007? How much better off would you have been through the GFC!?

Find Funds & more!

You can learn more about each of the funds mentioned in this article in Livewire’s Find Funds page. In it you can search for a range of managed funds, ETFs, listed investment companies (LICs), and listed investment trusts (LITs).

Once you’ve selected a category, it’s now simple to search for an individual fund in the “Search Fund Name” box, or tailor your search by selecting the Asset Classes you’re interested in. You can then sort your results by a range of performance periods, as well as view minimum investment and fees data, along with several performance data reporting formats.

I’m confident you will agree the Find Funds page is an invaluable resource to assist you with your investing research.