It's Been a Rough Stretch for ETFs. These Funds Bucked the Trend

Dow Jones2022-07-08

The second quarter of 2022 was brutal for most fund investors -- and many fear the worst is yet to come.

Stock funds fell everywhere, with nearly no place to hide. The iShares Russell 1000 (ticker: IWB) and iShares Russell 2000 $(IWM)$ exchange-traded funds, which track the performance of large-cap and small-cap stocks, respectively, both tumbled 17% in the quarter. And although cheaper stocks generally held up better, the value-focused versions of the two funds still lost 13% and 16%, respectively.

Inflation is showing no sign of letting up, and investors are worried that the Federal Reserve's plans to keep hiking interest rates could lead the economy into a recession next year -- if not in 2022. The fear pushed all sectors deep into the red, led by consumer-discretionary and communication-services stocks -- things people often cut first when they need to tighten their belt.Even energy stocks, which saw huge gains earlier this year on the back of rising oil prices, lost their momentum in the second quarter. The Energy Select Sector SPDR Pacer Swan SOS Fund of Funds ETF|ETF $(XLE)$ declined more than 6%, a sharp contrast to its 38% gain in the previous three months. Although energy giants are still pocketing record profits today, investors expect a recession would drag down demand, curb oil prices, and cut into their earnings.

The bleeding isn't limited to the U.S. The iShares MSCI EAFE ETF $(EFA)$, which tracks developed markets like Japan, Europe, and Australia, tumbled 15%, while the iShares MSCI Emerging Markets ETF $(EEM)$ was down 11%. The emerging markets fund held up better largely because Chinese stocks -- its largest component, making up one-third of the portfolio -- have stabilized after tumbling throughout 2021 and early 2022. The iShares MSCI China ETF $(MCHI)$ gained more than 5% in the second quarter.

In a volatile market like today's, investors shouldn't just look at index-tracking passive funds. Active managers staged a comeback in the quarter. According to Bank of America, 56% of large-cap active funds outperformed the Russell 1000 benchmark in the second quarter, by an average of 25 basis points. To put the numbers in perspective, the historical average since 2003 was just 36%.

Bond funds had one of their worst quarters, as well. The Fed raised the target interest rate by a quarter-point in March, a half-point in May, and three-quarters of a point at its June meeting. With more rate hikes widely expected, yields rose across the bond market. Short-term rates have climbed particularly fast, with the two-year Treasury yield nearly exceeding the 10-year yield -- a sign that bond investors have a gloomy outlook for the economy.

Bond prices, which move in the opposite direction of yields, continue to fall, but those with shorter maturities look more attractive now. When investors expect interest rates to go up, they usually prefer short-term bonds in hopes of harvesting higher yields later on. The buying demand could help support the bonds' prices. The iShares 1-3 Year Treasury Bond ETF $(SHY)$ declined just 1% in the second quarter, while the iShares 20+ Year Treasury Bond ETF $(TLT.AU)$ plunged 13%. Municipal bonds fared better. The iShares National Muni Bond ETF $(MUB)$ dropped just 3% in the second quarter.

Investors continued to back out of the struggling asset class, pulling $157 billion from bond funds in the second quarter. That outpaced the $69 billion in outflows in the first quarter, which was already the group's biggest asset loss since the first quarter of 2020, according to the Investment Company Institute.

After losing some $50 billion in assets in April, stock funds started seeing some inflows in late May as some investors entered the market again after the bloody selloff took a break. But the buying spree quickly turned around in June after the market started tumbling again. In the last two weeks of the second quarter, investors pulled more than $10 billion out of stock funds.

One of the brighter corners of the funds market was in riskier funds that make explicit bets on interest rates, stock market volatility, and currencies through derivatives like options and futures.

The Simplify Interest Rate Hedge ETF (PFIX), for example, holds put options that gain if 20-year Treasury rates go up. The ProShares VIX Short-Term Futures ETF $(VIXY)$ invests in futures contracts that profit from increases in the expected volatility of the S&P 500. The Invesco DB US Dollar Index Bullish ETF $(UUP)$ tracks the value of the U.S. dollar relative to a basket of the six major world currencies. The three funds gained 13%, 10%, and 6%, respectively, in the second quarter.

These strategies are best used as short-term speculative bets rather than long-term investments. They can be quite risky and volatile if market trends suddenly shift. In the second half of June, for example, both the Simplify and ProShares funds tumbled as much as 10%.

With that in mind, if you're confident that interest rates will continue to go up or stocks will remain volatile, these funds might not be a bad way to hedge your portfolio against recession risks.

Disclaimer: Investing carries risk. This is not financial advice. The above content should not be regarded as an offer, recommendation, or solicitation on acquiring or disposing of any financial products, any associated discussions, comments, or posts by author or other users should not be considered as such either. It is solely for general information purpose only, which does not consider your own investment objectives, financial situations or needs. TTM assumes no responsibility or warranty for the accuracy and completeness of the information, investors should do their own research and may seek professional advice before investing.

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