Volatility: Use your “explore” investments to tame it

But when it comes to investing, most of us can’t ignore our emotions. We read the news, see inflation numbers in the headlines, listen to economic forecasts and try to deduce where interest rates are headed. Armed with that information, we might be tempted to fine-tune our portfolios to try to juice returns or dampen risk.

Opportunities for your portfolio

Maybe you see an opportunity in the aftermath of the pandemic for hotel and airline stocks to soar. Or you see the potential for energy stocks to act as a hedge against stubbornly high inflation. A more pessimistic investor might look for downside protection in case stocks crash or want to change the duration of their bond portfolio from long to short, to protect against rising interest rates.

The idea is to find investments that don’t move with the overall market. For instance, if investments in one asset class rise by 10% and another asset class also rises by 10%, those investments would have perfect positive correlation. If the first asset class increased by 10% and the second asset class had no movement, they would be seen as having no correlation. Finally, if one asset class increased by 10% and the second asset class fell by 10%, they would have perfect negative correlation.

A diversified investor would hold stocks across many sectors and geographic regions. They might hold a mix of short-term and long-term government and corporate bonds. Investors can diversify further by adding real estate (or REITs) to their portfolio, along with precious metals like gold. These days, with cryptocurrencies like bitcoin and ethereum surging in price, many investors are now dabbling in this new “digital gold.”

It’s easy to get carried away with crypto. That’s why the concept of a “core and explore” portfolio is so popular with investors. The majority of the portfolio is the “core,” usually a mix of globally diversified stocks and bonds; the rest is the “explore” portion, dedicated to finding hidden gems and high-growth opportunities or getting defensive with a volatility-countering investment.

Here are some ideas to consider for the “explore” portion of your portfolio, if you’re looking to add some protection as well as some pizzazz.

Emerging markets: U.S. stocks are on fire again this year, posting an 18.5% increase so far in 2021. Go back a decade and the U.S. stock market has vastly outperformed other markets with an incredible 227% cumulative return since December 2011.

Meanwhile, emerging market stocks are flat on the year and have only returned a cumulative total of 56.6% over the last decade.

Further, emerging markets could be a key driver of global economic growth over the next few decades and may offer compelling long-term growth prospects for Canadian investors. Investors who want to capitalize on powerful consumer trends within key markets, particularly Asia, that may be overlooked by index-based emerging markets strategies, could consider the recently launched Horizons Emerging Markets Leaders ETF (HEMC).

Semiconductors: By now, we’ve all heard that one of the main causes of inflation and supply chain bottlenecks is the global semiconductor shortage. The U.S. administration under President Joe Biden announced earlier this year that it would set aside US$50 billion to expand domestic manufacturing of semiconductor chips.

In June 2021, Horizons ETFs launched Canada’s first semiconductor ETF: Horizons Global Semiconductor Index ETF (TSX: CHPS), which holds some 50 companies, including NVIDIA Corp., Taiwan Semiconductor Manufacturing Co., Intel Corp., Texas Instruments Inc. and Qualcomm Inc., to name a few.

Commodities: It can make sense to own commodities, like gold and crude oil, in your portfolio to counter the impact of rising inflation. Commodities can also be negatively correlated with stocks, giving investors a hedge against falling markets. Investors can add physical gold, invest directly in gold stocks, or invest in a gold ETF.

Investors can also consider putting money into commodity futures like crude oil or natural gas to take advantage of those rising prices. And yes, there are ETFs for that.

Corporate bonds: If the threat of rising interest rates is keeping you up at night, consider delving into the world of corporate bonds. While they’re riskier than long-term government bonds, corporate bonds could hold up better if interest rates go up, because of their higher yields.

Bonds aren’t exciting anyone these days, but short-duration corporate bonds have outperformed aggregate bonds, long-term federal bonds and short-term government bonds this year. And they should be poised to continue to outperform if interest rates keep ticking upwards. The Horizons Active Ultra-Short Term Investment Grade Bond ETF (HFR) is a high-grade corporate bond ETF designed to pay a higher yield as interest rates rise, which seems ideal for this situation.

What explore-type investments mean to investors right now

Investors are justifiably concerned about markets these days. The COVID-19 pandemic has caused unprecedented disruption in the global economy. We haven’t seen this movie before, so we don’t know how it’s going to end.

In the meantime, we have record government debt, persistently high inflation, soaring asset prices, historically low interest rates, a semiconductor shortage, global supply chain issues and volatile commodities. Throw in the rise of meme stocks and cryptocurrencies, and there’s no shortage of issues to distract investors.

If there was ever a time to develop an “explore” portion of your portfolio—either to take advantage of a potential growth opportunity or to protect your portfolio from rising rates or a stock market crash—this would be it.

Luckily, thanks to the continued development of ETFs, investors can easily access a particular sector, geographic region, commodity index or fixed income niche with a low-cost exchange-traded fund.

About Robb Engen, QAFP

Robb Engen is a fee-only advisor who will work with you to achieve your financial goals by creating a financial plan with actionable steps along the way.