Advocates of active management often argue that this is the best approach for dealing with challenging market conditions, but passive investors also have some options for events such as the end of the current market cycle. 
After 10 years, the bull run that has been in place for much of the post-financial crisis period is beginning to look a little long in the tooth and the global economy has started to show signs of slowing down.
In its 2019 ETF Investment Insights EMEA report, BMO Global Asset Management highlighted several strategies that exchange-traded fund (ETF) investor can use if the cycle is entering its later stages.
Recent ETF trends
Source: BMO Global Asset Management
Morgane Delledonne, ETF investment strategist at BMO Global Asset Management, said: “The global economy is entering a late-cycle phase, where economic growth remains strong but is losing momentum.
“Fundamentals look good, but some vulnerabilities are building, including the high level of public and corporate debt and the rise of populism and protectionism.
“As a result, we expect market volatility will remain elevated through 2019 and market corrections will become more frequent. One way to reduce the volatility drag on long-term returns is through strategies generating high income.”
Against this backdrop, the asset management house suggested several ways that ETFs can be used to allow investors to participate in the upside while protecting their portfolios on the downside.
Starting with equities, Delledonne said the easiest way to add high income exposure to a portfolio is by investing in companies that pay a high dividend.
However, she also noted that the chief risk of this approach is falling into a ‘yield trap’, or stocks that have a high yield but shaky fundamentals that make them a bad investment. She added that US corporate profit growth is likely to continue to decelerate in 2019, with declining growth prospects, labour cost increases and tighter profit margins.
“Therefore, we believe it is advisable to screen for quality before screening for dividend yield,” she said. “This is our approach in the BMO Income Leaders ETF range, which tracks the MSCI Select Quality Yield index.”
Performance of ETFs since launch
Source: FE Analytics
Another approach that ETF investors could take for the end of the cycle is to diversify away from traditional sources of income through the use of derivatives.
Delledonne explained that higher income can be achieved with relatively lower risk by implementing a covered call overlay. In this approach, index call options are sold against an equity index in exchange for an immediate additional cash flows on top of the underlying stock dividend, which boosts the overall yield of the portfolio.
“In this way, investors can combine superior income and investment growth from market returns,” she added.
Investors can get exposure to this approach in an active format through enhanced income funds (which tend to reside in the IA UK Equity Income sector). However, those that prefer a passive approach have options open to them such as the BMO Enhanced Income ETF range.
Turning to the fixed income space and Delledonne said that while yields remain low, there are a number of strategies that bond investors can use to minimise interest rate rise at the same time as generating a higher income.
She added that one such strategy is a ‘barbell’ approach. “You can implement this strategy with only two ETFs, a short-dated bond ETF for capital preservation and a longer-dated equivalent for higher yield,” the BMO strategist said.
“This strategy performs particularly well when yield curves are flattening (i.e. the shorter rates are increasing faster than longer-term rates).”
Fixed income investors who are searching for yield without credit or duration could also consider 1-3 years global investment grade corporate bonds, which offer diversification benefits alongside a balance between higher yields and downside protection.
She pointed to the BMO Barclays 1-3 Year Global Corporate Bond (GBP Hedged) UCITS ETF as a potential option for passive investors.
Performance of ETF since launch
Source: FE Analytics
“This maturity bucket offers good diversification benefits given its limited drawdowns, attractive yield, low duration and credit risks, and low correlation to equities,” the strategist continued.
“The ‘belly’ of the curve – medium-term maturities – currently provides a less attractive risk/reward trade-off, i.e. a lower yield per unit of duration.”
Furthermore, the prospect of higher interest rates means that fixed income investors have to be aware of the potential for bond issuers’ refinancing and re-rating risks are increasing.
Delledonne also noted that non-financial corporate debt has reached new highs, particularly in the US, but the credit market could come under greater pressure from “solid but slowing” economic growth in rising rate environment.
“Therefore, investors seeking income and diversification may be interested in investment grade corporate bond exposure, to balance the need for a higher yield and downside protection,” she concluded.