Covid and the markets: Top three things for investors to consider in 2021 – ETFs and financial products

Telsa stock traded in a range of 1200 per cent last year. Photo / AP

In a three-part series, investment and advisory group Jarden explores three key factors at play in investment decisions in 2021. In part one, Jarden CEO James Lee and director (Institutional Equities) James Bascand explain the implications of the surge in popularity of exchange-traded funds and financial products on market activity.

OPINION:

Like Groundhog Day, the February reporting season has come and gone. With it we have seen the impact Covid-19 had on corporate earnings, but the Covid hangover seems destined to follow us through the rest of 2021, with uncertainty remaining a key theme in recent corporate outlook statements.

In 2020 we saw capital markets oscillate between unequivocal fear - with days of 12 per cent swings in share prices - to a period of irrational exuberance as markets rallied more than 50 per cent in record time. Fast-forward to March 2021; New Zealand has a market up 15 per cent since pre-Covid January 2020, and up by more than 20 per cent in the US despite the economic damage Covid-19 has caused.

Investors are now faced with the dichotomy of capital markets at higher levels than 12 months ago, but with economic conditions being worse than where we started in 2020. When thinking about the year ahead and possible strategies for investment in 2021, we should consider some of the significant changes that occurred last year to our capital markets and contemplate the new world in which we are operating.

Three key developments in 2020 (outside of Covid-19) played a major role in reshaping how we should be thinking about capital markets:

• The surge in availability, accessibility, and awareness of exchange-traded funds (ETFs) and exotic products.
• The return of the retail investor.
• The realisation of how sensitive capital markets can be in an irrationally low interest rate environment, and what small absolute - but large relative - movements in rates can mean for valuations.

While things often evolve slowly in capital markets, these three factors have compounded on each other to lead to an increase in volatility that we believe is worth taking into consideration when making active investment decisions.

The rise of the retail investor, combined with access to cheap capital and a wider array of products and channels to market than ever before, means our future returns will be influenced by this increase in volatility. Addressing these issues is no short spiel, so we will look to discuss them as a series of three pieces over the next few weeks ... starting now.

So what is volatility, and why is it more important now than ever?

Last year, when the markets were really fluctuating in Australia, we learned that the increased volatility was being supported by a series of new financial products. These new products let you invest in a view that volatility in a future period will be higher or lower than what is currently implied. This product was new to us, so we spent some time trying to understand why it exists.

Generally, we associate the word volatility with negativity - that is, when things go down or when life takes a bad turn, things are often considered volatile. Even Google defines volatility as "liability to change rapidly and unpredictably, especially for the worse".

Volatility, however, is really just a measure of change - either up or down. But we often don't seem to notice when change is in our favour. Unfortunately, volatility is close to the worst thing for an investor because it makes genuine planning impossible as it drives the very essence of the emotions of fear and greed.

Just to highlight the extent of the volatility in 2020: in the space of 12 months, Summerset shares traded in a range of $3.36 to $13.25 (a 400 per cent range), Afterpay A$8.90 to A$160.05 (1800 per cent range) and Tesla US$72 to US$883 (1200 per cent range)!

These were the same companies, executing largely the same strategy they articulated in January as they did in December, but investor sentiment and trading flows created periods of, first, world-ending fear and, then, a haze of induced euphoria.

For some investors, this uncertainty led to a view that accurately pricing stocks was going to be challenging, and that volatility in these prices would likely increase. Hence the creation and uptake in volatility ETFs like VXX, VIXY, VIXM, VXZ, and XVZ.

ETFs surged in popularity through 2020. Photo / 123rf

Perhaps our favourite quote on the relevance (or not) of these ETFs comes from the ETF gurus at etfdb.com: "Overall, this product is of no use to the vast majority of investors. And those who are sophisticated enough to seek volatility exposure are probably better off managing their positions more closely."

What do we think?

Financial products often dominate markets, making up more than half of all assets in some markets, and more than 70 per cent of daily liquidity in some stocks that are directly or indirectly related to those products.

This increase in volatility means that for short periods markets will be increasingly dictated by sentiment and flow, rather than the fundamental numbers. Interpreting and assessing the "mood" of the market is thus becoming increasingly important for active investors.

So, as we look to understand the mood shifts, our focus this year is understanding the key drivers of those moods, availability of products to trade the moods (ETFs and other financial products), retail investors, and the current interest rate environment.

ETFs and financial products

Financial markets excel at developing products to allow investors to trade their view, and when markets go through long periods of growth, eventually even the most obscure view can be traded via some financial product. ETFs continued their surge in popularity through 2020, supported by a lack of discretionary spending options through Covid-19 lockdowns, improved customer experience and trading products like Robinhood, which provided accessibility for retail investors in a period of market turmoil.

Want to invest in technology? There are plenty of ETFs for that. Space exploration? Check. Robotics? Check. What about investing based on a storm in Houston? Social media sentiment? An ETF called FOMO? Tick, tick, tick.

How about clean/renewable energy? No problem.

In fact, New Zealand stocks over-index in most clean energy financial products globally, with Meridian Energy and Contact Energy having experienced unbelievable volatility in recent months as Joe Biden's pledge to tie the US economic recovery to tackling climate change drove over US$6 billion into two iShares Global Clean Energy ETFs.

In the three months from mid-October to mid-January, just two ETFs snapped up almost 10 per cent of Contact Energy, and 8 per cent of Meridian Energy's available shares as money poured into the ETF, forcing the managers to keep buying and buying the underlying investments. This naturally drove share prices through the roof despite no real change in either of the businesses. In fact, analyst expectations for earnings and dividends for Meridian Energy fell during that buying frenzy – share prices were in total juxtaposition to typical market reactions. We will come back to this one during the series.

These ETF products have the ability to dominate markets at times, as they are cheap and easy to access, but more importantly make it easy to express a simple view. Unfortunately though, what that means is the financials of that view don't matter in the short term - just the index construction.

Let us explain that. Every index is created differently: some only buy the biggest companies, some the fastest growing, some the ones with the most liquidity, some - like the Dow Jones - are price weighted. Some limit the number of shares they can own, some don't, some limit by geography, some by dividend yield. A few even have profit metrics (heaven forbid the profitability of a business should matter in investing).

Very few take ALL of those things into account, which is why we need to consider those ETFs when investing.

So, we have seen markets change with passive investing, but we also have new investors entering the market and interest rates so low they are encouraging people to invest. Trading with full knowledge of these three factors will give investors an opportunity to generate returns.

• Coming up in part two of this series: The rise of retail investors

• This article reflects the opinions and views at the time of publication, and is not to be relied upon as a basis for making any investment decision. Please seek specific investment advice before making any investment decision. Jarden is an NZX Firm, a broker disclosure statement is available free of charge at www.jarden.co.nz. Jarden is not a registered bank in New Zealand.