What Happens To ETFs When There Is Terrorism, War, Earthquakes, Or Bear Markets
In the last week, there have been huge inflows into popular American ETFs as the chart below shows.
In fact, most of the inflows come from the U.S.
On Wednesday, the minutes of the Federal Reserve’s Open Market Committee meeting in July came out. Officials in the committee were split on whether to raise interest rates in the U.S. Mixed signals from the U.S. economy, along with concerns for global economic growth, have kept the OMC members dovish on interest rates.
While the OMC looks at economic data to make its inferences, this past week, I looked at the options market. As my previous article indicated, investor expectations are strongly polarized and, at some point, there will need to be a reconciliation of the contradictory views.
Suppose a there is a shock to the global economic system. How would popular ETFs react? Of course, this depends on the type of shock. Using sophisticated and Bloomberg-owned risk models, this article examines will examine the effects of six scenarios on ten different ETFs:
- SPDR S&P 500 Trust ETF (NYSEARCA:SPY)
- PowerShares QQQ Trust ETF (NASDAQ:QQQ)
- SPDR Gold Trust ETF (NYSEARCA:GLD)
- iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX)
- iShares MSCI Emerging Markets ETF (NYSEARCA:EEM)
- Health Care Select Sect SPDR ETF (NYSEARCA:XLV)
- iShares Core MSCI Emerging Markets ETF (NYSEARCA:IEMG)
- Technology Select Sector SPDR ETF (NYSEARCA:XLK)
- Vanguard REIT Index ETF (NYSEARCA:VNQ)
- Utilities Select Sector SPDR ETF (NYSEARCA:XLU)
I will give the salient details for each scenario. A table below summarizes the findings. Since securities have exposure to different risk-factors, using a multi-factor model one can estimate the expected return of a security if we know how the risk factors behave. The Bloomberg risk models consider two things. First, the decomposition of a security’s overall risk into a combination of risk factors. Bloomberg does an exhaustive decomposition and considers hundreds of possible risk factors. Second, Bloomberg uses proprietary models to model the propagation of shocks across risk factors. (Think instantaneous correlation and lagged correlation.) You can run a similar analysis using PORT <GO> on the terminal. The scenarios considered below are standard and provided by Bloomberg. I give the description of the shock for each. One can also make custom scenarios. If you would like me to test what would happen to ETFs in a scenario not considered below, please say so in the comments!
Emerging Market Index Down 10%
Suppose the MSCI Emerging Market Index slips by 10%. This could happen if sentiment on Emerging markets turns due to politics, economics, or simply better opportunities for capital in developed countries.
It stands to reason that IEMG and EEM drop by 9.33% and 9.49%, respectively. QQQ and SPY would be expected to drop by 5.80% and 5.50%, respectively. GLD would be a way to preserve wealth, as it is expected to drop only 0.43% and VXX would increase by 36.04% as contagion fears spread.
Revolution and War
Using the historical risk factors returns for the period between January 22, 2014 and March 14, 2014 — the revolution in Ukraine and the annexation of Crimea — we can extrapolate what would happen if there is another crisis of a similar nature. A few weeks ago, a coup d’état failed in Turkey. Popular sentiment is turning from Venezuela to the Middle East. What could happen to ETFs?
Both VXX and GLD surge. The first by 30.41% and the second by 11.28%. Both VNQ and XLU would experience gains as well, 3.96% and 3.75%, respectively. The biggest losers would be, unsurprisingly, IEMG and EEM, both expected to decline by 2.25-2.67%.
Bear Market in USA
Suppose the S&P 500 drops by 20%, VIX surges by 150%, and crude oil drops by 20%. In this nightmare scenario, SPY leads expected losses by 20.41% followed closely by XLK (-19.75%) and QQQ (-19.62%). The shock is expected to propagate to emerging markets causing EEM and IEMG to drop by more than 17%. Naturally, VXX soars; it is expected to increase by 117.54%.
Major Terrorist Attack
What would happen to ETFs if a terrorist attack of September 11’s were to occur? Most of the ETFs we’re looking at would be down but not GLD nor VXX. The former is expected to remain unchanged in this scenario and VXX is expected to rise by about 27%. XLU and VNQ are both expected to decline but not as much as SPY, IEMG or XLK.
Natural Disaster
Not all shocks are man-made. In 2011, a major 9.0 magnitude earthquake and tsunami wrecked Japan. This is what could happen to your ETFs: most will remain unchanged. VXX would be expected to rise by only 8.74%, GLD to decline by 1.08% on recession fears, and, naturally, IEMG and EEM would swoon, but by less than 3%.
Equities up 10%
Suppose US, Europe, and Asia stocks rally 10%. We can expect the equity ETFs to surge, led by emerging markets (eg: EEM and IEMG), followed by the US technology sector. Naturally, VXX quickly melts by nearly 60%. Gold and bonds are also expected to decrease.
(Note: This table was updated on 08/18/2016 to include more ETFs. The values may differ slightly from those in the text as two days of trading have slightly affected the expected return for each risk factor. The overall analysis, however, still stands).
Conclusion
In the five scenarios considered, GLD seems to protect against massive losses and VXX allows one to profit from these sorts of shocks. However, a rally in equities may produce significant losses for both these ETFs.
Would you like to see how a shock affects your favorite stock or ETF? Would you like to see other shocks considered? Write it in the comments below!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Unique Finance). I have no business relationship with any company whose stock is mentioned in this article.
