Interactive Investor

Two ETFs to consider if you are worried about a tech bubble

15th January 2021 11:03

Tom Bailey from interactive investor

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Tom Bailey highlights ETFs that may provide investors with some protection if the tech bubble bursts.

There’s been no absence of US market bubble warnings over the past five years or so. Plenty of bears have come out to argue that the valuations of US tech stocks, particularly the most famous names, such as Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB) and Netflix (NASDAQ:NFLX), are too stretched and due a day of reckoning.

So far, those predictions have amounted to little. US tech and large-cap growth stocks have continued to outpace all others, surviving everything from Federal Reserve rate hikes and a US/China trade war to a global pandemic. 

However, there does appear to be a growing chorus of investors warning that US tech is in a bubble. This is certainly the view of veteran investor and founder of GMO Jeremy Grantham.

In his latest letter to investors, Grantham argues that the “long bull market since 2009 has finally matured into a fully fledged epic bubble”.

He continues: “Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behaviour, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.”

Aside from valuations and other traditional financial indicators, Grantham says he sees a bubble on the basis of investor behaviour. He argues: “The single most dependable feature of the late stages of the great bubbles of history has been really crazy investor behaviour, especially on the part of individuals. For the first 10 years of this bull market, which is the longest in history, we lacked such wild speculation. But now we have it. In record amounts.”

Examples of speculative behaviour, he argues, include investors bidding up the prices of shares in Hertz (NYSE:HTZ), Kodak (NYSE:KODK), Nikola (NASDAQ:NKLA) and Tesla (NASDAQ:TSLA).

Not everyone agrees, of course. Writing in the Financial Times, Martin Wolf recently argued that interest rates are at rock-bottom lows due to big structural shifts in global savings and investment. He says interest rates are more likely to fall further than rise, meaning markets do not currently look overvalued.

So, what’s an investor to do? Unfortunately, there are no easy answers. Even if we are in the middle of a tech bubble, no one knows when it will end. And as a result, anyone who attempts to reduce their exposure faces the risk of underperforming for perhaps several years.

Equity ETFs for sheltering from a bubble

Of course, if you are absolutely convinced that the US market looks like a “fully fledged epic bubble” the simple solution is to just go to cash or buy defensive assets, such as gold, that should, in theory, hold up when the market finally turns.

However, while investors may want to increase exposure to these assets, opting to dump all your US or tech holdings is not realistic, not least of all because we have no idea when this supposed bubble will end.

There are, however, some US equity ETFs that may provide investors with better protection when (or if) the party does finally come to end.

One option would be an equal-weighted ETF. This could be for either global or the US market. For the US, there is the Xtrackers S&P 500 Equal Weight ETF (LSE:XDEW).

This ETF is equal weighted, meaning each member of the index accounts for the same percentage. So, in an index of 100 stocks, each would receive a 1% weighting. In the case of this ETF, each constituent accounts for 0.20% each, which is periodically rebalanced.

The first advantage of this is that investors get less exposure to the more “bubbly” parts of the market. Market-cap weighted indices give investors higher exposure to the frothiest, most bid-up parts of the market. Were a bubble to burst and the valuations of those companies to fall heavily, investors would experience big losses. Being equal weighted, this ETF would make you underweight those parts of the market.

Second, an equal-weighted index gives the investor more exposure to the parts of the market that have performed less well in recent years. If the history of the Dot Com bubble is anything to go by, exposure to these more beaten-up parts of the market may be welcome.

For example, Robert Arnott notes in The Fundamental Index: A Better Way to Invest that between March 2000 and March 2002, while the S&P 500 lost more than 20%, the average US-listed stock actually returned more than 20%. More specifically, while the S&P 500 lost 9% in 2000, the average stock listed in the US enjoyed a double-digit gain. Likewise, in 2001, the S&P 500 lost 12% and the average stock enjoyed positive returns.

However, the downside here is that all the talk of a bubble waiting to burst turns out to be wrong. We could, as many argue, continue to see the sort of economic backdrop that allowed tech and growth stocks to do well in the first place. Namely, a continuation of low interest rates, low inflation and slow economic growth.

If that is the case, and tech valuations do not come crashing down anytime soon, being in an equal-weighted ETF means underperformance. That would have been the case for any investor over the last few years.

However, underperformance is still better than no performance, which is the possible outcome of bubble-wary investors going all to cash.

Another possible option would be HAN-GINS Tech Megatrend Equal Weight ETF (LSE:ITEK). As the name suggests, this ETF is both focused on tech and equal weighted. As a result, it has lower exposure to some of big-name stocks said to be driving the bubble, while still having exposure to tech.

Of course, if we are in an almighty bubble, this ETF could still see you make major losses. However, if you subscribe to a milder version of the bubble thesis, namely that some valuations for certain tech companies have simply gotten out of hand but tech remains an attractive theme, this could be an appealing ETF.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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