4 ETFs to help hedge against a market crash 

On Friday, May 20th the S&P 500 Index (SPX) briefly dipped into the bear market territory, falling more than 20% from its 52-week high of 4,818 to a new 52-week low of 3,810. This comes at the end of 7 consecutive weeks of losses, marking this month as the index's worst performance stretch since the dotcom bubble burst. 

With tech and retail stocks alike recently disappointing on their earnings, interest rates continuing to rise, and inflation showing no signs of being transitory, many economists are forecasting further downside on the horizon. A further strong negative catalyst or unexpected "tail risk" could send the markets into freefall. 

Investors are understandably panicked. Inflows to the iShares 20+ Year Treasury Bond ETF (TLT) increased significantly last week as the ETF increased in price amid a flight to quality. The CBOE Volatility Index (VIX) was up over 19% by Friday, with put option premiums skyrocketing in price. 

I don't believe in timing the market, but I do believe in hedging. Buying an instrument that offers downside protection could be worth the premium paid if the unthinkable happens. When the markets crash, hedging minimizes downsides, allowing portfolios to recover faster. 

Different approaches to hedging

VIX

In the introduction, I noted that the VIX sharply increased when the S&P 500 fell. This is not a fluke. The VIX is calculated via the market's expectations of implied volatility based on SPX index options. When things get rough (like last week), volatility spikes, and the VIX goes up. 

Now, investors can't buy the VIX directly. Instead, they can buy ETFs that track VIX futures, which are derivative contracts based on a future anticipated value of the VIX. For investors who can somehow time volatility right, using VIX futures ETFs could keep their portfolio in the green during a crash. 

The problem is that the VIX is a mean reverting instrument, meaning that over time, volatility tends to fall back to the average, making VIX futures lose money. Moreover, VIX futures suffer from contango, which also causes their value to decay. All in all, VIX future-based ETFs tend to be a poor permanent hedge due to their high negative carry and will quickly lose their value if held for long periods. 

Put options

Another idea is put options, which are derivatives that give the buyer the right, but not the obligation, to sell a stock at a certain price, known as the strike before an expiry date. When the SPX falls, SPX puts will generally increase in value (especially if the SPX price plunges below the strike), allowing investors to hedge their losses. Put options with strike prices that are out-of-the-money (OTM) possess greater convexity, meaning that the bigger the crash, the better the payout will be.

However, put options cost a premium to buy and will generally decay in value over time, a mechanic known as Theta. This also gives them negative carry, although not as much as VIX futures, so an investor could theoretically roll them out in time indefinitely at the cost of paying continued premiums. Still, they will be a source of drag for portfolio returns.

U.S. Treasury Bonds

Finally, investors can buy U.S. Treasury bonds. Intermediate and long-term bonds possess higher effective durations, a measure of interest rate sensitivity. This is important as, during a bad crash, there is a chance that the Federal Reserve will drop interest rates to stimulate the market. When this happens, higher duration bonds will soar in value. This is also aided by the "flight to quality," a behavioural phenomenon where investors panic-buy U.S. Treasuries en masse as a perceived safe asset. 

Unlike VIX futures or put options, Treasury bonds have a positive expected return thanks to the coupon (interest) they payout, making them suitable long-term holdings. However, the high effective duration of intermediate and long-term bonds works both ways. When interest rates rise, these bonds will lose value, as seen so far in 2022. As well, their negative correlation with equities tends to go positive in this scenario, too, reducing their diversification value. 

The lesson here is that each hedge has a different risk-reward trade-off. The old maxim of "can't have your cake and eat it too" applies here. Hedging costs money, and the market is efficient at pricing that. It's like insurance – investors pay a premium now to limit the size of their losses if the unthinkable happens. Whether or not that premium is worth the protection is dependent on an investor’s risk tolerance and investment objectives. 

Four ETF options for hedging

I used Trackinsight's ETF Screener to find a list of ETFs with built-in crash protection, whether VIX futures based, put options based or Treasury based. 

1. ProShares Ultra VIX Short-Term Futures ETF (UVXY): This ETF provides 1.5x leveraged exposure to the daily performance of the S&P 500 VIX Short-Term Futures Index for a net expense ratio of 0.95%. 
2. Simplify US Equity PLUS Downside Convexity ETF (SPD): This ETF holds 97% of its capital in the S&P 500 and 3% in a ladder of OTM SPX put options for a net expense ratio of 0.28%. 
3. Cambria Tail Risk ETF (TAIL): This ETF holds 80% of its capital in intermediate Treasury bonds and TIPS and 20% in a ladder of OTM SPX options for a net expense ratio of 0.59%. 
4. Amplify BlackSwan Growth & Treasury Core ETF (SWAN): This ETF holds 90% of its capital in intermediate Treasury bonds and 10% in S&P 500 LEAPS (Long-Term Equity Appreciation Securities) options providing 70% notional exposure for a net expense ratio of 0.49%.

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.