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3 ETFs to Use as 'Portfolio Insurance'

Stocks in this article: VXX LBND DGP

By Michael Johnston of ETFdb

Although there are now nearly 1,100 exchange-traded products available to U.S. investors, the universe of ETFs used by most long-term buy-and-holders is considerably smaller. Beyond the "plain vanilla" portfolio-building block ETFs, recent years have seen the introduction of hundreds of more targeted and complex ETPs offering exposure to exotic asset classes and regions of the world.

Many of these more specialized exchange-traded products aren't of much interest to those in it for the long haul; they are more appropriate for active traders looking to capitalize on short-term pricing inefficiencies or implement a sophisticated investment strategy. But some of the ETFs investors may be inclined to brush off as tools for traders may also actually make a lot of sense as a minor allocation in some long-term portfolios. Below, we profile three ETFs that may be effective as "portfolio insurance" against a prolonged downturn in stock markets. These funds aren't low-risk options that tend to exhibit very low volatility regardless of the macroeconomic environment (e.g., short-term Treasuries). Instead, they offer exposure to asset classes that tend to thrive when stocks encounter turbulence.

iPath S&P 500 VIX Short-Term Futures ETN (VXX)
This exchange-traded note is linked to an index consisting of short-term futures on the CBOE Volatility Index, better known as the "VIX" and often referred to as the "fear index." The VIX measures the anticipated volatility in equity markets, making it essentially a measure of investor anxiety. VXX maintains a strong, inverse relationship with global equity markets, meaning it will thrive during periods of uncertainty and fall when confidence in the global economy is running high (the VIX touched a record high during the most recent recession, just as most other asset classes were plummeting).

Because the market for VIX futures is contangoed, VXX will regularly face some pretty strong headwinds and should be expected to have a negative return over the long term. But because it maintains a correlation with domestic and international equity funds that approaches negative 0.90, it generally performs very well during periods of turbulence in equity markets. For example, on May 6, VXX gained more than 30% at one point, ultimately finishing the "flash crash" session with a more modest gain of about 9%.

The index to which VXX is linked consists of first- and second-month VIX contracts, making it most sensitive to changes in the spot level of that benchmark. iPath also offers an ETN linked to longer-dated VIX futures contracts; VXZ is linked to an index consisting of fourth-, fifth-, sixth- and seventh-month futures contracts.

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