Worried About A Market Crash? Here Are 3 ETFs That Will Protect You

Instead of moving to cash, try out these funds, which allow you to cap downside risk using different strategies.
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As the world continues to look forward to a post-COVID world, the economic recovery continues to progress nicely. Even though there are still some pockets of weakness - jobs, services - there's more than enough here to feel confident that we're in a fairly good place at the moment.

The equity markets have certainly responded in kind and them some. The S&P 500 has been regularly touching new all-time highs for months. Cyclicals and value stocks are finally participating. Of course, we have the Fed and the government to thank for all the free money flooding the marketplace.

On the flip side, however, stock returns have outpaced earnings growth and equities are looking expensive once again, even historically expensive according to a few metrics. If the Fed begins tightening policy in the near future (and indications are that it's at least being discussed right now) or if inflation begins running too hot, it's easy to see stocks pulling back 10-20% in fairly short order.

In other words, downside risk should be a consideration today. It might be time to consider layering on some protection to your portfolio.

While the natural inclination might be to move some of your portfolio to cash or bonds, there are ETFs out there that allow you to maintain most of your upside exposure in case stocks keep rallying, but hedge and manage to deliver gains even though the risk portion of your portfolio is declining.

These aren't funds that you necessarily want to dedicate a significant part of your portfolio to since they'll very likely underperform or produce losses in most bull market scenarios. But if there's a steep and sharp bear market, like the one we saw a year ago, these ETFs will really shine. These funds could be especially valuable to people who are concerned about principal protection in their portfolios, such as retirees.

The following 3 ETFs use different strategies to hedge against downside risk, but are worth considering in the current environment.

Cambria Tail Risk ETF (TAIL)

This more of a pure downside hedge. TAIL intends to invest in a portfolio of "out-of-the-money" put options purchased on the U.S. stock market. It may also buy more puts when volatility is low and fewer puts when volatility is high.

TAIL ETF

TAIL ETF

Cambria is very forthright in saying how the fund should be expected to perform. According to its website, "As the fund is designed to be a hedge against market declines and rising volatility, Cambria expects the fund to produce negative returns in the most years with rising markets or declining volatility."

We can see this in play as the fund has been steadily declining throughout the post-COVID bear market rebound. It's during the bear market itself, though, where TAIL really shined. While the S&P 500 was falling 30%, TAIL managed to produce a positive 30% return as those previously out-of-the-money put options quickly became very valuable.

How much of your portfolio you dedicate to a product like this is, of course, up to personal preference. Too much and you'll significantly cap your upside potential. 5% might be a good starting point depending on how much risk you feel there is at the moment.

Amplify BlackSwan Growth & Treasury Core ETF (SWAN)

SWAN takes a bit of a different approach by offering a portfolio that both participates in equity market upside and the downside protection offered by Treasuries. In essence, you've got more of a balanced portfolio, but one that is structured to try to avoid equity market downside.

SWAN ETF

SWAN ETF

SWAN invests 10% of portfolio assets in long-term S&P 500 LEAP option contracts with the remaining 90% getting invested in mixed duration Treasuries. The long call options have a delta of around 70, meaning that they could be expected to offer 70% of the upside of the S&P 500. The Treasury position would independently act like government securities normally would, but with the long-term inverse relationship to equities, they could be expected to offset some equity risk.

In a bull market, you could expect to receive 70% of equity market returns plus whatever Treasuries manage to return during that time. In a bear market, the call options would, in theory, simply expire out-of-the-money, helping to avoid some of the downside of a straight long position in the stocks themselves, while potentially offering some gains from Treasuries.

The fund only reconstitutes itself semi-annually, so there is a possibility that SWAN won't provide a consistent downside hedge, but historical risk measures suggest that this fund is only 50-60% as risky as the S&P 500.

AGFiQ U.S. Market Neutral Anti-Beta ETF (BTAL)

BTAL is a long-short strategy that establishes long positions in low beta stocks, while shorting high beta ones.

BTAL ETF

BTAL ETF

It's considered a downside hedge because of how you could reasonably expect equities to perform in down markets. During market declines, high beta stocks could be expected to produce greater losses than low beta stocks. The gains produced by the short high beta positions should, in theory, more than offset the losses from the long low beta positions, resulting in a net gain overall. Essentially, BTAL could expect to produce a gain whenever low beta outperforms high beta regardless of whether stocks overall are rising or falling.

As you can imagine, BTAL has produced losses recently as investors have loaded up on growth stocks during the economic recovery, but there's been some bounce back lately as low beta and value stocks have staged a rebound. Given the constant 50% short position, you don't want to make this a core position in your portfolio, but a small allocation could help cap some downside risk.

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