The events of this past week during the Reddit/RobinHood/GameStop/Hedge fund free-for-all are highlighting the risks that volatility brings to the table. This is obvious looking at the weekly charts for GameStop, Express, BlackBerry, AMC and others targeted by the WallStreetBets message board, but volatility risk is spreading into the broader market as well.
This is the chart of the VIX over most of January. It's gone from the relatively tame territory of just over 20 to the mid-30s in just a handful of trading days. That 32-34 range is where the risk of a sharper downturn in risk assets starts to rise.
Also worth watching is how the price action in the GameStops of the market continues to affect the price action in the broader market. GME's share price has moved in almost an inverse correlation to the price of the S&P 500. In other words, as the price of GME rises, traders perceive that overall market risk rises and they begin moving out. Conversely, GME price falls means a return to more normal behavior and traders move back in.
If there's anything that current market is teaching us right now, it's the idea that downside risk needs to be managed. Most investors shoot for maximizing upside but managing downside is just as important, if not more so, in generating superior risk-adjusted returns.
If you're a little intimidated by the high volatility in today's market, here are 4 ETFs you should consider adding that would protect your portfolio from downside risk.
Cambria Tail Risk ETF (TAIL)
TAIL is simply a pure downside hedge. It doesn't try to beat or even match the market. It's simply there to provide downside protection in the form of protective puts in case the market ever makes a sharp downward move. Cambria leaves no question as to what the fund can be expected to do. From its website:
"Cambria expects the fund to produce negative returns in the most years with rising markets or declining volatility."
In normal conditions, TAIL's portfolio consists mostly of intermediate-term Treasury bonds with a splash of TIPS. Currently, about 5% of assets are invested in a variety of S&P 500 put options that would rise in value as the index's value drops. 5% may not seem like a lot, but it's more than enough to deliver downside prevention.
Back in February/March 2020 when the market was melting down, TAIL managed to gain nearly 30%.
Amplify BlackSwan Growth & Treasury Core ETF (SWAN)
SWAN's strategy is similar yet quite different to that of TAIL. It also has most of its portfolio in Treasuries, but SWAN uses the remaining 10% of assets to invest in a series of in-the-money S&P 500 LEAP options instead of protective put options.
The design is such that the LEAP options allow investors to catch most of the upside of the S&P 500 during normal markets. If the market turns south, the options contracts would theoretically expire worthless and the remainder of the fund would essentially turn into a Treasury portfolio.
To theory, SWAN would provide gains in up markets, but be relatively flat in down markets. TAIL would be flat to negative in up markets, but provide gains in down markets. Which is better simply depends on how you want to position your portfolio.
AGFiQ U.S. Market Neutral Anti Beta ETF (BTAL)
BTAL isn't a pure downside hedge, but it's structure tends to make it one. It buys long positions in low beta stocks and shorts high beta stocks. In theory, during a down market, the short high beta positions would deliver gains greater than the losses expected in the long low beta positions. As long as low beta outperforms high beta, BTAL can be expected to produce gains, which is often what happens in down markets.
The long/short nature of the portfolio and the fact that high beta tends to outperform low beta given enough time means that BTAL will probably produce losses over the long-term. Its goal, however, is downside protection and the fund accomplishes that. Owning BTAL will probably limit some of your upside capture, but it'll also help lower your downside risk.
Direxion Flight to Safety Strategy ETF (FLYT)
FLYT's objective is pretty straightforward. It simply owns positions in asset classes that have historically demonstrated low to negative correlations with the broader equity market.
It generally maintains an allocation of around 50% U.S. Treasuries, 25% large- and mid-cap utility stocks and 25% gold bullion. It's sort of a mixture of defensive assets that provide varying degrees of protection. In a down market, utility stocks would probably still fall in value although probably to a lesser degree than the broader market. Treasuries would probably rise to some degree. Gold is a generally uncorrelated asset, so who knows what it will do.
Either way, FLYT is defensively positioned and could be a good hedge if things turn south.