Using ETFs As “Portfolio Insurance”

by on October 5, 2010 | ETFs Mentioned:

Although there are now nearly 1,100 exchange-traded products available to U.S. investors, the universe of ETFs utilized 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 that offer 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 more active traders looking to capitalize on short-term pricing inefficiencies or implement a sophisticated investment strategy. But some of the ETFs that investors may be inclined to brush off as tools for traders may 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 [for more ETF ideas, sign up for our free ETF newsletter]

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 that 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 -0.90, it generally performs very well during periods of turbulence in equity markets. For example, on May 6 VXX had 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 [also read Three ETFs To Protect Against A "Hindenburg Omen" Sighting].

PowerShares DB 3x 25+ Year Treasury Bond ETN (LBND)

When confidence in the global economy wanes, there are certain asset classes that thrive as “safe havens” for investors to ride out the storm. One such refuge is long-term Treasuries, which gain appeal during rough stretches thanks to the lack of credit risk and extended duration of coupon payments. This ETN from PowerShares and Deutsche Bank offers investors the option to establish leveraged exposure to long-dated Treasuries, thereby establishing a hedge against chaos in equity markets without tying up a significant amount of capital [see Ultimate Deflation-Fighting ETF].

LBND seeks to deliver monthly returns equivalent to three times the change in the Deutsche Bank Long U.S. Treasury Bond Futures Index, a benchmark that consists of T-Bond futures whose underlying assets have a remaining term to maturity of at least 25 years. It’s important to note that LBND resets its leverage monthly; that mutes the impact of compounding–both positive and negative–compared to leveraged ETFs that reset exposure on a daily basis.

Unlike VXX, this ETN can be expected to deliver a positive return to investors over the long-term–particularly in environments that feature more attractive interest rates. But it also has the ability to provide investors with a bit of protection in the event that stocks begin to crater, as this fund should perform very well during bear markets.

PowerShares DB Gold Double Long ETN (DGP)

Another tried and true safe haven is gold; demand for precious metals tends to spike when stocks are struggling. The PowerShares DB Gold Double Long ETN (DGP) offers investors a way to hedge against chaos in equity markets by doubling down on gold. Similar to LBND, this exchange-traded note resets exposure to the underlying index on a monthly basis. And as evidenced by the impressive rally in gold prices during September, this fund won’t always plunge when stocks are rallying [see Investors Flock To Gold ETFs].

DGP seeks to deliver monthly returns equal to 200% of the change in the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold, a benchmark that measures the performance of certain gold futures contracts. So far in 2010, DGP is up approximately 40%, as gold has surged despite relatively smooth sailing for global equity markets.

[For more ETF ideas consider trying out a free seven day trial to ETFdb Pro.]

Disclosure: No positions at time of writing.