Hedge Your Portfolio with ETFs

The stock market has been extremely volatile in August and there are no signs of the volatility moderating in September. In addition to concerns of an interest rate hike, there is a high level of uncertainty regarding the extent of China’s economic decline, potential problems brewing in emerging markets, and ongoing currency devaluations around the world. Stock valuations may also be historically lofty judging by measures like the Cyclically-Adjusted P/E (“CAPE”) ratio.

Investors looking to hedge against this volatility and/or the potential for decline may want to consider exchange-traded funds (“ETFs”) as options to offset long stock positions.

The iPath S&P 500 VIX Short Term Futures ETN (VXX) has soared more than 80% over the past 30 days, although it remains down roughly 13% over the past year. Using CBOE Volatility Index® futures as underlying instruments, the ETN increases in value as the market becomes more volatile and loses value when the market becomes less volatile. Investors that want to hedge against volatility – although not direction – may want to take a closer look.

Other volatility ETFs and ETNs include:

• VIX Short-Term Futures ETF (VIXY A)
• SYP 500 VIX Mid-Term Futures ETN (VXZ B)
• VIX Mid-Term Futures ETF (VIXM A+)

The ProShares Short S&P 500 ETF (SH A+) has risen more than 7.75% over the past 30 days, although it’s only 3.6% higher since the beginning of the year. Using both short-selling techniques and derivatives, the ETF gains in value as the S&P 500 declines in value on a one-to-one basis. Investors that are concerned that the market may fall over the coming months may want to purchase the ETF as a hedge against a decline.

Other short equity ETFs and ETNs include:

ProShares Short Russell 2000 (RWM A-)
ProShares Short Dow 30 (DOG A)
ProShares Short QQQ (PSQ A)

The Barclays ETN Shiller Cape ETF (CAPE) has fallen 6.8% over the past month and 3.26% over the past year, but the cyclically-adjusted price-earnings ratio strategy could equate to better performance in troubled markets moving forward. By purchasing sectors trading at the biggest discounts, the ETF attempts to capitalize on sector rotation dynamics over the long-term, although the fund is thinly traded with less than $30 million in assets under management.

Investors looking to implement the same type of strategy can do so using more-liquid ETFs targeting specific sectors, such as those offered by iShares. After identifying the market sectors trading at the biggest discount, investors can purchase undervalued ETFs and perhaps short-sell or buy put options on overvalued ETFs to capitalize on a return to normalcy. Long-term data has shown that these strategies may be effective, but of course, are no guarantee for the future.

There are many reasons for investors to be nervous about the market in September. While the market may decline, there are many ETFs that provide an opportunity to profit in terms of both volatility and direction. Investors may want to consider these ETFs as an option to hedge an otherwise long portfolio against decline, although they should carefully consider the risks involved with short-selling or volatility bets.