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Recently, I wrote two bearish articles. The first article was mainly about macroeconomic and fiscal issues, and the second article was about the conditions occurring in the stock market and commodities markets. In my first article, I predicted that the S&P 500 (SPY) could fall to near the 1200 level sometime before the end of the year, which is over 20% below the current level. Therefore, after reading the comments on that article, I decided to write another article on what investment options could work if my thesis was wrong and the market continues higher, but I still wanted to hedge for downside risks.

So what is the best option to hedge or replace a position in the SPY with something better? There are a number of options to consider, and they can be broken down into two categories: equity replacement and equity hedge, each of which I will cover below. I will be using return data to see which investment option[s] whether it be by itself, paired with the SPY, or paired with each another hedge could provide better risk adjusted returns than owning just the SPY.

Equity Replacement

Option #1: Low Volatility Stock ETF

The first option would be to substitute a low volatility ETF like the PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) for the SPY. According to the Powershares website, the holdings for SPLV "consists of the 100 stocks from the S&P 500® Index with the lowest realized volatility over the past 12 months."

Option #2: Dynamic Allocation ETF

The second option would be to substitute an ETF that dynamic allocates between different asset classes. The ETF that does this is the Barclays ETN+ VEQTOR S&P 500 Linked ETN (VQT), which according its fund page, "seeks to provide investors with broad equity market exposure with an implied volatility hedge by dynamically allocating its notional investments among three components: equity, volatility, and cash."

Equity Hedge

Option #1: Volatility ETF

The first option would be to hedge your equity position with volatility ETFs like the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). According to the iPath website, VXZ "offers exposure to a daily rolling long position in the fourth, fifth, sixth and seventh month VIX futures contracts and reflects the implied volatility of the S&P 500® at various points along the volatility forward curve."

Option #2: Bond ETF

The second option would be to hedge your equity position with a bond ETF, like the iShares Core Total U.S. Bond Market ETF (AGG). According to the iShares website, AGG "tracks the total United States investment grade bond market."

Option #3: Inverse S&P 500 ETF

The third option would be to hedge your equity position with a NON-Leveraged inverse ETF like the ProShares Short S&P 500 ETF (SH). According the Proshares website, SH "seeks a return that is -1x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next."

Which Option[s] are the best?

To find out which option is the best, I will be using the ETFreplay.com backtest tool to see which ETF[s] meet the goal of providing a better risk adjusted return than the SPY. Personally, in my portfolio, I use a hedge allocation of 10%; therefore, each of the hedge options above will receive a 10% allocation in my testing. The tables below are broken down into three categories: Equity Replacements, Equity Hedges, and Combinations.

To make sure all the funds are compared using the same period, I will be using a starting point of May 5th 2011, which is the inception date for SPLV.

Equity Replacement:

Allocation

Symbol

Return

Volatility

Risk adjusted return

Correlation to SPY

100%

SPLV

30.70%

13.20%

2.33%

93%

100%

VQT

19.20%

9.80%

1.96%

47%

100%

SPY

21.50%

18.90%

1.14%

As the table shows, both SPLV and VQT both have provided better risk adjusted returns than the SPY, so mission accomplished on that part. What was surprising is that SPLV just over doubled the risk adjusted return of the SPY, which is quite impressive.

Equity Hedges:

In the table below is each of the equity hedge options with a 90% allocation to the SPY, and a 10% weight to the hedge.

Allocation

Symbol

Return

Volatility

Risk adjusted return

Correlation to SPY

10%

VXZ

13.40%

14.00%

0.96%

99%

10%

AGG

20.30%

16.60%

1.22%

100%

10%

SH

17.00%

14.80%

1.15%

100%

100%

SPY

21.50%

18.90%

1.14%

The data in the hedge table shows that the option that performed the best was adding a hedge of the bond ETF AGG.

Combinations:

Being who I am, I did not want to settle at picking SPLV, VQT to replace the SPY in a portfolio, or just hedging a SPY position with AGG. Therefore, I tried out some different combinations to see what the results would be. I tried the following combinations:

Combination #1: 90% allocation to the highest equity replacement SPLV, and hedged with a 10% allocation to the highest equity hedge AGG.

Combination #2: 90% allocation to the second highest equity replacement VQT, and hedged with a 10% allocation to the highest equity hedge AGG.

Combination #3: 50% allocation to each of the equity replacement ETF options, SPLV and VQT.

Combination #4: 50% allocation to the highest equity replacement [SPLV], and a 50% allocation to the SPY.

Combination #5: 50% allocation to the second highest equity replacement [VQT], and a 50% allocation to the SPY.

Allocation

Return

Volatility

Risk adjusted return

Correlation to SPY

90% SPLV

10% AGG

28.50%

11.70%

2.44%

92%

90% VQT

10% AGG

18.20%

8.70%

2.09%

46%

50% SPLV

50% VQT

24.90%

9.60%

2.59%

86%

50% SPLV

50% SPY

26.10%

15.60%

1.67%

99%

50% VQT

50% SPY

20.40%

12.10%

1.69%

93%

100% SPY

21.50%

18.90%

1.14%

From the combinations I tried out, the best was using a 50/50 split between the two equity replacement funds, and provided better risk adjusted returns than just replacing the SPY with SPLV, or hedging SPLV with AGG.

Closing Thoughts

Based on my data, the best option is a 50/50 split between SPLV, and VQT. What makes this the best option is that for SPLV, it holds stocks with lower volatility than the SPY does. Then for VQT, it owns all stocks in the S&P 500 during good markets and transitions to volatility and cash during market corrections. What surprised me was how poorly the volatility and inverse equity ETFs performed compared to just owning the SPY. The above data suggests that hedging with a fixed volatility or inverse ETF is useless. While the bond hedge did not perform much better than the other hedges, it did have a better risk adjusted return than the SPY has, and could be an option if you wanted to hedge and still collect some income. In addition, what surprised me was how well VQT performed by dynamically allocating to different asset classes and eliminating the problem of hedging with a fixed volatility ETF like VXZ.

Disclaimer

Source: What Is The Best Way To Hedge S&P 500 Exposure?