Can ETFs Provide Downside Protection?

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Includes: PHDG
by: Dan Bortolotti
Summary

Investors embrace risk during periods of strong returns in equities, but they run away from it when the stock market turns volatile.

Finding a strategy or fund that captures most of the upside while significantly limiting losses is obviously appealing.

Instead of looking for a product that promises downside protection, I would suggest you simply use traditional ETFs for equities but combine these with some fixed income (bonds, GICs or cash).

Rena wants to know a hedged ETF can protect her investments.

Q. We would like to find a product that will offer good, solid downside protection. I purchased the Invesco S&P 500 Downside Hedged Portfolio ETF (NYSEARCA:PHDG), but I'm not sure if just leaving it in our portfolio is a good idea. We have a small account and never use stop losses, so we need a good product.
- Rena

A. "Downside protection" sounds like a wonderful thing. Investors embrace risk during periods of strong returns in equities, but they run away from it when the stock market turns volatile. Finding a strategy or fund that captures most of the upside while significantly limiting losses is obviously appealing. Unfortunately, Rena, it's fantasy.

Not that there's any lack of advisors or products making that promise. The ETF you are using, the Invesco S&P 500 Downside Hedged ETF, is one of these. The fund's literature says it "seeks to achieve positive total returns in rising or falling markets," and who wouldn't be happy with that? The ETF's strategy is to buy some combination of the stocks in the S&P 500 Index and futures contracts tied to the CBOE Volatility Index, nicknamed the VIX. The VIX measures the volatility of the U.S. stock market, so it spikes during periods of stress and fear. During a sharp market downturn, a futures contract pegged to the VIX would go up in value, providing the downside protection this ETF is trying to obtain.

The reality is the performance of this ETF has been dismal. Over the five years ending March 31, its annualized return was 2.39%, compared with 10.91% for the S&P 500 Index (returns are expressed in US dollars since this is a U.S.-listed ETF). Moreover, the ETF lost almost 10% in 2015, a year when the S&P 500 delivered a slightly positive return. It had a small loss again the following year when U.S. stocks delivered almost 12%. Unfortunately for investors in this ETF, it has mostly provided upside protection.

But it's not fair to target this specific fund: Its managers are not unique in their failure to protect investors from market downturns while also delivering positive returns during the good times. Virtually all market timing strategies (which usually involve shifting from equities to cash) have the same goal, and while many do sidestep some sharp declines, they frequently missed the recoveries, which can happen swiftly and unexpectedly.

Instead of looking for a product that promises downside protection, Rena, I would suggest you simply use traditional ETFs for equities but combine these with some fixed income (bonds, GICs or cash). This will reduce your losses during a downturn in the equity market. And while it will also reduce your expected returns compared with an all-stock portfolio, you can at least be sure your ETFs will capture all of the upsides when equities perform well. You will never be sitting in cash, or using exotic strategies that try to predict the volatility and direction of the market.

Experienced investors understand that, as tempting as it sounds, you cannot sidestep the risk of investing in stocks. In his book Debunkery, the veteran investment manager Ken Fisher put it best: "To my knowledge, no one has ever achieved market-like returns without some market-like downside. If you want to achieve something close to stocks' long-term average, you must accept downside volatility. No way around that."

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.