5 ETFs To Hedge Your Portfolio Against Downturns And Recessions

Summary

• Equities offer investors strong long-term returns, but risks are high, as are losses during downturns and recessions.
• These have become more frequent since the start of the coronavirus pandemic, as the world battles its largest disease outbreak in generations.
• Some ETFs offer investors simple, effective ways to hedge their portfolios, minimizing losses during ever more frequent recessions and downturns.
• An overview of some of these follows.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

DNY59/E+ via Getty Images

Author's note: This article was released to CEF/ETF Income Laboratory members on November 27th, 2021.

Markets have seen some wild swings these past few weeks, due to hawkish Federal Reserve comments, and the sudden emergence of the Omicron coronavirus variant. Equities saw some steep losses from late November to early December, but have stabilized. For now at least. Equity market fluctuations and losses are common, but undesirable, and deal-breakers for some. There are many ETFs which attempt to minimize and hedge equity market fluctuations, reducing losses during downturns, recessions, and down markets such as the ones we are currently experiencing. Due to current market conditions, I thought an article summarizing the strongest market hedge ETFs would be of use and interest to readers.

I've identified five funds which function as effective market hedges, and which have performed reasonably well during previous downturns. These, plus the S&P 500 for comparison purposes, are as follows:

(Source: Seeking Alpha - Chart by Author)

From the above, the Amplify BlackSwan Growth & Treasury Core ETF (SWAN) seems like a particularly strong choice. SWAN combines most of the S&P 500's upside potential, with almost none of its downside, an incredibly strong combination. The other four ETFs are good choices too, and I'll be briefly covering all five funds regardless.

SWAN - Balanced Equity and Treasury Fund

SWAN overview

SWAN is a balanced equity and treasury fund.

SWAN's treasury exposure consists of simple treasuries, of varying maturities. These account for 90% of the value of the fund. SWAN's treasury holdings perform particularly well during downturns and recessions, due to a flight-to-quality effect, and due to Federal Reserve policy.

SWAN's equity exposure consists of S&P 500 call options. These options have characteristics such that the fund experiences about 50% of the S&P 500's upside, while capping losses at 10%. SWAN's options are particularly effective at preventing significant long-term losses, less effective at preventing smaller, shorter-term losses.

SWAN's holdings and strategy are similar to a 1.4x leveraged fund, with a 0.5x equity exposure, and 0.9x treasury exposure.

SWAN Benefits and Performance

SWAN's treasury holdings and capped losses both minimize losses during downturns and recessions. Small gains are possible, but definitely not certain. SWAN itself posted very small gains during 1Q2020, the onset of the coronavirus pandemic, and the most recent downturn.

Data by YCharts

SWAN also performed reasonably well during 11/26/2021, during which news of a worrying new coronavirus variant first spread.

Data by YCharts

SWAN's equity holdings provide investors with significant equity upside. Combined with treasury income / yields, the fund's long-term returns are quite strong, with the fund experiencing most of the gains of the S&P 500.

Data by YCharts

SWAN's results are similar, but broadly superior, to those of most balanced equity and treasury funds. As an example, SWAN has higher long-term returns and lower losses during downturns than the Vanguard Target Retirement 2020 Fund (VTWNX), a balanced equity and bond index mutual fund.

Data by YCharts

SWAN combines most equity upside with almost no downside, and is a broadly superior investment than its peers. This is an incredibly strong value proposition, and makes SWAN a buy. As the fund focuses on minimizing losses, it is appropriate for more conservative investors and retirees.

SWAN Risks and Negatives

SWAN's reduced equity upside will almost certainly result in lower long-term returns than those of the S&P 500. Investors pay for significantly reduced downside with moderately reduced upside. I'm confident that this is a worthwhile tradeoff for many investors, but it is a tradeoff, and not just a pure benefit.

SWAN's strategy is dependent on treasuries outperforming during downturns and recessions. The fund should almost certainly underperform if both treasuries and equities are down. This is rare, but not unheard of. Both asset classes were down during October 2020, during which SWAN underperformed, as expected.

Data by YCharts

Notwithstanding the above, SWAN's holdings, strategy, and structure is such that significant underperformance is incredibly unlikely, even if both equities and treasuries are down. As can be seen above, SWAN barely underperformed the S&P 500 last time both asset classes were down. The difference in performance was in part simple volatility, and ultimately inconsequential.

I last covered SWAN here.

NTSX - Aggressive Balanced Equity and Treasury Fund

NTSX overview

The WisdomTree U.S. Efficient Core Fund (NTSX) is a balanced equity and treasury fund. It is quite similar to SWAN, but much more aggressive.

NTSX's treasury holdings consist of U.S. treasury notes. These account for 10% of the value of the fund, but provide investors with exposure to 60% of the gains/losses of said asset class. You can think of the notes as a 6x leveraged investment.

NTSX's equity holdings consist of S&P 500 stocks. These account for 90% of the value of the fund.

The fund's holdings are equivalent to a 1.5x leveraged equity and treasury fund, with a 0.9x equity exposure, and a 0.6x treasury exposure.

NTSX Benefits and Performance

NTSX's treasury holdings outperform during downturns and recessions, which somewhat reduce losses during these. As an example, the fund moderately outperformed the S&P 500 during 1Q2020. Losses were still quite high, due to the fund's large equity exposure.

Data by YCharts

NTSX's large equity exposure means that long-term total returns will almost certainly be quite strong. The fund has actually slightly outperformed the S&P 500 since inception, as its treasury holdings more than make up for its slightly reduced equity exposure.

Data by YCharts

NTSX's results are broadly similar to those of most balanced equity and treasury funds, just like SWAN. As an example, the fund has posted significantly greater returns than VTWNX, at a similar level of risk, volatility, and losses during downturns.

Data by YCharts

NTSX combines effectively 100% equity upside with moderately reduced downside, and is a broadly superior investment than its peers. NTSX is an aggressive version of SWAN, and appropriate for more aggressive investors who still wish to (somewhat) hedge their portfolios against downturns and recessions.

NTSX Risks and Negatives

NTSX's strategy is strongly dependent on treasuries outperforming during downturns and recessions. The fund will necessarily underperform if both equities and treasuries are down. Both asset classes were down during October 2020, during which NTSX underperformed, as expected, and same as SWAN.

Data by YCharts

Unlike SWAN, NTSX's use of leverage and lack of capped losses complicates matters. Leverage means more assets, which means more capital losses if asset prices go down. This is not an issue when equity and treasury prices move in opposite directions, as gains in one asset class compensate for losses in the other. This is a significant issue if both asset classes are down by a lot at the same time. It is extremely rare for this to happen, and has not come close to happening during the fund's existence. Extremely rare does not mean impossible, which means that this is a significant risk for the fund and its shareholders.

SWAN's strategy and holdings are such that these issues are significantly reduced, although not completely eliminated. SWAN's safer holdings and strategy make it a broadly superior investment relative to NTSX. In my opinion at least.

I last covered NTSX here.

IVOL - Inflation and Rates Hedge

IVOL Overview

IVOL invests in treasury inflation-protected securities, or TIPS, and in interest rate options.

TIPS, being treasuries, perform quite well during downturns, and also during periods of high inflation, as interest rate payments are indexed to inflation. TIPs account for 90% of the value of the fund.

IVOL's interest rate options perform well when short-term rates decrease, long-term rates rise, and when interest rate volatility spikes. Short-term rates tend to decrease during downturns, as the Federal Reserve almost always cuts rates during these as a stimulative measure. Due to this, these options tend to perform well during downturns. These options account for 5% of the value of the fund, but carry significantly higher exposure / expected returns.

IVOL Benefits and Performance

IVOL's holdings perform reasonably well during downturns and recessions, and so does the fund. IVOL itself posted gains of 3.0% during 1Q2020, significantly outperforming relative to the S&P 500.

Data by YCharts

IVOL's holdings also tend to perform better than most bonds when inflation is high and rising, as has been the case since about mid-2020.

Data by YCharts

IVOL should, naturally, perform better than most bonds during periods in which downturns and inflation are quite common. This has been the case since the fund's inception.

Data by YCharts

IVOL's strategy and holdings combine to create an effective market, inflation, and downturn hedge. This is an incredibly solid combination, and should prove particularly enticing for more risk-averse investors and retirees.

IVOL Risks and Negatives

IVOL lacks exposure to equities or other high-risk high-return assets. Due to this, expect the fund to significantly underperform relative to most broad-based equity indexes, including the S&P 500. This has been the case since the fund's inception.

Data by YCharts

IVOL's strategy and holdings are quite complicated, which increases risks, and makes it difficult to analyze and forecast the fund's expected returns. Complexity also means that the fund could perform in somewhat unexpected ways. As an example, the fund is likely to underperform during a downturn which coincides with significantly reduced long-term rates / a flattening yield curve. This is a relatively odd scenario, and has never happened during the fund's existence, but it is definitely possible.

I last covered IVOL here.

NUSI - Tech Exposure - Capped Upside and Downside

NUSI Overview

The Nationwide Risk-Managed Income ETF (NUSI) invests in tech-heavy Nasdaq-100 stocks, with an overlaid options strategy.

NUSI sells covered calls on the entirety of its holdings. NUSI receives premiums for these calls, but forfeits capital gains after a predetermined price, effectively capping the upside potential of the fund.

NUSI uses the premiums received to buy put options on the entirety of its holdings. These options effectively cap the downside potential of the fund.

NUSI's options strategy caps both upside and downside potential. The following summarizes the fund's strategy and expected performance.

(Source: NUSI Factsheet)

NUSI Benefits and Performance

NUSI's put options cap the downside potential of the fund, which significantly reduces losses during downturns. As an example, NUSI significantly outperformed both the S&P 500 and the Nasdaq-100 index during 1Q2020.

Data by YCharts

NUSI's lower losses during downturns are the fund's key benefit and value proposition.

NUSI Risks and Negatives

NUSI focuses quite heavily on tech stocks, and so should underperform if tech does likewise. The fund's put options do minimize any possible underperformance, but don't expect strong returns if tech stagnates. As an example, the fund underperformed during early 2021.

Data by YCharts

As an aside, NUSI's options are somewhat volatile, which can randomly affect the fund's share price and returns. NUSI actually underperformed relative to the Nasdaq-100 in the time period above, even though this does not make a lot of sense considering the fund's holdings. NUSI's underperformance was partly due to the aforementioned option price volatility, and also an issue with date cutoffs.

NUSI's upside is capped, which reduces returns during bull markets. As stocks mostly go up, capping upside is more impactful than capping downside, so investors should expect NUSI to underperform in the long-term. That has been the case since the fund's inception.

Data by YCharts

I last covered NUSI here.

TAIL - Treasuries and Short Equity

TAIL Overview

The Cambria Tail Risk ETF (TAIL) invests in fixed-income assets and is short equity through options. TAIL is the only fund out of all five which attempts to profit from downturns and recessions, instead of just minimizing losses during these.

TAIL's treasury exposure consists of simple treasuries, of varying maturities. These account for 90-95% of the value of the fund. As mentioned previously, treasuries outperform during downturns, due to a flight-to-quality effect, and due to Federal Reserve policy.

TAIL's equity exposure consists of S&P 500 put options of varying strike prices and maturities. Put options increase in price as share prices drop and as volatility increases, both of which happen during downturns.

TAIL Benefits and Performance

TAIL's treasury and put options holdings perform particularly well during downturns, and so does the fund. TAIL posted gains of 23.8% during 1Q2020, the strongest performance out of all five funds analyzed, and by quite a large margin.

Data by YCharts

TAIL's strategy is particularly effective during deeper, longer-drawn recessions, but should generally work during smaller negative price movements too. As an example, the fund posted gains of 2.8% during November 26th of 2021, when news of the worrying Omicron coronavirus variant first spread.

Data by YCharts

TAIL performs better than most of its peers during downturns and recessions, making it a reasonable trading opportunity for more bearish traders and investors.

TAIL Risks and Negatives

TAIL's put options are unprofitable investments when stocks are up, and stocks are mostly up. Due to this, the fund's put options will almost certainly lead to long-term losses, punctuated by significant gains during (infrequent) downturns and recessions. TAIL itself has posted losses of 23% since inception, equivalent to 6% annualized losses. Long-term returns will almost certainly be quite negative as well: this is not a long-term investment vehicle.

Data by YCharts

On a more positive note, TAIL's long-term returns are comparatively strong, with the fund outperforming most comparable negative equity / equity bear ETFs. TAIL's put options are structured in such a way that long-term losses are reduced, but not completely eliminated.

Data by YCharts

I last covered TAIL here.

Conclusion

Investors can protect their portfolios from losses by investing in hedged ETFs. I've covered five such funds in this article, all of which are effective market hedges, and which should perform reasonably well during future downturns and recessions.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.