Partial Hedge Strategies
The first two strategies give exposure to the stock market, but also attempt to take the worst of the sting out of extended down periods. The PowerShares S&P 500 Downside Hedged Portfolio (PHDG | B-44) is a strategy expected to protect investors somewhat during severe declines, while keeping a major exposure to the broad market.
PHDG is a fund that has done poorly of late, but I’m not sure it should be dismissed. This fund holds a mixture of stocks and products organized around VIX futures.
Products organized around VIX futures are probably best thought of as insurance—a product with a negative expected return—like an insurance premium. In other words, it’s a product that could have large positive returns when you need them the most.
The mix of stocks and VIX futures is determined by the level and direction of actual and forecast volatility.
In addition to stocks and VIX futures, PHDG also will go to cash in the event of a sharp decline. The rules chosen for this strategy worked quite well in backtesting, with good profits simulated in 2008 and 2009. The exact flavor of volatility we have endured recently has not been amenable to its strategy.
Other Approaches To Downside Protection
Nevertheless, I think an investor worried about a crash, but uncertain about timing, should consider PHDG, or the Barclays S&P Veqtor ETN (VQT | B-44), which follows the same index.
Meanwhile, the PowerShares S&P 500 BuyWrite Portfolio (PBP | A-68) is based on the Buy-Write index as calculated by the CBOE options exchange. The strategy embodied in the index buys the S&P 500 and writes (sells) calls against it.
The calls bring in a small premium at the expense of giving away some of the profit in sharply rising markets. The premium has provided a bit of a cushion when stocks declined dramatically. However, if we compare PBP with the S&P 500 over the period of 2001-2014, the drawdown was only reduced by about as much as the total return.
That is, investors could simply have taken a smaller positon in the S&P 500, invested the released cash in bonds and have been better off overall.