Downside Protection Diverges For ETFs

With equity markets off to a choppy start to the year, ETFs that fall into the volatility-hedged category are worthy of analysis.

While Pacer was an early entrant to the category, some of these ETFs, like a pair of such products issued by Global X, are relatively new and facing their first market downturn.

The current market environment has proven to be a test for volatility-hedged ETFs. These ETFs are not carbon copies of one another. They are all differentiated, with various methodologies and potential allocations.

Not surprisingly, some funds have handled this test better than others.

Smoother Ride

Growth-oriented tech names in particular have struggled this year, creating an opportunity for ETFs like the Pacer Trendpilot 100 ETF (PTNQ) to shine. This ETF tracks an index that holds either Nasdaq-100 securities or three-month U.S. T-bills based on whether this basket of securities closes above its 200-day simple moving average for at least five consecutive days.

Though this process means the fund can lag the market in either direction, PTNQ is only underperforming the Invesco QQQ Trust (QQQ) by 7.2%, with significantly less volatility.

Currently, the portfolio is equally split between equities and T-bills, meaning PTNQ has not bounced back as much in recent days relative to QQQ. However, should there be continued drawdowns in these names, PTNQ is better positioned to weather the storm.

New Entrant

Global X recently launched a fund that offers hedged exposure to the Nasdaq-100 as well. The Global X NASDAQ 100 Tail Risk ETF (QTR) made its debut in August. Rather than toggling allocations, this ETF buys 10% out-of-the-money put options on the index on a quarterly basis.

Buying out-of-the-money put options is a double-edged sword. As the options have no intrinsic value at time of purchase, it lowers the price of the premium—but also decreases the amount of the downside protection.

This can be seen through the performance of the ETF since launch, which has slightly underperformed QQQ over that time frame.

For the downside protection for this fund to kick in, the Nasdaq-100 needs to fall below the strike price of the most recently purchased put options. If not, the fund is left with the cost of the premium as a drag on performance.

For this reason, PTNQ is likely to offer better protection in most market environments with the exception of a steep and severe drop in the index.

Alike But Different

There are also volatility-hedged products that provide exposure to fixed income, which could be compelling in the current market environment marked by inflation worries, strong economic growth and looming Fed action.

The Pacer Trendpilot U.S. Bond ETF (PTBD) and the CP High Yield Trend ETF (HYTR) bring this type of strategy to the fixed income space.

Both ETFs toggle exposure between high yield bonds or Treasurys, with PTBD targeting seven- to 10-year Treasury bonds. HYTR opts for three- to seven-year Treasuries, a decision that could provide more protection in a rising rate environment.

These funds also provide a perfect example of how similar funds can differ based on their rules. As of this article’s writing on Feb. 1, PTBD offers 100% exposure to high yield, while HYTR is currently fully held in Treasuries.

This has led to disparate performance during the first month of the year, with HYTR outperforming both the iShares Core U.S. Aggregate Bond ETF (AGG) and the iShares iBoxx USD High Yield Corporate Bond ETF (HYG). PTBD, on the other hand, has lagged both.

Longer-term performance has followed a similar trajectory, with HYTR notching positive performance over the past year, while PTBD is in the red, though still outperforming AGG.

HYTR’s small size—only having gathered $10 million in assets since its January 2020 launch—means that it faces closure risk as well as substantial spreads, adding to its already pricey expense ratio.

Courtesy of FactSet

However, strictly from a performance standpoint, HYTR has made up for its elevated cost over the past year relative to the $1.31 billion PTBD.

Contact Jessica Ferringer at [email protected] or follow her on Twitter