Investors Hedging Rally With These ETFs

Yet as the market has climbed sharply since early February, some investors have been quietly hedging their bets. Exchange-traded products tied to gold and the CBOE Volatility Index (VIX) have seen billions of dollars in inflows since the market bottom, suggesting that confidence in the rally is shaky.

The five-largest gold ETFs―including the SPDR Gold Trust (GLD | A-100) and the iShares Gold Trust (IAU | B-100)―had inflows of $4.1 billion since Feb. 11, according to FactSet data.

Meanwhile, the five-largest VIX products―such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX | B-47), the ProShares Ultra VIX Short-Term Futures ETF (UVXY), and the VelocityShares Daily 2x VIX Short-Term ETN (TVIX)―saw inflows of $1.3 billion in the period.

What Is A Hedge?

After two big double-digit stock market corrections in the past seven months—one in August of last year and one earlier this year—it's understandable that investors may be concerned about another potential pullback.

At the same time, investors may be reluctant to reduce their equity allocations significantly in case the market continues to rally to new highs.

A hedge―something that will protect investors against losses in case the market retreats―is a way to bridge these conflicting concerns.

Gold Viable Long Term

Gold certainly has a reputation for being a hedge against market turmoil, though its performance during the last two corrections has been uneven.

Prices for the yellow metal surged nearly 20% during the market meltdown earlier this year. However, gold didn't perform nearly as well during the correction in August of last year, when it only rose a few percentage points before quickly giving back those gains.

Returns For SPY, GLD Since Aug. 17, 2015

Nevertheless, gold seems to be holding up well this year, and investors buying into ETFs such as GLD and IAU believe that if the stock market reverses course again, a jump in the price of gold could help offset some of their equity losses.

Gold ETFs hold physical bullion, and they're cheap enough to hold over longer time periods.

Short-Term VIX Products

Meanwhile, the various VIX products are also potential hedging instruments, but they're very different than gold.

Volatility tends to spike during stock market corrections; in August of last year, the VIX surged from less than 11 to more than 50, and in the correction earlier this year, the VIX rose from less than 16 to 32.

With the VIX down to about 14 now, some may see it as an attractive time to go long volatility to hedge their portfolios. Buying into ETPs like VXX, UVXY and TVIX―which use futures for exposure to the VIX― is one way to do that.

At its best point during the August correction, VXX doubled, while the 2x-leveraged UVXY and TVIX spiked more than 250%. In the more recent correction from this year, VXX gained upward of 60% compared with 120% for the two leveraged products.

Returns For SPY, VXX, UVXY Since August 17, 2015

With monster moves like those, VIX products have the potential to act as good hedges―but only in the short term.

Because exchange-traded products use futures to get exposure to the volatility index, they are subject to the effects of contango, which can eat into returns longer term (each of the three VIX products mentioned is down more than 99.7% since inception).

Rather, VIX ETPs are best regarded as instruments for short-term trading or hedging needs.

Contact Sumit Roy at [email protected].