Protection ETFs Aren’t Perfect

Downside-hedged ETFs offer a promise that seems too good to be true—participation when the market rallies, while protecting when the market corrects.

And this promise is attractive, as the S&P 500 just notched its 35th record close for the year. This exceeds the number seen in all of 2020, which naturally leads investors to seriously consider that a downturn might be just around the corner.

Valuations also look increasingly stretched as the market marches higher. No bull market lasts forever, and timing the beginning and end of a market trend is a fool’s errand.

Could ETFs that try to time the market for you be a better way to play the game?

FactSet lists 12 different ETFs in the volatility-hedged ETF category. The funds included in this category all have different areas of the market they are trying to offer exposure to, as well as different methods for hedging this exposure.

There are other ways to try and protect on the downside, including covered call and defined outcome ETFs. Here we exclusively look at ETFs that are offering volatility-hedged exposure to the S&P 500.

3 Funds, 3 Different Methods

The largest fund in the volatility-hedged ETF category is the Pacer Trendpilot U.S. Large Cap ETF (PTLC). PTLC attempts to capture the upside in the U.S. equity space while taming the downside by toggling between S&P 500 exposure and three-month U.S. Treasury bills, depending on momentum signals.

The resulting portfolio can either be all equity, all cash or a 50/50 mix.

The Invesco S&P 500 Downside Hedged ETF (PHDG) takes a slightly different tack, shifting allocations between S&P 500 equities, VIX index futures and cash.

The Direxion Dynamic Hedge ETF (DYHG) takes yet another route to dynamically hedge against the volatility of the index. The ETF uses high frequency price data on the S&P 500 to gauge volatility, adjusting its net exposure to the market based on this information.

When it comes to cost, PHDG seems like a clear winner at first glance. The expense ratio is 0.40%, lower than PTLC’s 0.60% price tag or the 0.58% cost for DYHG. The fund is relatively small at just $168 million, which leads to a significant increase in the average spread relative to PTLC.

PHDG might be small, but in terms of assets, it is over 23 times larger than DYHG. The Direxion fund has only gathered $7 million after being on the market for just over a year. The inception in June 2020 also means that it has not yet been tested by a prolonged market downturn.

Protection Comes At A Cost

When it comes to protecting on the downside, both PTLC and PHDG have been successful in the past. During the time period from Oct. 2, 2018 through Dec. 24, 2018, the SPDR S&P 500 ETF Trust (SPY) dropped by 19.2%.

PHDG did fulfill its promise, dropping by 11.2%. PTLC fared even better, only losing 7.9%.

The time period from Feb. 15, 2020 through March 23, 2020 provides another glance at the protective power of these types of strategies.

This bear market, sparked by the spreading COVID-19 pandemic, saw SPY drop by 33.6% in just over a month. PTLC shielded investors from the downturn once again, falling by 23.0%. PHDG managed to eke out a positive return of 0.7% as the VIX closed at an all-time high. (Read: Current Stock Volatility Unheard Of)

While it is evident that these funds can do well protecting in down markets, their reliance on quantitative “triggers” such as the 200-day moving average means that they do not fully jump back into markets as soon as they start to rise.

Though the strong rally we have seen since the lows reached in March 2020 is not a typical market environment, the returns depicted since then show the cost of opting for protection.

Courtesy of StockCharts.com

As shown, PTLC is underperforming SPY by 55%. And though PHDG managed to make it through the market turmoil without a loss, it has been underperforming SPY by more than 70% since then.

Even with taking the emotion out of the process by relying on quantitative signals, no ETF can perfectly time the market.

Though history is no indicator of future results, it does seem like volatility-hedged ETFs like PTLC and PHDG still have merit for those investors who prioritize downside protection.

These strategies are a better option for those who feel we might be nearing the top, but do not want to miss out by sitting on the sidelines in cash.

Another use would be to complement beta exposure in the portfolio, offering some protection while allowing for fuller participation if the market continues to go up.

As with any investment, being able to accurately assess risk tolerance and cost—including opportunity cost—is key to making the best decision.

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