Don't Get Out Of The Stock Market: 6 Ways To Risk Hedge Your Investment Portfolio Instead!

Don't be one of those "sell low, buy high" investors!

When investors consider what to do when stocks are down, they usually give themselves two choices: stay in or get out. It’s often a decision between 100% stocks (or some combination of equities and fixed income) or 100% cash with no in-between. Many people view this as an “A or B” choice and they shouldn’t.

Portfolio construction is very nuanced and investors should give themselves every opportunity to generate positive returns. The decision to move into cash may or may not ultimately prove to be the correct one, but we know that most people do a horrible job of deciding WHEN to get in and out.

In order to benefit from the decision to get out of the market altogether, investors need to be right twice: once when selling and once later when buying. You need to 1) sell at the right time before a decline, 2) have the market actually experience a decline and 3) have the discipline to buy back in at a lower price. A failure on any of these three front and odds are you going to come out worse than when you started. Most people tend to react emotionally and the “sell low, buy high” path that’s usually taken ends up doing more harm than good.

That’s why I’m a big advocate of hedging instead of selling.

These strategies give you the ability to still generate returns from the bulk of your portfolio, but still use a percentage of it to protect yourself on the downside. In most cases, limiting your downside risk can be just as, if not more, profitable than trying to capture above average returns on the upside. It’s not as sexy, but it’s just as effective.

There are a lot of ways of hedging your portfolio to protect your principal. Here are seven to consider.

T-Bills

For years coming out of the financial crisis, cash was essentially a dead asset. It yielded nothing and merely sat as a parking spot for money in your portfolio. Today, cash is no longer trash. Short-term Treasury bills yield more than 5% and are a legitimate investment option that should be considered.

Here’s an idea. If you’re worried that the market is going to crash (or at least go down) over the next 12 months, why not set a portion of your portfolio in an essentially risk-free asset, capture the yield and call it a day? Moving your entire portfolio into T-bills might be a radical step, but maybe it shouldn’t be dismissed altogether if you’re really worried. Stocks over the long-term have generated an average annual return of about 8%, so a 5% yield with almost no risk or volatility could be a consideration. The idea of sitting the next year out, taking the 5% return and revisiting the market next year at this time may not be the worst idea in the world.

The iShares Short Treasury Bond ETF (SHV) gives you a mix of bills with maturities of one year or less. The U.S. Treasury 12 Month Bill ETF (OBIL) gives you exposure to just the most recently issued 1-year T-bill. Or, of course, you could just buy a 1-year bill directly from the Treasury and hold it until maturity.

Buffer ETFs

Buffer ETFs have become incredibly popular over the past few years and now account for more than $26 billion of investor ETF assets. These are the products that provide a degree of portfolio downside protection in exchange for a cap on upside potential (think of it simply as narrowing your range of potential returns). The kicker is that you need to hold on to the buffer ETF for the entire outcome period (usually 12 months) in order to experience the full benefit.

Consider the Innovator U.S. Equity Power Buffer ETF - June Series (PJUN) that just started its outcome period at the beginning of the month. Assuming you hold it from June 1st through May 31st of next year, you’d be protected against the first 15% of losses for the S&P 500 over the 12-month period. The cap on gains for that period is 14.83%.

Translation: If the S&P 500 returns up to 14.83%, you pocket the entire return of the index just as you would if you were invested in the Vanguard S&P 500 ETF (VOO)! (Fund expenses mean the final outcome might be slightly different, but you get the picture). If the S&P 500 is down up to 15%, you lose nothing! If the S&P 500’s 12-month return is outside of that +14.83% to -15% range, that’s when either your positive return is capped or you can experience losses again.

The good news for investors is that there are buffer ETFs with new outcome periods on every month of the year, providing varying levels of downside protection and for all sorts of markets, including large-caps, small-caps, international stocks, emerging markets, Treasuries.

The FT Cboe Vest Fund of Buffers ETF (BUFR) is a good way to invest in a laddered series of buffer ETFs.

Tail Risk Hedges

This is pure downside protection. Tail risk ETFs typically buy a series of put options on the S&P 500 (or some equity index) that only pay out when the underlying securities decline in value. If the market goes up, they usually expire worthless and the fund moves on to the next hedge. If the market tanks, tail risk ETFs tend to pay off big.

Consider the Cambria Tail Risk ETF (TAIL). It invests in out-of-the-money puts on the U.S. stock market with various strike prices and expirations. It also adjusts its options exposure based on market volatility. During the COVID bear market in 2020, when the S&P 500 was down more than 30% on the year, TAIL was actually up 30%!

The catch of these funds is that they generally only pay off when there’s a sizable pullback in stock prices. Cambria even admits in its fund literature that it “expects the fund to produce negative returns in the most years with rising markets or declining volatility.” It costs money to buy those put options and roll them over regularly. When they expire worthless more often than not, it tends to produce negatively trending returns over time. However, when the market corrects and you REALLY want portfolio protection, that’s when a fund like TAIL really comes through.

Risk Rotation Strategies

Risk rotation ETFs don’t necessarily provide a downside risk hedge, but they do aim to rotate in and out of certain asset classes based on a pre-determined set of triggers. In general, they try to position the fund more conservatively when the market is looking riskier and try to position the fund more aggressively when market conditions are looking more favorable. It can be a good way to generate positive returns regardless of which way the financial market winds are blowing.

The Global X Adaptive U.S. Risk Management ETF (ONOF) rotates between large-cap U.S. stocks and 1-3 year Treasuries based on four different technical trading indicators. The ATAC U.S. Rotation ETF (RORO) rotates between U.S. growth & small-cap stocks and U.S. Treasuries based on lumber relative to gold as a risk trigger.

The Pacer Trendpilot U.S. Large Cap ETF (PTLC) invests in a combination of the S&P 500 and 3-month Treasury bills based on whether the index is trading above or below its 200-day moving average, a popular signal often used by momentum traders. The First Trust Dorsey Wright Focus 5 ETF (FV) is an equal-weighted portfolio of five different equity market sub-sectors selected for having the greatest short-term relative strength.

Long/Short Strategies

Long/short strategies are kind of exactly how they sound. They invest a portion of the portfolio in stocks, bonds or other securities and short the other portion. Because some of the volatility of the long and short positions can offset each other, there’s typically some risk reduction benefits, but the real goal is to capture the gains from the “positive” opportunities, while potentially also profiting from the “negative” opportunities.

My favorite example of long/short is the AGF U.S. Market Neutral Anti-Beta ETF (BTAL). It essentially goes long a portfolio of low volatility stocks and shorts high beta stocks. It’s effectively designed to generate positive returns whenever low vol outperforms high beta, something that usually occurs when markets are more risk-off. Outside of just the ability to post gains in down markets, it’s also proven to be a very effective risk hedge over time. Despite its 50/50 long/short split, it’s demonstrated an ability to generate superior risk-adjusted returns when paired with the S&P 500 in modest allocations.

Target Risk

If you’re unsure of when or even if you want to rotate in and out of asset classes, how about a strategy that just dials down the risk in all situations?

Target risk strategies probably go hand-in-hand with the term “asset allocation”. Instead of going all in on stocks, these funds usually invest in a pre-determined mix of stocks and bonds. Some will even add in auxiliary asset classes, such as real estate or commodities. Target risk funds are usually what you find in 401(k) or college savings plans.

If you’re worried about risk management, something like the iShares Core Conservative Allocation ETF (AOK) might be a consideration.

Conclusion

Risk management in your portfolio shouldn’t be just about “getting in” or “getting out” of the market. The growth of the ETF marketplace has provided investors with a lot of different ways to manage their portfolio. Risk hedging is perhaps one of the best innovations that has become available to retail investors via ETFs.

Each of these strategies can give you ways to either protect your portfolio from downside risk, rotate in and out of risk assets based on market conditions or just provide a more defensive option for investing. These are great ways to keep your focus on long-term goals and avoid the pitfalls of error-prone market timing!