A couple weeks ago, you probably experienced something you haven’t had to really worry about since at least 2022 - volatility! After roughly a year and a half of near constant market calm, it took just a couple of market events and a rapid leverage unwind to send the VIX to a level seen only two other times in its history - the COVID pandemic and the financial crisis.

I won’t rehash all the details around how and why this happened. It’s already been covered ad nauseam both here and elsewhere. While losses were steep and painful, the worst part might not even be the fact that it came on so suddenly. The worst part is that so many investors found themselves and their portfolios ill-prepared to handle it.

The Downside of the Magnificent 7

Since coming out of the 2022 bear market, there’s one group of stocks that has outperformed unlike any other - Apple, Amazon, NVIDIA, Microsoft, Alphabet, Facebook and Tesla. Collectively, they’re known as the magnificent 7.

While there was a sense of mania and FOMO that regularly drove these stocks to new highs, there was actually some very good reasons why they became leaders in the first place. For starters, mega-cap tech delivered some of the best earnings and revenue growth results of any group in the economy once inflation topped out and investors started spending again. Second, this earnings boom coincided with the emergence of the AI trade. NVIDIA, of course, would become the poster child for this, but really any big tech company that was developing an AI solution got lifted in the rising tide.

Investors saw these results and piled in. It got so frenetic that the S&P 500 developed a top-heaviness that it hadn’t seen in the index’s entire history! If they couldn’t buy these stocks through funds or ETFs, they were buying the stocks individually to lever up some more. Heck, my parents texted me asking if they should buy NVIDIA and they keep most of their savings in CDs!

But those big returns inflated valuations and put them at high risk of a mean reversion. A disappointing jobs report and a surprise rate hike from the Bank of Japan it turns out what all it took. The jobs report raised fears that the potential for recession is starting to rise in the U.S. and the soft landing might be at risk. That led to investors dumping anything considered risky or expensive. The leverage unwind amplified those losses.

At its low point, the Vanguard S&P 500 ETF (VOO) lost 8%, but tech and the magnificent 7 did worse. The Roundhill Magnificent Seven ETF (MAGS) fell as much as 18% before recovering some of those losses.

This wasn’t as bad as 2022 in terms of losses, but it probably felt worse. 2022 was a slow and steady decline where the VIX rarely made it out of the 20s. This pullback happened in a matter of days and most investors probably didn’t see it coming.

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The Desire To Make Radical Portfolio Changes

When we see volatility like this pop up, the laws of behavioral finance take over, which is to say that investors tend to panic. The question “should I get out of the market” gets uttered frequently as people fear more losses. This is usually the point where investors do the most damage to their portfolios. They lock in losses by selling at lows and fail to participate in the inevitable rebound.

Market timing rarely works, especially for retail investors. It takes a strong contrarian conviction to buy when everyone else is selling and that’s very challenging for most.

That’s why instead of selling stocks when volatility rises, investors should think about hedging their positions. Finding something that zigs when the market zags. By doing this, you can reduce overall portfolio volatility, provide some level of downside protection and not have to worry about market timing.

Hedging Your Portfolio

There are a few different ways to do it. Sure, you can add to bond or cash positions, but that’s not necessarily a dynamic way to hedge your portfolio. And 2022 proved that this diversification method doesn’t always work.

There are two primary ways that I think investors should consider hedging against downside risk without eliminating their equity exposure.

Low or Negative Correlation Products

You may be thinking about something like the Invesco S&P 500 Low Volatility ETF (SPLV) here. The problem with this is that SPLV still invests in S&P 500 stocks and has a 90% correlation with the index. You’re only getting minor risk reduction benefits. A sector ETF, such as the Utilities Select Sector SPDR ETF (XLU) or the Consumer Staples Select Sector SPDR ETF (XLP) would do better in that regard.

I’m talking, however, about a REALLY low correlation. One that would provide meaningful risk reduction.

To achieve this, you’re probably talking about ETFs that use derivatives, such as options or futures contracts, or take outright short positions in order to potentially produce gains when the market declines. You definitely don’t want to overweight these products or make them core positions in your portfolios. But in modest quantities and in the right situation, they can really hedge your downside risk when you need it most.

Downside Protection Buffers

These funds, which hedge against a pre-determined level of losses in exchange for a cap on upside potential, have become wildly popular in recent years. There are now hundreds of these funds available covering almost every timeframe, market and chosen risk level.

The next evolution debuted only recently - 100% downside protection. While they tend to cap a lot of upside capture (multiple of these funds are quoting 8-9% caps), the 100% downside hedge will be appealing to a lot of folks who want stock market gains with no principal risk.

ETF Portfolio Hedges

So let’s talk about a few examples of ETFs that would fit in one of the categories we just discussed and how each of them works.

Cambria Tail Risk ETF

The Cambria Tail Risk ETF (TAIL) doesn’t invest in stocks at all. It’s strictly a combination of Treasuries and S&P 500 put options. Of all the ETFs available in the marketplace, this is one of the purest downside hedges you’ll find.

Cambria is very transparent about what you should expect from this fund. In the fund’s fact sheet, the company states:

You can see, however, that during periods of high volatility, TAIL delivers. In very general terms, if the S&P 500 were to decline by 30%, you could expect TAIL to rise by 30%. In backtests, a 10% allocation to TAIL in combination with the S&P 500 has reduced overall risk by 15%, while minimally impacting overall risk-adjusted returns.

AGF U.S. Market Neutral Anti-Beta ETF

The AGF U.S. Market Neutral Anti-Beta ETF (BTAL) is one of my favorite funds. It essentially goes long low volatility stocks and shorts high beta stocks. In short, it’ll produce positive returns in any market environment where low volatility stocks are outperforming (although in more bullish market environments, it’s likely to produce flat to negative returns).

In backtests, the best risk-adjusted returns have come with an allocation of 63% S&P 500 and 37% BTAL. Historically, that combination would reduce absolute returns by about 27%, but it would reduce portfolio risk by 42%!

If your goal is long-term growth of capital, you may not want to allocate that much to BTAL, but its -0.6 correlation to the S&P 500 demonstrates that it can reasonably be expected to rise in value significantly during market corrections.

Pacer Trendpilot U.S. Large Cap ETF

If you follow technical indicators, you probably know that the 200-day moving average is often used as a buy/sell signal. The Pacer Trendpilot U.S. Large Cap ETF (PTLC) does just that.

It’s not a pure buy/sell though. Instead of selling and moving to cash, the fund moves to Treasuries when the share price drops below that trigger level. You can see in the chart above how this happened during the majority of 2022 and helped shield investors from a fair amount of stock market losses.

This trigger isn’t infallible though. For example, it didn’t protect investors at all during the recent correction. That’s because the S&P 500 was so far above its 200-day moving average at the time that it never managed to cross below that level even after stocks declined significantly. This strategy can generally be considered helpful over the long-term, but short-term results can vary.

Innovator Defined Equity Protection ETF - 2Yr to July 2026

Here’s one of the 100% downside hedge ETFs I mentioned earlier. The Innovator Defined Equity Protection ETF (AJUL) uses a 2-year outcome period instead of the more common 1-year time frame. That means investors must hold shares for the full two years in order to achieve the 100% downside protection. By or sell within that two-year window and your results may vary (there are, however, 100% buffer ETFs out there that only require a 1-year outcome period, most notably from iShares).

The current cap on this ETF is 18.2%, meaning investors can capture S&P 500 returns of up to 18.2%, while maintaining the 100% downside buffer. An 18% return over the course of two years may not sound like much in an environment when stocks have produced returns much above that recently. Keep in mind though that the U.S. stock market has averaged roughly 9% a year over the long-term, so the ability to capture most returns is still there. Plus, the 100% downside protection is the real selling point.

Buffer ETFs are perhaps the best way to shield yourself from downside risk without trying to time the market. You may choose to go with a more limited downside buffer in exchange for higher return caps, but, regardless, these have proven to be great ways to eliminate the biggest tail risks from your portfolio.

Final Thoughts

While return maximization has been the primary focus on many over the past 18 months, investors are starting to see why risk management is so important. Yes, the idea of trading off some capital gain potential in exchange for downside protection may not seem as appealing, but just as much outperformance can be achieved by limiting downside as trying to maximize upside.

These hedges are probably best used in limited quantities, but all can help in mitigating some of the biggest fears you’ve probably felt over the past month.