7 of the best ETFs for downside protection

Investors looking for downside protection can find some gems in this group of ETFs.

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With the S&P 500 (.SPX) up around 25% year-to-date and the other major domestic equity benchmarks residing near record highs, talking about downside protection may not be a high priority for all market participants at the moment.

Then again, there is such a scenario as the “blow off top,” which some market observers believe is happening as we speak. Add to that is the looming specter of 2020 being an election year and the day-to-day wranglings of the trade spat with China. Translation: now is as good of a time as any for investors to consider avenues for downside protection.

Fortunately, that objective is easily met with an array of exchange traded funds (ETFs). In fact, ETFs are arguably the best instruments with which to bolster downside protection or profit from swooning equities because the fund structure eliminates the time constraints associated options strategies and the need to identify the right stocks to sell short.

Best of all, investors do not need to be explicitly bearish to gain some downside buffer with ETFs. With that in mind, let’s have a look at some of the best ETFs to use for protection in turbulent markets.

iShares Edge MSCI Min Vol USA ETF

Expense ratio: 0.15% per year, or $15 on a $10,000 investment.

The iShares Edge MSCI Min Vol USA ETF (USMV) is the king of one of this year’s most popular ETF destinations, that being funds that emphasize low volatility. What makes USMV compelling for both short- and long-term investors is that the upside “sacrifice” in this fund is manageable as highlighted by its nearly 24% year-to-date gain.

What that says about USMV, one this year’s top asset-gathering ETFs, is that not only does it achieve its objective of lower downside capture when markets falter, but that it delivers ample upside when equities rally.

“One strategy that has been appealing when it comes to capturing less market downside is minimum volatility,” BlackRock said in a recent note. “Minimum volatility is designed to reduce risk, while maintaining 100% equity exposure. Why is this important? Humans tend to experience the pain of losses more than the joys of equivalent gains, a bias known as ‘loss aversion.’”

Indeed, USMV’s upside and downside capture specs are impressive.

“When we say that US minimum volatility has captured 80% of the upside of the S&P 500 but only 59% of the downside, many investors assume that means the strategy has lagged but with lower risk,” according to BlackRock. “Yet, since its inception in 2008, minimum volatility has outperformed the S&P 500 by 2% annualized.”

ProShares Short QQQ

Expense ratio: 0.95%

As its name implies, the ProShares Short QQQ (PSQ) is an inverse ETF, one designed to deliver the daily inverse performance of the widely-followed Nasdaq-100 Index. So if that benchmark falls by 1% on a given day, PSQ should rise by roughly the same amount.

That means PSQ isn’t a leveraged ETF, which expands its potential audience, because leveraged ETFs aren’t intended for all investors. And because it’s not a leveraged fund, PSQ can be held for longer periods than geared equivalents.

There are no guarantees the following scenario materializes, but if markets weaken in significant fashion, many of the high-flying growth (technology and internet) names that dominate the Nasdaq-100 would be among the first to be hit.

Bottom line: PSQ is a fine hedge for investors with long exposure to tech ETFs or individual tech stars like Apple (AAPL) and Microsoft (MSFT).

Invesco S&P 500 High Dividend Low Volatility ETF

Expense ratio: 0.30%

The Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) checks at least two of 2019’s big boxes: above-average dividend yields and reduced volatility. That said, the Invesco fund is a case study in the trade-off investors make when looking for lower volatility as the fund is higher by just 13.5% year-to-date.

In its defense, SPHD has been 130 basis points less volatile than the S&P 500, and its dividend yield of about 4% is more than double that of the benchmark equity gauge. SPHD follows the S&P 500 Low Volatility High Dividend Index, a collection of the 50 S&P 500 members with the combination of lowest trailing 12-month volatility and high dividend yields.

Due to the combination of defensive posture and high yields, stocks with those traits often trade at premium valuations, but that’s not the case with SPHD as about 85% of the fund’s roster are classified as value stocks.

WisdomTree Yield Enhanced U.S. Aggregate Bond Fund

Expense ratio: 0.12%

Fixed income instruments are among the first places investors flock to when seeking downside buffers. The WisdomTree Yield Enhanced U.S. Aggregate Bond Fund (AGGY) offers those benefits along with some spice relative to traditional aggregate bond ETFs, which are usually effective, but boring, low-yield instruments.

AGGY slightly reduces exposure to Treasuries and U.S. agency debt while boosting investment-grade corporate bond exposure compared to more traditional rivals. The WisdomTree fund splits the widely-observed Bloomberg Barclays U.S. Aggregate Enhanced Yield Bond Index into 20 spheres.

“Constraints are applied to ensure the fund does not deviate too far from the Aggregate Index,” said Morningstar in a recent note. “For example, the index’s duration must be within one year of the Aggregate Index’s. Also, the weight of each sector is bound to stay within either 20% (for Treasuries, credit, and securitized bonds) or 10% (for agency bonds) of the Aggregate Index’s weighting to each.”

Direxion MSCI USA Defensives Over Cyclicals ETF

Expense ratio: 0.45%

As noted earlier, if markets rapidly swoon, it’s likely that growth stocks would bear the brunt of that punishment. Should that scenario arise, the Direxion MSCI USA Defensives Over Cyclicals ETF (RWDC) would likely be in the spotlight.

RWDC is a long/short ETF that, you guessed it, is long a defensive index and short a group of consumer discretionary, communication services and technology stocks, among others.

“RWDC seeks investment results that track the MSCI USA Defensive Sectors – USA Cyclical Sectors 150/50 Return Spread Index. The Index measures the performance of a portfolio that has 150% long exposure to the MSCI USA Defensive Sectors Index (the “Long Component”) and 50% short exposure to the MSCI USA Cyclical Sectors Index (the “Short Component”),” according to Direxion.

Embracing RWDC doesn’t mean sacrificing upside as highlighted by the fund’s 4.30% gain over the past month.

VanEck Vectors Real Asset Allocation ETF

Expense ratio: 0.64%

The VanEck Vectors Real Asset Allocation ETF (RAAX) is a compelling idea for investors looking for downside protection because this fund can move between being fully invested and cash allocations. Currently, RAAX is fully invested, but if markets tank it can raise cash and dramatically reduced equity exposure.

Adding to its defensive posture, RAAX is not confined to owning common stocks. Rather, the fund currently features exposure to infrastructure, gold and other hard asset investments. RAAX is an ETF of ETFs, meaning its non-cash holdings are other ETFs. Six of the fund’s 14 holdings are other VanEck products.

RAAX “seeks to maximize real returns while seeking to reduce downside risk during sustained market declines by allocating primarily to exchange-traded products that provide exposure to real assets, which include commodities, real estate, natural resources, and infrastructure,” according to VanEck.

Invesco S&P SmallCap Low Volatility ETF

Expense ratio: 0.25%

There are few certainties in financial markets, but among them are the following: small-cap stocks are more volatile than larger fare, and smaller stocks are likely to decline more when the broader market turns bearish.

Investors can mitigate some of that risk with the Invesco S&P SmallCap Low Volatility ETF (XSLV). XSLV features the same trade-off as other low volatility strategies: less upside but less downside.

This year, XSLV is rewarding investors as it’s outpacing the S&P SmallCap 600 Index (.CVK) by 180 basis points while being 460 basis points less volatile.

XSLV holds 120 stocks, nearly 70% of which hail from the financial services and real estate sectors.

Todd Shriber owns shares of SPHD.

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