Tony's ETF Buyer's Guide: Hedging Against a Market Crash

Long volatility ETFs

You might think that investing directly in the VIX—the market's volatility index—would be a straightforward way to benefit from market crashes. However, it's not that simple.

You can't directly invest in the VIX itself, as it's an index that measures the market's expectation of volatility over the next 30 days, based on S&P 500 index options.

Instead, to gain exposure to the VIX, you must use derivatives—specifically, VIX futures. These futures contracts bet on the future price of the VIX, and yes, you can access these futures via ETFs. But there are a few critical points to understand.

Firstly, VIX futures are not a perfect replacement for the VIX itself—their prices are correlated to, but not synonymous with, the spot price of the VIX. Generally, shorter expiry futures track the spot price more closely, while longer-dated ones do so less accurately.

Another significant aspect to consider is the net asset value (NAV) of these ETFs, which tends to decay over time. This decay occurs primarily because the VIX futures curve is often in contango, meaning future prices are higher than the spot price, leading to losses when futures contracts are rolled over at higher prices.

Additionally, the VIX is mean reverting, which means that volatility spikes are generally temporary and tend to return to a median level over time. This dynamic causes long volatility ETFs to perform poorly over extended periods.

Three ETFs that provide exposure to VIX futures are the ProShares Ultra VIX Short-Term Futures ETF

, ProShares VIX Short-Term Futures ETF

VIXY

-0.12%

, and ProShares VIX Mid-Term Futures ETF

VIXM

-0.77%

. All of these ETFs experience decay over time and have undergone numerous reverse splits to adjust for declining NAV, as seen below.

VIXY and UVXY are the most correlated to the spot VIX, as they track short-term futures. UVXY is particularly notable because it is leveraged 3x, providing amplified exposure to changes in the VIX.

On the other hand, VIXM, which tracks mid-term futures, has less correlation to the spot VIX, but its NAV erodes more slowly due to its longer-dated futures.

Personally, I would not recommend using these ETFs because of the negative carry—the cost of holding these ETFs over time—and the fact that successfully capitalizing on them involves precise market timing.

You might incur gradual losses over time (more slowly for VIXM, more quickly for UVXY), waiting for a significant market crash that may or may not arrive. When a crash does happen, you must act quickly and accurately to rebalance or take profits at the right moment.

Tail risk ETFs

A bad market crash exemplifies tail risk—a high-severity, low-probability event that, assuming a normal distribution of outcomes, sits three standard deviations down on the left tail.

These are the kinds of events you truly want to hedge against. Not the gradual downturns like 2022, where trends emerge and you can adjust your strategy, but sudden, unexpected, and catastrophic losses that occur rarely.

Interestingly, there are ETFs specifically designed to hedge against these kinds of risks—tail risk ETFs. Most of these ETFs employ put options on major indexes to achieve their goal.

Unlike the long volatility ETFs, the negative carry—the cost of maintaining the hedge—is significantly less. You'll still pay to hold them, much like an insurance policy, but the premiums are less burdensome.

From Cambria ETFs, we have two examples: the Cambria Tail Risk ETF

and the Cambria Global Tail Risk ETF

FAIL

. TAIL buys put options on the S&P 500 index, while FAIL targets international markets by purchasing puts on the MSCI EAFE Index and MSCI Emerging Markets Index.

Both ETFs maintain a core holding of Treasuries, which not only helps offset the cost of the puts but also provides additional diversification away from equity risk, albeit with the trade-off of interest rate risk in years like 2022.

These ETFs are also much cheaper than their long volatility counterparts, both charging a 0.59% expense ratio. While they do exhibit some negative carry, they have delivered what's known as "crisis alpha" during significant downturns, like in March 2020 during the onset of COVID-19 and more recently during the market downturn on August 5th.

Another intriguing option is the Alpha Architect Tail Risk ETF

, which also utilizes put options but incorporates a more complex options overlay to offset negative carry. This includes 1) box spreads, which aim to deliver a tax-equivalent return to 3-month Treasury bills, and 2) put spreads to generate additional income.

I'm cautiously impressed with CAOS, which has delivered positive carry since its launch in March 2023. It hasn't yet been tested in a major crash, but it was in the green on August 5th. I'm curious to see how the box spread and put spread strategies perform when rates fall and during a major market crash.

Unlike the long volatility ETFs, these tail risk ETFs can be held long-term. The idea is to "diversify your diversifiers"—you layer on fixed income, trend-following, and then a small allocation to tail risk hedges like these ETFs.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.