When Market Jitters Escalate, Use These 2 ETFs To Hedge Your Bets

Many retail investors are currently wondering how the rest of October, which has a reputation for being a volatile and often negative month for stocks under normal conditions, may play out in 2020. Along with such market headwinds as a still raging global pandemic and a related economic recovery potentially losing momentum, this year's US Presidential Election in early November adds to the nervousness. At the same time, stock valuations for many Wall Street darlings remain sky-high.

Since the end of August, broader markets have been falling. Of course, we can't predict which way equities will head next, but we do know that diversification and hedging strategies can help most long-term investors protect their portfolios from extreme volatility caused by the unknown.

Since many investments are typically cyclical, likely to be favored at times, avoided at others, through diversification, most retail investors can achieve respectable returns year after year. Luckily, there are also plenty of hedging vehicles that may be appropriate, especially for shorter periods. Today, we will discuss two such exchange-traded funds (ETFs).

• Current Price: $13.64
• 52-Week Range: 9.01-19.06
• Dividend Yield: 7.12%
• Expense Ratio: 0.73%

Multi-asset strategies offer access to a range of investment vehicles within a single fund. Asset classes may include bonds (government and/or corporate), equities (mostly dividend-paying stocks), preferred securities ("hybrids" that share the characteristics of both stocks and bonds), master limited partnerships (MLPs which typically distribute over 70% of their cash flow to investors) and real estate investment trusts (REITs whose focus is on income-producing properties).

Understandably, each of these asset classes comes with its own unique risks and rewards.

The First Trust Multi-Asset Diversified Income Index Fund (NASDAQ:MDIV) is an ETF that follows such a multi-asset strategy. It tracks the NASDAQ US Multi-Asset Diversified Income Index, which only invests in US-listed assets.

MDIV started trading in 2012; it now has around $450 million under management. The current fund composition: Dividend Paying Equities (21.79%), High Yield Corporate Bond ETFs (20.78), Preferred Securities (20.77%), REITs (20.44%), and MLPs (15.09%).

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It is important to note that the First Trust Tactical High Yield ETF (NASDAQ:HYLS) makes up 20.71% of MDIV. HYLS, which has close to $2 billion in assets, invests at least 80% of its net assets in high yield debt securities rated below investment grade, i.e., junk bonds that come with credit risk. The fund's main objective is income.

In an environment where interest rates are close to zero, funds that specialize in junk bonds get plenty of attention. This year, HYLS is down about 3%. But its 30-day SEC yield is 4.25%.

Going back to MDIV, no other security in the fund has more than 1.75% in weighting. Other holdings include The Geo Group (NYSE:GEO), Annaly Capital Management (NYSE:NLY), and DCP Midstream (NYSE:DCP).

Year-to-date, the fund is down about 27%. However, since the lows seen in March, it is up over 50%.

Investors wanting to allocate some of their assets to a diverse range of income-generating sectors should keep this fund on their radar. We would look to buy the dips, especially if there is a decline toward $12.5.

h2 2. Cambria Tail Risk ETF/h2

• Current Price: $21.66
• 52 Week Range: 19.22-27.23
• Dividend Yield: 1.09%
• Expense Ratio: 0.59%

We've discussed various hedging strategies using covered calls with LEAP options, straight put purchases, and put spreads in recent articles. Such strategies can be used for both hedging and speculative purposes.

Nonetheless, most market participants do not feel comfortable with these more sophisticated approaches, even if just for hedging. As a result, fund managers have been increasingly introducing niche ETFs that utilize various derivative products that can be used even by small investors.

The Cambria Tail Risk ETF (NYSE:TAIL), which manages a portfolio of put options purchased on the US stock market, is one of these funds.

TAIL started trading in 2017 and has over $400 million in assets. The actively-managed fund is defensive in nature as it aims to mitigate significant downside market risk. The fund invests a small percentage (currently about 5%) in a basket of out-of-the-money (OTM) put options on the S&P 500 index. The rest of the assets (about 95%) are in intermediate-term US Treasuries.

Since the start of the year, TAIL is up about 12%. It hit an all-time high in mid-March. The options held by the fund would have increased in value and exercised profitably as the S&P 500 went down. Treasuries can also be an effective hedge against market downturns when equity prices decline.

Yet, between early Spring and September, broader markets have been going up while volatility has decreased. As a result, TAIL's performance has been on the decline, too.

An ETF such as TAIL may be appropriate for bearish investors as a hedge against market declines and rising volatility. However, market participants should note that the fund will not likely have positive returns during years when markets rise, and volatility declines.

Written By: Investing.com