While the equity markets experienced their worst week since the financial crisis, an ETF strategy that tries to mitigate downside market risk stood out.
The Cambria Tail Risk ETF (Cboe: TAIL) increased 8.8% over the past week and gained 11.1% year-to-date.
Meanwhile, the S&P 500 Index plunged 11.2% and fell 8.0% so far this year.
The U.S. equity market bull rally made a swift U-turn last week as a spreading coronavirus outbreak popped in various countries around the world, stoking fears of a slowdown in the global economy as governments constrain travel and businesses in an attempt to contain the contagion.
However, investors may want to consider alternatives strategies to better manage downside risks. Alternative investments, like TAIL, can be incorporated into portfolio to provide diversification from equities or better protect an investor from drawdowns in stocks while allowing for some upside participation.
TAIL tries to provide income and capital appreciation from investments in the U.S. markets while protecting against downside risk, according to a prospectus sheet. The active ETF will invest in cash and U.S. government bonds, and utilizing a put option strategy to manage the risk of a significant negative movement in the value of domestic equities, or more commonly known as tail risk, over rolling one-month periods.
The TAIL strategy offers the potential advantage of buying more puts when volatility is low and fewer puts when volatility is high. While a portion of the fund’s assets will be invested in the basket of long put option premiums, the majority of fund assets will be invested in intermediate term US Treasuries.
A put option provides the buyer the right to sell the underlying index to the put seller at a specified price within a specified time period. In the event of a decline in the underlying index, the put may help reduce the downside risk. Consequently, the put option becomes more valuable as the underlying market weakens relative to the strike price.
Traders who write put options have essentially sold the right to another investor to sell shares at an agreed-upon price. On the other hand, the buyer has purchased the chance to sell stock to the put writer. In other words, the party who writes puts acts as an insurance provider for the portfolio’s downside but gains access to premiums, or income.
“TAIL’s strategy is inherently defensive. Research performed by Cambria suggests that, historically, a portfolio of puts purchased on the broad market can help to protect and diversify a traditional long-only portfolio from market downturns,” according to Cambria.
For more information on alternative strategies, visit our alternatives category.