Here’s an update of a post I did back in May where we showed how a volatility ETF (XVZ) can be used as an easy way to hedge when market risk is high. I use our Market Risk Indicator to signal that there is a high risk that the market is going to accelerate to the downside and an appropriate time to hedge. This creates a simple hedge strategy for long term investors. The nice thing about this hedge is that our risk indicator doesn’t signal often so changes to the portfolio are few and far between. For example, from July of 2004 (as far as my XVZ data goes back) until July of 2007 there were no signals. When perceptions of risk get high our market risk indicator tends to signal more. From July of 2007 until September of 2008 there were several signals as the housing and banking crisis was coming to the attention of investors. During 2013 the indicator didn’t signal which made for easy investment and hedging decisions if you used this simple strategy.
Here’s an updated chart that gives a comparison of using this hedge strategy (50% long and 50% XVZ when our market risk indicator signals) or simply staying long the S&P 500 index (SPX) from July of 2004 until 12/31/2013.
Update 1/11/14: I’ve done another post that shows performance for varying sizes of the hedge. That post also isolates a some time frames so you can see how it performs in different market conditions. The details are here.