Equity Exposure With Controlled Drawdown For 2021

As 2020 draws to a close with stocks near record highs, investors are understandably concerned by a growing disconnect between stock prices and economic fundamentals. 2021 may give us more clarity on the broader economic impact of COVID-19 and the changes to regulation and taxes introduced by a Democrat president. Given these rising risks, and not knowing how long this disconnect may last, many investors will be searching for ways to limit their exposure to a drawdown while simultaneously maintaining their exposure to further equity upside.

In 2017 and 2018, I published a pair of articles highlighting a stock replacement strategy that could serve to maintain equity exposure while simultaneously limiting downside exposure during severe market pullbacks. Specifically, I proposed using a small allocation to a short VIX futures ETN or ETF as a replacement for investment in the S&P 500 and showed how an investment of just 20% in one of these short VIX futures products offered investors similar performance to a full 100% investment in equities.

Those findings now look more interesting than ever, primarily because a partial 20% allocation to a risky asset would allow 80% of a portfolio to be allocated to safe havens like cash and cash equivalents - effectively limiting losses in an uncertain market to just 20%. Those original articles can be found on our website here: Volatility as a Stock Replacement Strategy; Volatility as a Stock Replacement Strategy: Part II.

2021 may be setting up to be an ideal year to implement an equity allocation strategy that would limit portfolio downside to just 20%, while at the same time maintaining as much upside potential as possible. The next few months therefore might be a good time to rotate out of equities and into the VIX linked Stock Replacement Strategy I discussed in those articles.

However, since writing those articles two years ago the market for VIX futures ETNs and ETFs has undergone some significant changes that make the strategy's implementation a little less obvious. Most significantly, two highly popular exchange-traded products that offered inverse VIX futures exposure have been retired or delivered. On February 20, 2018, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) was retired, and seven days later its cousin product, the ProShares Short VIX Short-Term Futures ETF (SVXY), had its short VIX futures exposure cut in half. These changes have left the market with no -1x VIX futures ETN or ETF available to implement the simplest version of the 20:80 VIX stock replacement strategy I proposed.

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This article is not intended as and does not constitute investment advice. Investing involves risk, including the possible loss of principal. Past performance does not ...

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