• Pearl Capital Advisors LLC


In this paper, Pearl Capital Advisors compares the effectiveness of multiple instruments commonly-used to hedge US equity markets. Foremost among these instruments is the VIX Futures.


The last two bear markets were particularly painful for many investors. The tech bubble produced a drawdown in the S&P 500 that reached nearly 50%. From the start of the drawdown until it was fully recouped, over seven years had passed. The global financial crisis saw the S&P 500 down over 55%. From start to finish, investors needed nearly six years to recover their investment. Over the last 65 years, investors have spent half of that time recovering from drawdowns in the S&P 500 that exceeded 20%, not to mention all the time in between dealing with pullbacks and corrections.

The rebounds in markets following significant drawdowns are remarkable, even staggering. For example, since 1950, the S&P 500 has generated approximately 560% in returns during the recoveries of drawdowns greater than 20%. However, the returns generated during these recovery periods have not advanced portfolios above previous highs, but merely recouped losses created by the drawdowns themselves.

Therefore, hedging is a tool investors may use to potentially cushion the blow of these drawdowns which have and will continue to occur. Hedging is a tool to preserve capital so investors may spend more time gaining new ground, not just liberating lost ground caused by significant market drawdowns.

Because hedging can play such a critical role in investing, we felt it was necessary to provide investors with an analysis of which hedges have proved most helpful and most consistent. This paper will compare the effectiveness of instruments commonly used to hedge US equity markets, as represented by the S&P 500.

A common list of instruments and strategies are consistently named as hedges against volatility in US equity markets. Among these instruments and strategies ("instrument(s)") include: Short-Term Treasuries, Gold, Managed Futures, VIX ETFs and Futures, and the Japanese Yen.

In this report, we will present the correlations for each instrument versus the S&P 500 and attempt to demonstrate the effectiveness of each instrument in times of equity market stress. The daily returns of each instrument are scaled for volatility in order to compare them on an equal basis.

Please refer to the following abbreviation key to understand subsequent analysis:

Each instrument is also presented within the same four time periods in which the S&P 500 absorbed significant declines. These periods are:

August 2008 – March 2009

August 2011 – September 2011

August 2015 – September 2015q

October 2018 – December 2018

As mentioned, because each of the instruments listed above varies in its inherent leverage and/or volatility, we have scaled the data to remove the impact of any leverage or idiosyncrasies. The method we have chosen is to force each instrument to exhibit the same volatility as the other instruments over the time period considered. It is our assumption that by scaling the data in this way, we reveal which instruments, pound-for-pound, provide the most muscle to carry an equity portfolio through stressful market conditions. Therefore, the data presented in this study do not constitute reflections of returns or standard deviations that may be achieved as the returns have been scaled. Rather, the analysis speaks to relationships and the core effectiveness and hedging qualities of a given instrument as a hedge.

Correlation Analysis

As seen in the chart below, each instrument has expressed some measure of negative correlation on a fairly consistent basis to US equity markets as represented by the S&P 500. The VIX_1 instrument carries the greatest level of negative correlation and is the most consistent in doing so in the periods shown. Gold, ST CTA, and Yen have had some period of positive correlation while SHY, CTA, and VXZ seem to hold the middle ground consistently.

We can further drill down into the correlation relationship between the S&P 500 and each instrument by presenting the scatterplot for each instrument and for each time period. Within each chart, we also present the linear-regression trend line to reveal positive or negative correlation trends in the data. The R-squared coefficient is also presented in the top right corner of each scatterplot graph.

Visually, one can compare each instrument’s relationship to the S&P 500. In each and every case above, VIX_1 shows the tightest and strongest negative relationship to S&P 500 as well as the highest R-squared coefficient. VIX_1 consistently provides a compelling offset to negative moves in the S&P 500.

Portfolio Impact Analysis

Correlations are just one part of the analysis. Beta, or magnitudes of the movements in instruments in response to movements in the S&P 500, is also an important consideration. In other words, for every point down in the S&P 500, the question becomes how much exposure to a given instrument is required in order to fully offset that decline. The below charts attempt to show the effectiveness of each instrument in shoring up US equity volatility risk. Each chart displays a hypothetical 50/50 portfolio with each instrument and the S&P 500 for each period. Each combination is indexed to a starting value of 1,000 to show variation and portfolio behavior.

As we can see, all instruments offset, to a degree, the S&P 500 volatility. However, VIX_1 is the instrument which most consistently provides a profitable hedge and maximizes the given portfolio’s ending value, in the periods shown. Below, we present the rankings based on the ending value of each portfolio index shown above.

The VIX_1 instrument consistently provides superior hedging to the S&P 500. In three of the four periods studied, it is the clear leader. VIX_1 is the second-best instrument during the October 2018 to December 2018 period, but it is only outpaced by VXZ, another VIX-based instrument, which finished second in the overall rankings. The VIX Futures complex certainly provides a consistent answer to equity market volatility.

Interestingly, no real distinction exists between using treasuries, gold, CTAs, or "safe-haven" currencies to hedge domestic equities. All produced roughly the same ending values in the portfolios above over the four periods shown. Interestingly, the CTAs which are often looked to as the classic hedging instrument for equities were on the lower side of the rankings cluster, with Yen, treasuries, and gold leading the CTAs.

Furthermore, when taking into account volatility, VIX_1 also consistently delivers as the best match with the S&P 500. Below is a table of volatility scores, which are the annualized standard deviations computed from the daily changes in the Hypothetical 50/50 Portfolio Indices shown above. Again, VIX_1 is the clear leader, producing the lowest volatility combination with the S&P 500. The other instruments cluster around the same volatility scores, on average (between 0.25% to 0.28%), with gold producing the highest combined volatility.

Effectiveness of Hedges on Negative S&P 500 Days

Another important point of analysis is to evaluate how each of these instruments responds on the days when the S&P 500 was negative in the four periods of our analysis. While VIX_1, for example, may provide the best hedge for a given overall period, it is essential to know if it responded as desired on the days during the period when the S&P 500 was negative. Understanding hedging responses for each instrument on each such day in the S&P 500 is crucial to test the hedging effectiveness of each instrument. Below, we show just the movements of each instrument on the days when the S&P 500 was negative. We chart these movements by creating an index that grows on a cumulative basis.

We should also examine the correlations of these instruments to the S&P 500 on the negative days of the S&P 500 during the periods shown.

While no material inconsistencies exist between the overall correlations and the correlations on days when the S&P 500 is negative, it is interesting to note the VIX_1 is the only instrument whose correlations become more negative when measuring against negative days only. Below is a table that shows the correlation coefficients for each instrument and for each period. The values are boxed in red (correlation became more positive), green (correlation became more negative), and yellow (correlation unchanged).

As before, below we present the ending value rankings for the above cumulative growth indices on days when the S&P 500 was negative. Also as before, VIX_1 is the clear leader. In each time period, VIX_1 provides the best hedging response to negative daily moves in the S&P 500. The Yen, VXZ, CTA, Trend, and ST CTA instruments all cluster together with average rankings between 4-5. Gold and SHY are the least effective of the group with average rankings between 6-7.


While all of the above instruments do reduce S&P 500 volatility and improve upon a stand-alone S&P 500 portfolio, the VIX_1 in each aspect pulls away as the clear favorite. It has the strongest and most consistent negative correlation of the instruments analyzed. It also delivers the greatest positive risk-adjusted impact to a domestic equity position. And VIX_1 has the greatest positive response on days when the S&P 500 was negative. Pound-for-pound, it shoulders the hedging burden more effectively than any other instrument analyzed.

VIX Futures should therefore be the instrument of choice for domestic equity hedging solutions. Investors should therefore look to firms and managers who trade VIX Futures as a starting point to find protection for their portfolios. Furthermore, institutions who believe they already have their portfolios insulated from potential future equity volatility should re-evaluate those allocations in light of the data presented in this article.

For institutions who have allocations to managed futures programs that trade the VIX Futures as one of many markets traded, it is usually only a small component of the portfolio. Therefore, investors should consider a full allocation to a manager who trades the VIX Futures in a way which is designed to capture moves in the VIX Futures as described in this paper in order to maximize the superior hedging effectiveness of the instrument.

Finally, even though markets are near all-time highs, allocators should take very seriously the risks associated with investing in equities. As we have discussed in our article, Crash or Consolidation, equity markets have become extended by historical valuation measures. "[T]he current earnings / market cycle is stretched and will look to reset over a significant period of time as has occurred historically...[I]nstitutions may need to make portfolio adjustments for a potentially significant period of low equity returns." Those portfolio adjustments should include allocations to managers with specialized expertise in hedging with VIX Futures.