Will These 3 ETFs Really Protect You in a Crash?

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There are thousands of exchange-traded funds that specialize in stocks, and they all carry some stock market risk. But risk-averse investors often turn to a certain group of ETFs that have reputations for being less volatile than the overall market. Investors in these funds are willing to give up some upside during bull markets in order to minimize losses when the Dow and other major stock indexes head south.

The problem with defensive ETFs is that they can't always give you all of the protection you might expect. In particular, Vanguard Dividend Appreciation (NYSEMKT: VIG), iShares Edge MSCI Minimum Volatility USA (NYSEMKT: USMV), and PowerShares S&P 500 BuyWrite (NYSEMKT: PBP) all suffered losses on Monday that were less than the S&P 500's 4.10% drop, but they still suffered the bulk of the market's decline. Below, we'll look more closely at these ETFs to see if they'll really get the job done in a true market crash.

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Down with dividends?

Many investors look at dividend stocks as a way to guard against market crashes. Even as share prices fall, dividend stock investors count on getting regular income from their investments. In particular, the Vanguard Dividend Appreciation ETF focuses on stocks that have stood the test of time by building a track record of dividend growth. Even during past market downturns, these stocks have been able to keep their payouts moving higher, and most of them have enjoyed long-term price gains as well.

Dividend stocks have been extremely popular in recent years, and that has sent their shares much higher than they'd usually go during a typical bull market. As a result, some market participants fear that dividend stocks could suffer greater losses in a downturn this time around than they ordinarily would -- and Monday's experience suggests that those concerns might well be valid.

Shying away from volatility

Some ETFs are more explicit in their aversion to the market's ups and downs. The iShares fund seeks out stocks that carry less risk than the overall market, weighing various volatility characteristics in order to weed out stocks that could see greater swings during downturns. The fund has a historical track record of declining less than the overall market when it heads south.

Like the Vanguard dividend ETF, the iShares minimum volatility ETF holds a large number of consumer products companies, many of which overlap because of their relatively healthy dividend payments. Today's 3.68% drop is indeed smaller than the overall market's decline, but it still represents 90% of what the S&P 500 lost. That may not be as much risk protection as investors had hoped to see.

Boosting income

Finally, some investors turn to the options market to manage the risk in their portfolio. Buy-write funds own shares of stock and then write call options against that stock. If the shares rise in value, then the options can lock in gains. If the shares decline, then the fund gets to keep the option premium it received as additional income.

The problem with buy-write funds is that they don't provide options-related protection against downward moves in the underlying stocks. In other words, you remain fully exposed to downside risk, but you exchange part of your upside for the option premium. The fact that today's decline is smaller than the overall market's move shows that while the additional income can provide some ballast against downward moves, it's far from complete protection.

Be smart with ETFs

Conservative investors need to be aware of the risks involved in any stock exchange-traded fund. Some might not react quite as badly to market crashes as others, but you're still likely to see substantial losses that can come as a big surprise if you had expected more insurance against a potential crash.

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Dan Caplinger owns shares of Vanguard Dividend Appreciation ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.