Hedging With Inverse ETFs

October 19, 2010

Debt Be Not ProudIn designing hedging strategies, investors can choose from a variety of tools and approaches. In recent years, inverse exchange-traded funds (ETFs)1 have joined the list of available hedging tools used by institutional and other investors. In this article, we first discuss the factors investors should consider when constructing any hedging strategy. We then explore the critical aspects of hedging with single inverse (e.g., -1x) ETFs. We show that while these tools can be effective hedging vehicles, they require careful monitoring and rebalancing to maintain the hedge. We finish by comparing hedging with single inverse ETFs to hedging with leveraged inverse ETFs (e.g., -2x), the latter requiring less upfront capital but more frequent rebalancing.

Key Hedging Strategy Considerations
A hedging strategy involves adding positions to a portfolio with the objective of reducing volatility of returns. Many investors choose to hedge risk rather than sell positions in their portfolios because of liquidity, tax, trading cost or other portfolio management implications.2 To hedge a portfolio position, investors add negatively correlated investments—investments that move in the opposite direction—to all or a portion of the portfolio in an attempt to offset some or all changes in value of the target position. In designing a hedging strategy, investors should consider the following factors:

Choosing a Benchmark Index—Many investors use hedging instruments based on indexes to reduce risk associated with broad market moves, referred to as benchmark risk. Index-based hedges are often more liquid, accessible via exchanges and may be less costly than customized portfolio hedges using swaps or options in the OTC market. This can make it easier to monitor, trade and adjust the size of hedges over time, as well as to exit the hedging strategy. Selecting an appropriate benchmark index typically involves comparing the return and security characteristics of the target position with those of various indexes and identifying the index, or set of indexes, that have the highest correlation to the target position. Hedging strategies can range from simple—hedging an S&P 500 portfolio with an S&P 500 index product—to more complex—hedging across multiple asset classes that may require blending a group of index products and that would need to be regularly rebalanced to maintain consistency with the target position. This article focuses on the former.

Determining How Much to Hedge—How much to hedge depends on the amount of benchmark risk an investor is seeking to reduce, with the maximum being a full hedge (100 percent of the long position) that would reduce the return expectation of the hedged position to that of a cash equivalent.3 Many investors attempt to hedge only a small portion of a portfolio’s market exposure, such as 10 percent or 20 percent, to help reduce volatility of returns. In cases where investors are interested in hedging a specific portfolio exposure, such as a sector allocation, the amount of the hedge will naturally be driven by the size of that exposure.

Selecting the Hedging Vehicle—When selecting a hedging vehicle, investors should consider various factors, such as the return profile of the hedging vehicle, effectiveness, expected duration of the hedge, liquidity, cost, financing and ease. Investors looking to hedge equity risk, for instance, can short stocks or ETFs or choose from a variety of derivative strategies, such as selling futures or swap contracts, buying put options or selling call options. More recently, the choice of buying inverse ETFs has been added to the hedging menu. That is the focus of this article.

Monitoring and Rebalancing the Hedge over Time—Effective hedging normally requires a dynamic process, monitoring and rebalancing the hedge to maintain alignment with the value of the position or portion of the portfolio being hedged. Common sources of misalignment are active (alpha) risk or benchmark (beta) differences between the hedging vehicle and the index itself. A portfolio with active risk may outperform or underperform its benchmark index over a hedging period, calling for adjustment in the size of the hedge. Consider, for example, an initial $100 investment in an actively managed mutual fund that outperforms the index by 5 percent. An investor who had hedged by being short the benchmark index now has at least an additional $5 at risk and should consider adding to the hedge to account for the alpha achieved—a practice known as rebalancing the hedge.

Designing Rebalancing Strategies—The design of a rebalancing strategy for a hedge should reflect the desired level of monitoring and customization required to adjust for changing market and volatility conditions. Common rebalancing approaches include calendar rebalancing, where adjustments are made at regular time intervals, such as monthly or quarterly, and fixed-percentage rebalancing, which triggers rebalancing when the difference between the hedge and the long position return reaches a certain percentage level, such as 10 percent.4 A fixed-percentage trigger is more adaptive to market conditions than calendar-based rebalancing. With a fixed-percentage trigger, more frequent rebalancing typically occurs during high-volatility periods. The size of the band or range should be based on the investor’s goals, risk tolerance and expected transaction costs. Generally, the tighter the band, the more frequent the rebalancing and the smaller the deviation of net exposure. Rebalancing the hedge also involves capital, transaction cost and tax considerations, which largely depend on which of these rebalancing strategies is utilized and on prevailing market conditions.


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