Hedging With Inverse ETFs

October 19, 2010

Hedging Using Inverse ETFs
Now, let’s examine one particular hedging method in greater detail—hedging using inverse ETFs. Inverse ETFs are investments that seek to provide an inverse multiple (e.g., -1x or -2x or -3x) of the daily return of a benchmark before fees and expenses. These ETFs debuted in 2006, although similar inverse mutual funds have been in existence since 1994. Inverse ETFs have grown significantly. Today, more than 100 ETFs cover a broad range of equity, fixed-income, commodity and currency benchmarks.5 Many investors consider inverse ETFs to be attractive hedging instruments for the following reasons:

  • Inverse Correlation: An inverse ETF seeks to achieve the inverse of the one-day performance (or a multiple thereof) of the ETF’s stated benchmark index before fees and expenses.6 As such, buying an inverse ETF may provide index returns with the negative correlation, on a daily basis, necessary to implement an effective hedge, without requiring investors to short securities.
  • Accessibility: Inverse ETFs trade much like stocks on security exchanges and are generally bought and sold in the same way. Typically, no special accounts or other special arrangements are needed.7
  • Intraday Pricing and Liquidity: Since inverse ETFs trade much like stocks, they are priced throughout the day to reflect market fluctuations. For some investors, this can facilitate better monitoring and rebalancing.

Rebalancing the hedge is a particularly important consideration when hedging with inverse ETFs due to the single-day objective of these ETFs. Figure 1 uses a simple two-day example to illustrate the potential additional rebalancing requirements when using single inverse ETFs. The table shows the impact of both 5 percent up and 5 percent down daily moves on a fully hedged $100 long position8 where the long position and the single inverse ETF have the identical underlying benchmark.

Figure 1

In Scenario A, where there has been a rise of 5 percent, we see that a purchase of an additional $10 of the single inverse ETF is required to return net exposure back to 0 percent. In Scenario B, where there has been a decline of 5 percent, we see that a sale of $10 is required to return net exposure to 0 percent.10

 

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