Hedging With Inverse ETFs

October 19, 2010

Hedging With Leveraged Inverse ETFs
Up to this point, our discussion has focused on single (-1x) inverse ETFs. Investors could alternatively use leveraged inverse ETFs, which pursue returns equal to -2x or -3x of a benchmark index’s one-day return. The primary benefit of using a leveraged inverse ETF is that less up-front capital may be needed to implement the hedging strategy. However, maintaining a leveraged inverse hedging strategy over time—keeping the net exposure close to zero—is likely to require more frequent rebalancing than would a -1x inverse ETF strategy. To illustrate how inverse exposure and upfront capital requirements vary when using leveraged inverse ETFs, Figure 4 compares inverse ETF hedging strategies with varying degrees of leverage: -1x, -2x and -3x.

Figure 4 presents a long position of $100 that is fully hedged (100 percent) by -1x, -2x and -3x inverse ETFs. Working from the midpoint of $0, we see the initial cost of capital for each of the ETF hedges in the left-hand bars. The bars show how the use of additional leverage (-2x and -3x) can reduce the amount of upfront capital required for the hedge ($50 and $33.33 vs. $100), while still maintaining the desired net exposure (100 percent).

Figure 4

An important consideration when hedging with leveraged ETFs is that variations in net exposure are magnified in response to index moves. This means that hedges with leveraged inverse ETF exposure will most certainly require more frequent rebalancing. Figure 5 illustrates this point by showing the impact of a 5 percent market move on a -1x, -2x and -3x inverse ETF hedge. When the market rises 5 percent, the $5 gain in the long portfolio triggers exposure gaps across all three ETFs, but in varying degrees. The use of higher multiple inverse ETFs leads to larger net exposure gaps over the course of the hedging period.15 For instance, the use of a -1x ETF results in a 10 percent performance gap and a $10 net exposure gap ($105 vs. $95), but the same position hedged with a -3x ETF results in a 20 percent gap with a $20 net exposure gap ($105 vs. $85). This potential for larger net exposure variances demonstrates the need to increase the frequency of rebalancing when hedging with leveraged ETFs rather than single inverse ETFs.16

Figure 5


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