Hedging With Inverse ETFs

October 19, 2010

Case Studies: Hedging With Leveraged Inverse ETFs In Different Market Conditions

To examine the effects of leverage across market conditions, we compare single- and leveraged-ETF hedging strategies across the declining and rising market-return scenarios presented earlier in the article, as well as across a third, choppy index-return scenario (H1 2009), where the index experiences high volatility but has flat return over the entire six months. Case Studies III, IV and V show the performance of the S&P 500 when hedging with a leveraged ETF, which for illustration purposes is represented by a -2x strategy. As a point of comparison, we include the single inverse ETF hedge (-1x) in the exhibits.

Case Study III: Leveraged Inverse Hedge In A Declining Market

Overall, the -2x strategy, with the lower initial investment, showed slightly higher volatility of hedged positions but a very similar pattern of returns compared with the -1x inverse hedging strategy. In Figure 6, we see that in the second half of 2008, returns were slightly lower and somewhat more volatile with the -2x strategy given the index volatility and corresponding size of daily moves. Rebalancing frequency doubled, moving from a -1x strategy to a -2x strategy.

Figure 6

Case Study IV: Leveraged Inverse Hedge In A Rising Market

Figure 7 shows that during the second half of 2009 when the index was rising in value, the -2x hedging strategy had slightly higher returns than the comparable -1x example but also slightly higher risk.

Figure 7

Case Study V: Leveraged Inverse Hedge In A Choppy Market

In Figure 8, we compare the inverse ETF hedging strategies in a choppy index return period where the index was volatile but ended the period with only a 3.2 percent return. Rebalancing frequencies were much greater, moving from the -1x to the -2x hedging strategies. The -2x strategy was rebalanced on average every eight days versus every 23 days for the -1x strategy. Performance was very similar among both hedged strategies during these choppy market conditions, indicating that rebalancing the size of the hedge was effective in mitigating the impact of the volatile market conditions on the effectiveness of the leveraged hedging tools.

Figure 8

Another way of thinking about how a hedging strategy with a -2x inverse ETF would compare with one using a -1x ETF is that for a given trigger, say 10 percent, more frequent rebalancing would be required since the ETF returns are a multiple of the inverse index moves. In the tables under the previous three charts, you can see that the frequency of rebalancing was greater with the addition of leverage.17 This illustrates that the leveraged inverse ETF is more likely to appeal to investors who are looking to lower the upfront investment associated with the hedge and who are comfortable with rebalancing on a more frequent basis. An alternative to reduce the frequency of rebalancing is to have a wider trigger (e.g., 15 percent instead of 10 percent) when using leveraged inverse ETFs, with the trade-off being that the investor assumes greater variation in net exposure between rebalances.


Hedging is a risk management practice that requires investment discipline and agility. Whether managing the risk of a specific sector allocation or an entire portfolio, investors are best served by having a process addressing a range of hedging considerations including benchmark selection, how much to hedge, the hedging vehicle and an approach to monitoring and rebalancing.

Investors are increasingly considering single and leveraged inverse ETFs as potential hedging instruments. With proper monitoring and rebalancing, a single inverse ETF may provide the inverse correlation on a daily basis necessary for an effective hedge and can offer the benefits of accessibility and intraday pricing/liquidity. Additionally, leveraged inverse ETFs require less capital to initiate the hedge than single inverse strategies. On balance, these vehicles, like any other hedging instrument, must be carefully monitored and managed. Leveraged inverse ETFs, in particular, may magnify benchmark exposure with less capital but require more frequent rebalancing to maintain the hedge.

In terms of measuring the effectiveness of an inverse ETF hedge, we evaluated relative return, volatility and maximum drawdown results of the hedged portfolio, as well as the pattern and frequency of rebalancing. As we saw across very different index return scenarios, inverse ETF hedges, with and without leverage, potentially reduced volatility and magnitude of returns. It’s important to note that while we presented illustrations for different market scenarios, the examples are still theoretical, and other hedging vehicles could be more effective than inverse ETFs. Market conditions can vary considerably, and transaction costs, cost of capital, and tax consequences will all affect the final outcome of a hedging strategy. Regardless of your hedging method, it is important to carefully customize and closely monitor and calibrate your hedging strategies to achieve and maintain your desired risk targets.

This article is not intended as a recommendation for any specific investment program. It is not intended to be an investment strategy and does not infer or guarantee a profit by using the strategy.


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