1 Inverse exchange-traded funds are designed to provide an inverse multiple (e.g., -1x or -2x) of the daily return of a benchmark (before fees and expenses).
2 Hedging also differs from diversification in that hedging’s sole purpose is to mitigate the risk of return volatility rather than to serve as a potential new source of returns.
3 In a situation where the beta sensitivity of the hedging tool to portfolio risk is less than 1.0, a fully hedged position may require a notional hedge amount of more than 100% of the portfolio value. For example, if the portfolio has a beta of 1.2 to the hedging vehicle, a full hedge could entail the dollar value of the hedge position being 120% of the portfolio value.
4 Another more dynamic rebalancing approach uses percentage triggers that are larger in volatile market conditions and smaller in lower-volatility markets, such as Bollinger bands.
5 Total inverse ETP assets were $21.6 billion, with average daily volume of $5.8 billion for the first six months of 2010. Source: Bloomberg. Inverse exchange-traded product data as of June 30, 2010.
6 Some exchange-traded products have monthly objectives or even multiyear holding periods with knockout features. ETPs with nondaily objectives are beyond the scope of this article.
7 With all investments, users should take care to read the prospectus and fully understand how inverse ETFs work and what risks are involved.
8 The long position and single inverse returns are chosen to provide an illustration of the direction and size of the rebalancing trades. Returns are not intended to predict fund performance levels in particular market conditions. Inverse ETF returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.
9 Net long exposure is equal to the value of the long assets multiplied by any explicit leverage minus the short assets multiplied by any explicit leverage. Note, this assumes the long position’s beta equals that of the inverse fund’s underlying index. Investors hedging based on beta comparisons can adjust the inverse fund weightings accordingly.
10 Proceeds from selling this position could be invested elsewhere or held for future funding needs for the rebalance process. In practice, investors not facing any constraints on the long position may consider rebalancing both the long and the inverse positions simultaneously, reducing long positions to augment inverse positions or vice versa, which is conceptually similar to rebalancing between stocks and bonds.
11 Summary of Assumptions:
- The inverse ETF strategies are represented by multiplying the ETF multiple of -1x or -2x by the index return every day of the period.
- All return calculations exclude fees, financing, interest and expenses.
- There were no capital constraints. That is, losses could have exceeded -100%.
- Rebalancing was based on end-of-day index prices and implemented at those prices on the same day.
- No transaction fees or taxes were incurred in connection with rebalancing the single and leveraged inverse ETF positions.
12 To apply this methodology to partially hedged scenarios (e.g., 50%), the same band can be said to apply around the portion of the long position that is being hedged. For instance, in the examples in Figure 1, a 50% hedge target would imply $50 of the long assets were hedged with $50 of inverse assets. A 10% increase in value of long assets could lead to a $52.50 long position hedged with $47.50 of the inverse position. The net exposure would then be $5, which is also 10% of the initial $50 being hedged.
13 Without any rebalancing of hedge, S&P 500 with 50% hedge return and risk was -12.06% and 8.57%; S&P 500 with 100% hedge return and risk was -3.85% and 14.21%.
14 The fully hedged portfolio began the period with zero net exposure and was only exposed to market movements to the extent net exposure did not exceed either + or -10% in either direction. Without rebalancing, as the index position fell and the inverse position rose unchecked, net exposure would have peaked at negative 90% in this period.
15 Similarly, had the long positions declined in value, the ending net short portfolio exposures could be equivalently greater with increased leverage. The long position and -1x inverse returns are chosen to provide an illustration of the direction and size of the rebalancing trades even if long positions were identical to the index. Returns are not intended to predict fund performance levels in particular market conditions. Inverse ETF returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.
16 While trading frequency likely increases with more leverage, average trade size decreases, owing again to the use of less capital. Figure 5 shows that an investor would have to purchase $15 of additional exposure when using a -2x fund and $10 when using a -1x fund. This equates to $7.50 of -2x fund units vs. $10 for the -1x fund.
17 Despite a greater rebalancing frequency, total capital traded was still less for leveraged inverse ETFs, as many rebalance trades were also sells.