In 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.
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.
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
Case Studies: Hedging With Single Inverse ETFs In Different Market Conditions
We use case studies to further illustrate hedging with single inverse ETFs, demonstrating the need to rebalance. With case studies representing periods of rising and falling benchmark returns and different volatility environments, we can show how the frequency of rebalancing is linked to market conditions and how the net exposure varies between rebalancing points.
We present two different market scenarios using S&P 500 returns: 1) a period of declining returns (H2 2008); and 2) a rising return period (H2 2009). To simulate the performance objective of an inverse and leveraged ETF, we’ve taken each of the S&P 500’s daily returns and multiplied them by -1 and -2, thus ignoring fees, financing, interest and expenses.11 In all of the case studies, we employ a fixed-percentage rebalancing approach to keep the net exposure of the combined long and hedge positions within a fixed-percentage band of +/-10 percent. With a fixed-percentage approach, rebalancing occurs when this range is exceeded in either direction.
Case Study I: Single Inverse Hedge In A Declining Return Environment
Figure 2 shows the risk/return characteristics and net exposure of fully (100 percent) and partially (50 percent) hedged positions in the S&P 500 during the second half of 2008. The table at the bottom of Figure 2 shows the net exposure of the 100 percent hedged position12 and the points where rebalances occurred, which are seen where the black line pierces the +10 percent and -10 percent rebalancing bands. Through early August 2008, net exposure would have stayed relatively stable, only breaking out of the band and requiring rebalancing twice between June 30 and the end of August. At that point, the S&P 500 began to decline steeply, with higher volatility through year-end. During this latter period, fluctuations in net exposure increased as the gap between the return of the S&P 500 and the inverse strategy increasingly diverged, prompting the need for more frequent rebalancing. For the six months as a whole, the 10 percent rebalancing band required the hedge to be adjusted, on average, about every 10 days.
As summarized in the table at the bottom of Figure 2, rebalancing helped maintain a consistent hedge during the six-month horizon, and the hedge significantly reduced losses and return volatility over the entire six-month period. A 50 percent hedged position declined by just over 10 percent during this period when the index return was -28.5 percent, and reduced volatility from 54 percent to less than 15 percent.13 As hoped, the fully hedged position has close to zero return and zero volatility.14
Case Study II: Single Inverse Hedge In A Rising Return Environment
In our next case study, we looked at the same hedging strategies against S&P 500 exposure but in a period of rising returns, specifically the second half of 2009 when the S&P 500 appreciated by 22.6 percent. Results for this market scenario are shown in Figure 3.
Over this period, the volatility of the S&P 500 index was 17 percent, much less than that experienced during the turbulent second half of 2008. Not surprisingly, the net exposure of the hedging strategies was far less volatile as well. A 10 percent band applied over this particular period prompted rebalancing about every 31 days versus the average of every 10 days in the second half of 2008. All of these rebalances were additions to the size of hedge position, as the inverse position declined relative to the index. This would have required adding additional capital to the hedging strategy over this period. The hedging strategies succeeded in reducing the volatility of S&P 500 exposure and maintaining the desired equity exposures near 0 percent and 50 percent, but at the cost of lower returns.
In both market scenarios, we see that the -1x hedging strategies, using a 10 percent rebalancing band for the hedge, fulfilled the objective of reducing downside return risk significantly, measured both by volatility and maximum drawdown. On balance, it is important to understand that these hedging strategies may significantly reduce upside returns as well.
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).
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
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.
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.
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.
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.
Joanne Hill and Solomon Teller, “Rebalancing Leveraged and Inverse Funds,” Eighth Annual Guide to Exchange Traded Funds & Indexing Innovations, Institutional Investor Journals (Fall 2009): 67-76
Nassim Taleb, “Dynamic Hedging,” John Wiley & Sons, Inc. 1997
John Hussman, “How Hedging Works,” HussmanFunds.com, April 18, 2005
Matt Hougan, “How Long Can You Hold Leveraged ETFs?” Journal of Indexes, March/April 2009
Mark Miller, “Hedging Strategies for Protecting Appreciation in Securities and Portfolios,” FPA Journal, August 2002
Joanne Hill and George Foster, “Understanding Returns of Leveraged and Inverse Funds,” Journal of Indexes, September/October 2009
Werner Keller, “Dynamic Risk Control for Equity Portfolios,” Keller Partners, LLC, April 2008
Ira Kawaller, “Tailing Futures Hedges/Tailing Spreads,” The Journal of Derivatives, Winter 1997
Tom Konrad, “Five Hedging Strategies,” Seeking Alpha, Sept. 8, 2009
Investopedia Staff, “A Beginner’s Guide to Hedging,” Investopedia, August 2003
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.