Hedging Against a Bear Market

Hedging Against a Bear Market with Inverse ETFs

Equities

Hedging equities with inverse ETFs can be a prudent way to reduce risk in your overall portfolio. Using inverse ETFs is what we consider a dynamic hedging strategy and is part of a tactical asset allocation strategy. As we wrote in our Hedging basics with Inverse ETFs section, using inverse ETFs is optimally a shorter-term strategy, especially when the inverse ETF is leveraged. The longer the inverse ETF is held, the longer is the contra-compounding risk (assuming a choppy market). But inverse ETFs can be a valuable tool that can be used to opportunistically take advantage of a stock market or sector, that is primed for a swift reversal or simply has become overbought.

Why the Need to Hedge?

The total market value of stock markets worldwide was about $70 trillion as of the summer of 2015, spurred on by global central banks that have injected roughly $22 trillion into the global financial system through various quantitative easing methods. With the total market capitalization of the U.S. equity markets pushing $17 trillion (which has tripled off the 2009 lows) there is a real need to reduce risk in portfolios. Inverse ETFs are a quick and easy way to hedge a portion of an investment portfolio. With over 100 inverse and alternative ETFs available, there is sure to be one that fits your portfolios specific needs.

An inverse ETF can reduce the systemic risk in your portfolio. No hedge is perfect, so that’s all you can ask for, reducing the risk with this hedge. There are pros and cons to all different types of hedging vehicles and inverse ETFs is just one of a few different ways to hedge against a bear market. Truly eliminating risk is probably only available with a 100% cash allocation. Unfortunately, this probably isn’t a feasible option for many individuals (especially retirees who live off the income), or institutions such as pension funds or endowments who need the growth and income from an investment portfolio to meet projected benefit obligations (PBOs). Some of the main risks include valuation risk and sentiment risk.

Correlation Risk

The next bear market could be at least as bad as the other bear markets we’ve witnessed over the last fifteen years. There are a few reasons for this, one being the continued trend towards passive investing or indexing. This has its own risks and that is the dwindling benefits of diversification. We’ve mentioned before that even if you have an equity portfolio that appears diversified, with a number of seemingly uncorrelated or negatively correlated assets the fact that so many mutual funds and ETFs now simply track major indices could mean that everything sells off in a more concentrated matter over next bear market.

The trend towards indexing or passive management is growing. We’ve had such a long period of time where the buy and hold strategy has outperformed it’s active management brethren indexing has become such a popular way to invest. Add that active managers tend to underperform their benchmarks while charging higher fees has only exacerbated the trend. The numbers are bearing this out, from ICI:

Even when money comes out of mutual fund we see it going into indexing of another sort, ETF indexing. becomes preferable to most). This can be evidenced by a consistent uptrend in stocks and when looking at the percentage of money invested into indexed mutual funds versus active continues to increase. It’s now over 20% of all equity mutual fund assets (from ICI):

So what we’re seeing is the benefits or diversification getting less and less since when the market does sell-off, correlations converge towards 1. Perfect positive correlation (1.0) is when all assets move in tandem as one entity (the market). What we’ve come to think about as “the market”, probably more than any other, is the Standard & Poor’s 500 Index or S&P 500. This index is made up of the 500 largest, most recognized U.S. companies.

Active Management Should Outperform

But styles ebb and flow. We think an era of active management will probably start to dominate and that means making changes to your portfolio, including hedges through vehicles including inverse ETFs. now, following a strong run by the buy and hold crowd. It again seems foolish to try and beat the market but we see a couple hints at why we think there is a major shift towards active management about to occur.

One is the recent bad press for ETFs following the August flash crash. Once the darlings for their low costs, real time pricings and diversification benefits, their assets under management swelled to $2 trillion in the U.S. But now we’re hearing rumblings of them referred to as ‘structured products’ and that they don’t work like they used to.

Mutual Funds

If you have a significant portion of money in mutual funds (pools if money invested in large baskets of stocks), using an inverse ETF to hedge against a stock market sell-off can be useful since mutual funds can only sell at the end of the day, when all investors in the fund receive the same price, the net asset value. That is a terribly inefficient way to trade, but mutual funds aren’t meant for trading so they dutifully serve their purpose. The problem arises when you want to reduce a portion of your portfolio during the market hours and you can’t. That’s where inverse ETFs can fill the void.

Since 2007, we’ve seen an increase in outflows from actively managed domestic equity mutual funds and into indexed (passive) mutual funds and ETFs. The extent can be viewed in this graphic below from ICI.

So we see that even when funds are leaving the passive mutual funds, much of it is just going into passive ETFs. Either way, it remains indexed but with a potentially worrisome unintended consequence which was exposed in the August, 2015 flash crash- ETF concentration risk.

But we think that active management with tactical strategies will be the best protection if there is a severe bear market in stocks. In order to get intraday hedging, inverse ETFs are a way to achieve this. They are quick to deploy and can hedge exposure since mutual funds investors are basically frozen intraday and only redeem their shares at the end of day’s closing net asset value (NAV). Additionally, you may face a fee when you sell your mutual fund if you hadn’t held it long enough-called a . And some illiquid bond funds have toyed with the idea of using “gate” fees or exit fees when you sell. So for investors with significant holdings in mutual funds, inverse ETFs offer a nimble way to reduce some risk if you can’t or are unable to sell shares.

Pensions

The other is that pension funds are dumping hedge funds in droves since many haven’t beaten the indexes. Unfortunately, the hedging that will be necessary if there is a bear market won’t be there.

International Markets

Globalization has brought capital to the far corners of the globe. Now, not only developed international markets are covered, but emerging markets have become almost mainstream. Even so-called frontier markets are available at most major investment houses. But with barriers to entry now so low, the diversification once enjoyed by having a portion of an investment portfolio earmarked for international has been reduced. Currency issues in Asia now affect U.S. markets like never before. European sovereign debt crises dominate our trading as well. These events used to be more compartmentalized, but not today. So if something goes awry across the seas, you can be sure it’ll make it’s way here to some degree. So a domestic hedge with an inverse ETF will likely hedge some international exposure as well since so many of our mid and large capitalization U.S. stocks have operations overseas. One-third of revenues for companies in the S&P 500 come from international markets. So using an inverse ETF as a hedge against the S&P 500 Index not only hedges our domestic market but also some international exposure. ProShare’s ‘Short S&P 500’ (SH) is an inverse ETF that aims to return the opposite (-1X) of the S&P 500 for one day.

Valuation Risk

Small-Cap

If the market does enter a bear market, as we mentioned above, it could be particularly fierce. One segment that experienced an enormous bounce of the 2009 lows is the Russell 2000 Index, which is made up of smaller capitalization, higher growth stocks. The valuations of the Russell 2000 are now very expensive compared to the market. In 2014, the trailing P/E was 49 times reported earnings, versus a multiple of 39 back in March 2000. Take a look at how high the Russell 2000 has come in relation to its two prior major peaks, 2000 and 2007. Small cap stocks should get hit disproportionately hard during the next downturn. In 2015, the Russell 2000 is more than double the level it reached at the height of the dotcom bubble.

The Russell 2000 stocks have also gotten a boost from its tracking ETF, IWM, which has enjoyed tremendous growth over the last few years. IWM’s assets under management have swelled to over $25 billion as investors have ridden the coattails of some of the most aggressive stocks in the market, small-cap biotechs. Even Janet Yellen has warned of ‘substantially stretched valuations” of some small-cap social media and biotech stocks.

ProShares has an inverse ETF that hedges exposure to small-cap stocks, the ‘Short Russell 2000’ (RWM) which has some nice attributes. It aims to return the opposite of the Russell 2000 Index, and thus, the mirror opposite of IWM.

Large Cap

The largest cap companies in the world are in the Dow Jones Industrial average. The problem is, by some metrics, the Dow is the most overvalued ever. The dividend yield for the Dow Jones Industrial Average is just 2% and has been there for years now. In many ways, this is the purest valuation metric there is. This is overvaluation on a historic level. With the inclusion of Apple into the Dow at the end of 2014, it has become relevant again. Unfortunately, many professionals believe that Apple’s inclusion marked the top for the Dow, and maybe the market.

There is an inverse ETF (DOG) that hedges exposure to the Dow Jones Industrial Average. It aims to return the opposite of the Dow Jones Industrial average on a daily basis.

The most followed and investable index in the world today is the Standard & Poor’s 500, which comprises 500 of the largest U.S. companies. It’s ETF counterpart, the Standard & Poor’s depository receipt (SPY) tracks the return of the S&P 500 and is by far the largest ETF in the world with $168 billion in assets. To get a sense of how lopsided this is, SPY is 100 times larger than its inverse counterpart, the ProShares ‘Short S&P 500’ ETF (SH) which has just roughly $1.6 billion in assets under management. It will be very interesting to see how the disparity in assets under management gap between these two polar opposite funds converge. This disparity, in and of itself, is a useful contrary indicator.

The SH could be a core holding for a bear market, given its size and liquidity, with over $3.2 million shares traded daily, (3-month average). It’s also not leveraged, so the market timing doesn’t have to be quite as precise, and the benchmark it tracks is arguably the most sustainable in the world. And as the trend towards indexing gets more and more popular, the entire stock market becomes more correlated to one another. Additionally, it has 11 different counterparties in its derivatives holdings and has a relatively low expense ratio of 0.89%.

What will the Inverse ETF do?

So if the inverse ETF achieves its objective, it will increase if the index or benchmark it tracks decreases. It is this offsetting that can reduce risk. The goal of using an inverse ETF to hedge a stock portfolio is to protect, or immunize, all or a portion of the investment portfolio from market declines. As an example, say you have a portfolio of stocks worth $250,000 invested in a mix of a few individual stocks, a couple mutual funds and maybe an ETF.

Again, we like to think of deflation as a reduction in the amount of money and credit in the system. The credit part of that equation can be reduced by 1-repayment or 2-the debt being defaulted upon (or ‘restructured’). Both ways, the debt has been reduced or extinguished. Assuming a lessening of demand for more debt, the overall amount of debt comes down.

Mutual Funds

If you have a significant portion of money in mutual funds (pools if money invested in large baskets of stocks), using an inverse ETF to hedge against a stock market sell-off can be useful since mutual funds can only sell at the end of the day, when all investors in the fund receive the same price, the net asset value. That is a terribly inefficient way to trade, but mutual funds aren’t meant for trading so they dutifully serve their purpose. The problem arises when you want to reduce a portion of your portfolio during the market hours and you can’t. That’s where inverse ETFs can fill the void.

That is a paltry amount to be paid for high-risk corporate bonds, especially considering that is a lower rate than the risk-free rate just seven years earlier (in July 2007, right before the U.S. entered the Zero-Interest Rate Policy, ZIRP, the Fed Funds rate was 5.28%). In other words, our collective complacency has allowed us to equate the risk of owning junk bonds to being essentially risk-free. Of course, the most direct inverse ETF that would hedge against a collapse in junk bonds would be the SJB. We like this option better than the HYHG because we don’t think it will be interest rates that crush the junk bonds, but more the credit risk as they often move with equities.

ETFs

Of course, one solution to the drawbacks of mutual funds was the invention of the ETF. ETFs have swelled to X. But as Augusts flash crash unveiled, ETFs have their own issues. The evidence is still coming in, but there is a chance the proliferation of ETF use has unintended consequences. Here is a scatterplot of the openings of many ETFs from that morning. While the graph may look like a piece of modern art, its actually quite telling and exposes the concentration risk in many of these ETFs.

Hedging Against a Bear Market