Hedging Exposure

Hedging with Inverse ETFs

hedging with inverse ETFsOne of the benefits of using inverse ETFs is the ability to use them as a hedge against other holdings in your portfolio.

There is a wide variety of inverse ETFs to reduce market risk in a portfolio.

Hedging with Inverse ETFs can be tailored to specific asset classes you may own (or are exposed to) in your portfolio:

Here is a simplified example of how an investor might use an inverse equity ETF to hedge against a typical stock portfolio: Assume you have a brokerage account with roughly $100,000 in market value, invested in equities. You have a long time horizon until retirement so it is invested in equities (stocks).

Let’s say you own 4 stocks, two mutual funds and a couple ETFs. The market is up strongly this morning you have enjoyed a nice run but think the market is overdue for a serious correction (sell-off) and you want to protect your gains. You’re not sure if you should do nothing, sell everything (and go to 100% cash in a money market fund), or sell a few different positions that you think might be due for short-term drops, etc. You have some decisions to make…

Hedging with Inverse ETFs

Instead, you could buy an inverse equity ETF with inverse exposure (it will move in the opposite direction) to the broader stock market (an index like the S&P 500). Let’s say you purchase the inverse ETF ‘SH‘, which moves opposite the S&P 500 on a one-for-one, daily basis. If the stock market goes lower by 1%, SH should go up 1% (which offsets or ‘hedges’ your other equity holdings which will have presumably followed the market lower).

Let’s assume SH trades at $25. For a full hedge of your $100,000 portfolio you could purchase 4000 shares of SH ($25 x 4,000 = $100,000). Since the SH is a single inverse ETF, it moves the opposite (-1X) the S&P 500 so it should nicely offset much of the move in your underlying stocks, equity ETFs and mutual funds. As your $100,000 stocks/ETF/mutual funds portfolio lose 1% (assuming it correlates to the broader market), your $100,000 SH hedge has gained approximately 1% so you have lost minimal money and the hedge has been successful (this simplified example doesn’t include transaction costs, etc).

But with a fully hedged, inverse ETF position, you give up any upside to the underlying portfolio, you are simply trying to protect against a market sell-off. With the full hedge, the S&P 500 would have gone higher by 1% instead of lower, yet portfolio would still gained 0% due to the loss on the hedge itself, the inverse ETF.

Another nice attribute of inverse ETFs is the ability to quickly and cheaply put on a ‘partial hedge’. Say you can’t decide whether to do the hedge described above or not. Maybe you remember your grandfather saying to buy stocks for the long run and don’t worry about the fluctuations. Or perhaps a financial advisor has expressed a similar view. Well, it doesn’t have to be all or nothing. Instead of the full 4000 shares of SH, you could have bought 2000 shares (costing $50,000) and be theoretically 50% hedged. Continuing with the example above, when the S&P 500 went down 1% your stock/ETF/mutual fund portfolio would lose the 1%, but the $50,000 partial hedge would gain 1% so your overall portfolio (including the hedge) would have lost just 0.5% overall. The partial hedge allowed you to limit some of the downside but also let you participate in some of the upside had the market gone higher. Your overall portfolio would have still gained roughly 0.5% had the market (S&P 500) gone higher instead, offsetting the loss on your partial hedge.

Selling Your Positions

Suppose you decide you want to raise cash in the account by selling stocks. That’s fine, raising cash is never a bad option if you’re worried about the markets, but there are some factors you’ll need to consider. First, you have to figure out which positions to sell. Often, stocks in a portfolio have vastly different cost bases and you know that selling your AAPL stock (that you love and have had for years) will trigger a hefty tax bill you don’t want to pay (assuming a non- retirement account).

Further, you may need the income coming from the investment, either in the form of dividends or interest (perhaps you own a high-yielding product such as a Master Limited Partnership, MLP in the account). You may feel uncomfortable paying a 1% account wrap-fee just to sit in cash, earning zero. Perhaps it was a hassle when you first purchased the securities (illiquidity problems, etc.) and don’t want to sell them just to get back into them in the near future. Finally, maybe your positions are spread around in three different accounts that require phone calls to different brokers to liquidate.

In this example, it may be advantageous to hedge with inverse ETFs instead of selling your holdings. Raising some cash is never a bad idea, the problem is it’s usually done after a major sell-off, when it might be more advantageous to put cash to work. You can compare hedging with inverse ETFs to other hedging strategies to identify which might work best for your particular situation and the type of account you’re hedging.

Hedging with Inverse ETFs
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Hedging with Inverse ETFs
Hedging with inverse ETFs may be a way to protect your portfolio from volatility and a severe bear market.
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