Table of Contents Show
Hedging is a technique that helps to mitigate the decline in the price of an asset. A sort of insurance against market crash.
Let’s say you own shares of a company and plan to hold onto them, but are afraid that the stock will suddenly plummet. In this case, you can “buy insurance” – that is, bet on the fall of these stocks. If the fall does not occur, you will lose a small portion of the capital you bet against. However, if the fall does happen, this bet in the opposite direction can compensate for your losses from owning the shares. This is briefly describing the principle of hedging: when we buy regular insurance, we also hope that the insurance event will not occur, even though it will mean that the money spent on insurance was spent “in vain”.
Both private investors and large funds use hedging. Some of the funds are even called “hedge funds”. They offer professional management of capital, where cunning trading strategies and hedging with the help of derivative instruments are used for maximum profit at a given risk. Such organizations manage the money of large players: the entry threshold for private investors in American hedge funds is $5 million.
More modest investors have to optimize risks on their own. The main problem is that typical hedging instruments are complicated. Most often, futures, options, and swaps are used for hedging, and knowledge is needed to use them.
Another popular way to hedge against asset depreciation is to open short positions: when an investor borrows securities from a broker, sells them at the current price in order to buy them back at a cheaper price later and return the debt to the broker. However, the market can move in the opposite direction – the use of shorts in inexperienced hands can result in significant losses.
As a result, more understandable hedging tools for investors have appeared on the market – inverse ETFs. Essentially, these are the same exchange-traded funds as regular ETFs, but they move in the opposite direction.
For example, let’s consider the American stock market – the S&P 500 index. Its exact movements are mirrored by the VOO and SPY funds with minimal error. At the same time, the ProShares company offers the SH fund – it behaves inversely to the S&P 500: when the S&P 500 rises, SH falls and when it collapses, SH rises.
Let’s take a closer look at the pros and cons of inverse ETFs and what they represent. But, nevertheless, this article will help to better understand the principles of hedging and improve one’s approach to portfolio optimization. Because even with the tools available to the average investor, risks can be managed. For example, gold and shares of gold mining companies like “Polyus” often serve as a natural hedge against falling stocks.
Is it even worth engaging in hedging?
Overall, for a “lazy” investor who follows the “buy and hold” principle for the long term, hedging is not necessary: statistically, markets grow more often than they fall, and every recession in the economy is followed by its recovery and a new cycle of growth. After the 2008 crisis, the business cycle lasted for 11 years until we faced a collapse in 2020. During this period, despite all the local declines, the S&P 500 index showed growth of over 300%. Therefore, a patient investor could calmly wait out corrections and remain in profit even without portfolio management.
On the other hand, the rise in unemployment and active stimulation of economies by central banks in 2018-2019 indicated the approach of a recession. It was unknown what event would serve as the trigger for the market crash, but it was clear that it would happen. Therefore, it was possible to prepare for the crash – at least by rebalancing the portfolio’s sectoral stocks – by focusing on defensive industries.
So-called bear markets, i.e. a decline in quotations of more than 20%, were observed in 2008 and 2020 – the falls were 56.8% and 33.9% respectively. If we count from 1950, a bear market occurs on average every 7.78 years. In addition, corrections occur every 1.84 years – when the market falls by 10-20%. For example, during the period from 2008 to 2020, investors experienced 6 similar falls. They also witnessed 7 declines ranging from 5 to 10%.
In addition to the fact that the markets regularly experience storms, the strength of these disturbances increases. Blackstone’s research shows that with each decade, the volatility of the S&P 500 increases. If you count the number of days when the index moved 3% or more during a trading session, then there were 95 such days from 2000 to 2009 – this is more than in the previous 50 years. From 2010 to 2020, there were 50 such days – this is less than in the 2000s, but still confirms the trend of increasing volatility.
As a result, investors often face drawdowns and volatility, so it is possible to insure oneself with the help of hedging.
What is the difference between diversification and hedging?
Diversification reduces most of the specific risks associated with the issuer, sector, specific country, and asset class and generally mitigates portfolio volatility. However, it works best only under normal market conditions and loses its effectiveness in crisis scenarios.
The fact is that during falling markets, the correlation between assets increases significantly: during panic, investors sell valuable papers of a wide range, regardless of sectors, capitalization of issuers, and geography.
Moreover, bonds, which are considered a classical portfolio diversifier for stocks, can also fall during a market crash just like risky assets. This was the case in March 2020 during the coronavirus crash, as shown in the graphs below.
In a calm market, for example during the period of 2014-2017, high-risk assets such as the S&P 500, global stocks, developing markets papers, REIT were positively correlated only with each other. Low-risk assets such as municipal and corporate bonds, and long-term treasuries, were also only related to each other. And between these two groups of assets, there was practically no correlation. But during the market crash in March 2020, all correlations were strengthened – not only within each of the mentioned groups but also between all asset classes. As a result, bonds fell together with stocks.
That is, in critical moments when the protective function of diversification is most needed, it fails. In this sense, the hedge mechanism is reliable and better protects against crisis scenarios.
Hedge is an investment intended to move in the opposite direction of the underlying asset. The correlation of the hedge to the asset remains negative in any scenario, which means the mechanism guarantees compensation for drawdowns.
“Hedging is a flexible strategy that can be widely applied to minimize losses across all instruments in a portfolio, be it stocks, bonds, gold, and commodities. Alternatively, it can be used narrowly to protect a specific position.”
This can be done tactically – for example, when an investor creates short-term protection in anticipation of a correction. Or hedging can be used as part of an investment strategy. Everything depends on the investor’s needs, his goals and risk tolerance. But most often, hedging is tactical in nature, as the hedging mechanism itself carries risks and additional costs. For example, in the case of inverse ETFs, this is an increased fund commission. Therefore, it is important to clearly understand how, when and why to use this tool.
Main types of hedging
I will list the most popular instruments for hedging.
Opening short positions. In this case, an investor borrows stocks, sells them, and then buys them back at a lower price. The difference between the sale and the subsequent buyback of the stocks is the profit obtained in a falling market.
Cons of this method: for margin trading, a collateral account is required – after all, you are borrowing shares. In addition, the broker charges a commission for renting the shares and may forcibly close the investor’s position at an disadvantageous price.
Purchase of PUT options. This is a contract between two investors, according to which the buyer of the contract has the opportunity – but not the obligation – to sell an asset at a pre-agreed price, regardless of its future quotes. In other words, if an investor expects the price of a certain asset to fall, he buys a PUT option on it, fixing the current price of the asset. In the future, if the quotes really start to fall, the investor will be able to sell his asset at the original price – as if there had been no fall. And if the quotes do not fall, then the right to sell can be unused – the investor will only lose the premium paid for the option.
Sale of futures contracts. This is a similar contract between two investors for the purchase or sale of an asset on a specified date in the future at a pre-agreed price. If an investor believes that the price of the asset will fall, they sell futures. In the future, the buyer of the futures will be obligated to purchase the asset not at the current price, but at the price agreed upon at the time of entering into the futures contract.
Swaps. Another type of urgent transaction when the parties exchange payments within a certain period. It is often used by banks and funds for currency hedging.
Purchase of inverse ETFs. These ETFs are created to mirror benchmarks inversely. In other words, when the index drops, they rise. There are inverse ETFs offering proportional growth – 1x, as well as 2x and 3x leverage. The first ones increase by the same amount as the base index falls by 1%, while the other two provide 2% and 3% respectively. This yield is achieved through the use of a credit leverage, i.e. “leverage”.
If the investor has a high risk tolerance and is interested in using less capital for hedging, they can turn to similar ETFs with double and triple effect. In the article about the all-weather strategy, I briefly touched upon the use of margin ETFs. I want to emphasize that this is rather a trading tool, although it is permissible to use it in a long-term strategy, and there is a mathematical justification for this. However, we do not recommend that investors use any margin tools, including inverse ETFs with multipliers of 2x and 3x. Therefore, the rest of the article specifically discusses inverse ETFs 1x.
Despite the fact that opening short positions and derivatives are the main methods of hedging, they are quite complicated for investors and require additional conditions, such as the use of margin accounts with collateral, i.e. additional cash reserves. And the most significant disadvantage of shorts and futures is that an investor can lose more than they invested. In fact, the size of the losses in this case is not limited.
At the same time, there is no need to open a special account for buying a reverse ETF. However, there are also risks associated with using this instrument. Let’s take a closer look at them.
The principle of operation of inverse ETFs.
The main difference between regular ETFs and inverse ETFs is that the latter are designed to achieve the stated goal within one day. This is done so that, regardless of when you buy the fund, it provides the stated multiplier for that day – 1x, 2x or 3x. And over a horizon of many days, the cumulative return of the fund becomes distorted and it ceases to be a mirror to the benchmark.
The problem is that inverse ETFs incur losses in a volatile market: if the asset price first falls and then returns to the original, the result for the inverse ETF will be negative, not zero as with regular instruments and short positions. But when there is a trend on the market and the benchmark falls for several days in a row, the result for the inverse ETF exceeds the short position. Thus, on time horizons longer than one day, the inverse ETF acts as a nonlinear tool: its mirrored result is not proportional to the movement of the benchmark.
Let’s consider a hypothetical example: we invested in a reverse ETF with an underlying asset worth $100 (7381 ₽). Then, the asset quotes fell by 20% on the first day – to $80, and on the second day by 25% – to $60. Accordingly, the value of the reverse ETF will first increase by 20%, and then by 25%. It will be equal to $100 × 1.2 × 1.25 = $150. The profit obtained is $50.
At the same time, if we opened an equivalent short position, its gain would be equal to the benchmark decline in absolute terms: $100 – $60 = $40. Thus, when there is a trend in the market, the yield of a reverse ETF exceeds the yield of a short position.
Now let’s assume that on the third day the asset price returned to $100. Then the profit from the short position will be zero. However, for the inverse ETF the picture is different: the asset’s growth on this day was 66.7% – from $60 to $100. Therefore, the inverse ETF will lose 66.7% of $150, which is $100. As a result, the investor’s position will be $50 – he will incur a loss of 50% from the initially invested $100.
As seen from the example, even if the investor correctly predicted the correction of the asset by betting on its decline, strong volatility can result in losses. Theoretically, if the value of an asset drops from $100 to $1 in a day, and then rises to $2 the next day, the value of the inverse ETF position will become zero. But this is a hypothetical example, since in practice, the S&P 500 has never moved more than 12% during a trading session.
Volatility losses are the main reason why inverse funds only provide the declared multiplier within one day and rebalance their positions daily. This, among other things, results in higher management fees compared to regular ETFs of around 1%. Although for Russian investors, the fee may seem normal: regular funds quoted on the Moscow Exchange often charge a comparable fee for their services. But this only means that inverse ETFs on the Moscow Exchange would charge even more.
Thus, during a prolonged market decline, inverse ETFs will grow more than the benchmark index will fall. In other cases, when we hold an inverse ETF for a long period of time, for example, a year, we will go through a large number of waves replacing each other, and the losses from volatility will greatly affect the final result – the yield of inverse ETFs will be lower than when opening short positions, not to mention associated commission expenses. For example, if we compare the SPY ETF with its inverse version SH, then the benchmark grew by 15.73% over the last year. Accordingly, with a short position, we would receive a loss of -15.73%, but with SH, we will have -24.97%.
Let’s summarize: the longer an investor holds a reverse fund, the more their overall profitability will diverge from the benchmark. This is due to the complex interest rates on a volatile market, where losses and profits alternate. On short trend segments, however, the addition of daily results actually increases fund profitability.
The table below shows the hypothetical returns of an inverse ETF in rising, falling, and volatile markets. As you can see, two days with a return of -5% in an ascending market lead to a return of -9.75% for the inverse ETF. Two days of profit of 5% in a descending market result in a total return of 10.25%. In an unstable market, where a loss of 5% alternates with subsequent growth of 5%, this leads not to zero profitability, but to a loss of -0.25%. These data are given for illustrative purposes and do not take into account the costs associated with purchasing and managing the ETF.
The specified deviation of reverse ETFs from the benchmark results in the fact that investors who use reverse funds for long periods, for example, more than a month, should periodically rebalance their hedge position. It is desirable to keep your finger on the pulse and monitor the market condition daily.
Behavior of inverse ETF 1x in different market situations
Rising Trend | Benchmark | Inverse ETF 1x | Investment of $100 in inverse ETF |
|---|---|---|---|
| First day | +5% | −5% | $95 |
| Second day | +5% | −5% | $90.25 |
| Total result | +10% | −9.75% | $90.25 |
| Bearish Trend | Benchmark | Inverse ETF 1x | Investment of $100 in inverse ETF |
|---|---|---|---|
| First day | −5% | +5% | $105 |
| Second day | −5% | +5% | $110.25 |
| Total result | −10% | +10.25% | $110.25 |
| Market Volatility | Benchmark | Inverse ETF 1x | Investment of $100 in inverse ETF |
|---|---|---|---|
| First day | +5% | −5% | $95 |
| Second day | −5% | +5% | $99.75 |
| Total result | 0% | −0.25% | $99.75 |
Portfolio rebalancing
Rebalancing involves periodic adjusting of the proportion of the inverse ETF in the portfolio to restore its original ratio. Rebalancing may be done regularly or when a certain deviation from the norm occurs – when the difference between the initial size of the hedge and its actual share reaches a specified percentage. For example, when the deviation of the hedge from the initial share reaches 10%.
In this case, the higher the fund multiplier, the more frequent rebalancing is required: a 3x fund will deviate from the benchmark much faster than a 1x fund. More frequent rebalancing may also be required if the inverse ETF is based on a volatile index: as we showed in the previous section, the more volatile the underlying instrument, the stronger the deviations of the inverse ETF.
If a hedge is created for a long-term period, it is preferable to use the calendar-based method, where rebalancing occurs at certain intervals: weekly, monthly or quarterly.
Of course, rebalancing incurs additional costs – brokerage commissions and tax consequences, but its effect can increase the overall portfolio performance.
Once again: the effect of compound interest and the nature of the market can reduce the yield of a reverse ETF, but rebalancing can to some extent mitigate this factor.
Let’s compare the use of the SH fund as a hedge with portfolio rebalancing and without it. In the example below, rebalancing was carried out when the hedge share deviated by 10%. As a result, the rebalanced hedge position for SH reflected the S&P 500 chart best throughout the period. It showed a result of 3.43% compared to -3.69% for the S&P 500 and outperformed the position without rebalancing -1.25%.
Examples of hedging
In a modern portfolio, in addition to the classical equities and bonds for diversification, alternative instruments such as gold, commodities, and real estate are often used. Therefore, let’s look at examples of using hedging for different asset classes. In doing so, as in the previous example, we will use a rebalancing strategy when the hedge ratio deviates by more than 10% from the target.
Let’s consider the behavior of the market during the 2008 crisis. The S&P 500 index fell by 37% by the end of the year, and volatility increased to 41%. If an investor had used hedging with the inverse SH fund, they could have reduced losses and smoothed out portfolio volatility.
With a hedge ratio of 10% in the portfolio, the investor’s yield could be higher by 7% and the volatility lower by 10%. And with a hedge ratio of 20%, the yield would increase by 13% and the volatility would decrease by 17%. In 2008, 20 rebalances were required due to deviations from the initially set 10% allocation.
Example of hedging with the help of the ETF SH during the market crash of 2008.
| Portfolio | Loss | Volatility |
|---|---|---|
| S&P 500 unhedged | 37.00% | 40.96% |
| S&P 500 hedged 10% | -30.02% | 30.91% |
| S&P 500 hedged 20% | -24.21% | 23.73% |
As I have already said, individual investors can find hedging options among the instruments available on the Moscow Exchange, although they will be less efficient than inverse ETFs due to less obvious inverse correlation. For example, gold is a common option. On the Moscow Exchange, funds such as VTBG, FXGD, and TGLD serve as analogues to gold. Let’s compare the effectiveness of hedging using inverse ETFs and gold during the March 2020 crash. The hedge ratio will be 20%. There will be no rebalancing.
Hedging with gold would be less effective than with inverse ETFs, but still would allow to offset the maximum monthly drawdown by 3.7% and volatility – by 6.85%. In addition, the gold portfolio performed better on the rebound.
Example of hedging using inverse ETF and gold during the crash in 2020.
| Portfolio | Loss | Volatility |
|---|---|---|
| S&P 500 | -19.39% | 46.45% |
| S&P 500 with 20% SH | -12.49% | 25.78% |
| S&P 500 with 20% GLD | -15.69% | 39.6% |
Remember
- Hedging is a mechanism for protecting against a decline in an asset.
- Market volatility and correlation between different instruments only increase with each decade, making diversification increasingly difficult.
- A strategic investor often encounters corrections and bear markets enough times to consider insurance against a decline.
- Diversification effectively protects capital and smooths portfolio volatility under normal market conditions, but becomes less effective in a falling market.
- Popular hedging instruments are quite complex for the average investor and require knowledge of the futures market.
- Inverse ETFs are analogues to derivative instruments. Inverse ETFs have a daily target. Holding them for longer periods leads to a stronger deviation from the declared multiplier: 1x, 2x, or 3x. Periodic rebalancing of the hedging position allows this effect to be neutralized, but increases brokerage fees and tax consequences.
- The average investor can use hedging through the instruments available to them on the Moscow Exchange, such as gold. The effectiveness of this method will be lower than hedging with an inverse fund.
Responses