Is Hedging With ETF Indexes a Relevant Strategy?

Exchange-traded funds (ETFs) offer broad exposure to the market, allowing investors to achieve a wide range of objectives within their portfolios. This can include hedging options for investors concerned about economic or market cycle volatility and the resulting impact on investment returns. Here we discuss four hedging strategies that utilize index-based ETFs.

Hedging With Inverse ETFs

Investors who are long in index-based funds or stock holdings but worried about short-term risk can take a position in an inverse ETF, which appreciates when its tracking index falls in value. For example, a long position in the Invesco QQQ (QQQ), which tracks the NASDAQ 100 Index, could be hedged with an offsetting position in the ProShares Short QQQ (PSQ). With this hedge in place, losses in the Invesco QQQ are neutralized by gains in the ProShares Short QQQ.

Investors can also hedge stock portfolios with inverse index funds composed of similar holdings. For example, a portfolio of stocks built to track the S&P 500 Index could be hedged with the ProShares Short S&P 500 ETF (SH), which aims to appreciate by the same percentage as the declines on the index.

Hedging With Leveraged Funds

With leveraged inverse funds, however, the intrinsic volatility results in a lower capital requirement to offset declines. With a fund offering triple leverage, such as the ProShares UltraPro Short QQQ (SQQQ), the capital required to fully offset changes in an index is approximately one-third of the long position.

For example, a 3% decline in a $10,000 position in the Invesco QQQ results in a loss of $300. In a triple-leveraged inverse fund, the percentage loss on the index is multiplied by three for a gain of 9%. A gain of 9% on a $3,300 position is $297, offsetting 99% of the loss. Investors should note that, due to the reset of leverage on a daily basis, the performance of these types of funds is generally more predictable when they are used as short-term trading vehicles.

Writing ETF Options

Investors also have the option of hedging with leveraged inverse funds. Adding leverage to an inverse fund multiplies the percentage changes on the index being tracked, which makes these ETFs more volatile but allows for smaller allocations of capital to hedge positions. For example, the capital required to fully hedge long exposure with a non-leveraged fund is equal to the amount invested in the long position.

Investors expecting markets to move sideways for a period of time can sell options against their positions to generate income. Referred to as covered call writing, this strategy can be implemented using a wide range of index-based ETFs including the Invesco QQQ, the SPDR S&P 500 ETF Trust (SPY), and iShares Russell Mid-Cap ETF (IWR).

In a sideways to down market, investors can write calls against an ETF, collect the premiums, and then write calls again after expiration if the shares are not called away. The primary risk in this strategy is that option sellers forego any appreciation above the strike price on the underlying shares, having agreed in the contract to sell shares at that level.

Buying Puts on ETFs

Investors seeking to hedge against price declines on their index-based ETFs can buy put options on their positions, which can offset some or all losses on long positions, depending on the number of options purchased.

For example, an owner of 1,000 shares of an ETF trading at $80 might buy 10 put options with a strike price of $77.50 priced at $1.00, for a total cost of $1,000. At the expiration of the option, if the price of the ETF drops to $70, the loss on the position is $10,000. The 10 puts, however, have an intrinsic value of $7.50, or $7,500 for the position. Subtracting the $1,000 cost of buying the put options, the net gain is $6,500, which reduces the loss on the combined positions to $3,500. In this example, buying 16 put options with an ending intrinsic value of $6.50 results in a net profit of $10,400, which completely covers the loss on the ETF.

Hedging Exchange Rates With Currencies ETFs

Just like with equity market hedging, before the wide acceptance of ETFs, the only way to hedge a non-U.S. investment was to use currency forward contracts, options, or futures. Forward contracts are rarely available to individual investors, as they are often agreements between large entities that are traded over-the-counter.

Individual investors can still attempt to hedge exchange rate risk of long non-U.S. investments by purchasing corresponding amounts of funds that take a short U.S. dollar position, such as the Invesco DB US Dollar Index Bearish (UDN). On the flip side, an investor who is based outside of the United States can invest in shares of funds like Invesco DB US Dollar Index Bullish (UUP) to take a long U.S. dollar position to hedge portfolios from exchange rate risks.

Inflation Hedging

Inflation hedging with ETFs hedges against an unknown and unpredictable force. While inflation has ranged in small bands historically, it can easily swing up or down during normal or abnormal economic cycles.

Many investors seek out commodities as a form of hedging against higher inflation based on the theory that if inflation rises or is expected to rise, so will the price of commodities. In theory, while inflation is rising, other asset classes like stocks may not be rising, and investors can participate in the growth of commodities investments.

There are hundreds of ETFs to access precious metals, natural resources, and just about any commodity that can be traded on a traditional exchange. Examples include the U.S. Oil Fund (USO) and the SPDR Gold Trust (GLD). There are also broad commodity ETFs like Invesco DB Commodity Tracking (DBC).

The Bottom Line

The benefits of using an ETF for hedging are numerous. First and foremost is cost-effectiveness, as ETFs allow investors to take positions with little or no entrance fees (commissions). In addition, since shares trade like stocks, the process of buying and selling is a straightforward process for most individual investors. Lastly, ETFs cover many markets, including stocks, bonds, and commodities.