How to Hedge a Portfolio with ETFs

There are numerous benefits to hedging your investment portfolio with ETFs. It’s cost-effective – allowing investors to invest with little or no commission, provides access to a wide variety of markets, reduces volatility, and increases accessibility to the activity of hedging as a whole.  

Smaller investors, who historically had limited access to hedging due to the higher minimum requirements associated with protective strategies, will be attracted by the possibility of buying and selling ETFs in small increments. Indeed, there are a variety of ways that individual investors can now use ETFs to hedge their portfolios. In this article, we will discuss several key ways this can be done.

1. Buying inverse ETFs on the stock market

Inverse ETFs are a low-cost way for a portfolio manager to take market risk out of a portfolio or a specific section of a portfolio in part or entirely. They are designed to move in the opposite direction of an index.  

Options and futures are frequently used by investors to hedge their stock and bond positions. S&P 500 Index futures, for example, are one of the most extensively used and actively traded tools in the equity market, and are utilised by larger institutions such as mutual funds, pension funds and active traders. 

ETFs such as the ProShares Short S&P500 (SH), the ProShares UltraShort S&P500 (SDS), and the ProShares UltraPro Short S&P500 (SPXU), move in the opposite direction of the S&P 500 Index and can be used instead of futures contracts to take short positions in the general stock market, making them easier, more liquid and less expensive.  

While the technicalities of using short equity ETFs may differ significantly from those of using futures, and the matching of hedged positions is not exact, buying a short ETF provides convenient access as a means to an end. In other words, if the stock market declines, the inverse fund’s share price will rise, potentially helping to offset losses in the portfolio’s holdings. 

One of the advantages of utilizing inverse ETFs to hedge your portfolio is that your risk is defined and limited. An investor who shorts the market entirely, hypothetically, faces undefined and limitless risk, but the risk of an inverse ETF is simply determined by the amount you have invested. 

Using inverse ETFs as a hedge to decrease asset correlation and investment risk can be a powerful diversification strategy. It’s also a method that necessitates careful implementation, monitoring, and rebalancing on a regular basis. Inverse ETFs, when used correctly, can be a useful tool for hedging portfolio risk. 

Some inverse ETFs can move up to three times as fast as the underlying index – these are leveraged ETFs that require rebalancing on a regular basis. However, do note that these inverse ETFs can be much more volatile in the overall market. 

2. Hedging with currencies

Before the widescale acceptance of ETFs, one of the only ways to hedge a non-US investment was to do it with currency forward contracts, futures, or options, just like with stock market hedging. Individual investors rarely have access to forward contracts because they are often over-the-counter agreements traded between larger firms. 

Forward contracts allow one participant to take on the risk of a long position in a currency while the other takes a short position, similar to hedging or betting.  

The ETF’s assets are valued at the same level as the forward exchange contracts. If your home currency gets stronger, lowering the value of your overseas investments, the gains from the forward contracts should be sufficient to compensate for your losses. However, if your home currency decreases in value, your forward contracts will likely to lose money, wiping out any currency gains. 

As a result, currency swings cancel out in either direction, and roughly estimated, you get the same return as the local stock market. Why is it merely a rough estimate? Because there is no such thing as a perfect currency hedge. Inevitably, there will be a minor disparity between the hedged ETF’s predicted value and the ETF’s actual value. 

Smaller investors can hedge the exchange rate risk of long non-U.S. investments by buying funds that have a short U.S. dollar position. An investor based outside of the United States, on the other hand, can invest in shares of funds that take a long U.S. dollar position in order to protect their portfolios from exchange rate fluctuations.  

The levels of accuracy when matching the portfolio’s value to the hedged position are up to the investor. However, due to ETF’s liquidity and the fact that they never expire (unlike options and futures), investors can make adjustments easily. 

Furthermore, be aware that dollar-tracking ETFs are meant to match the dollar’s performance to a basket of other major currencies and, as a result, will not hedge the exchange rate risk associated with any particular currency. 

While many financial theorists feel that currency volatility does not have a significant role in long-term equities returns, investors with shorter time horizons are more susceptible to exchange rate swings.  

UK investors, for example, are exposed to currency risk on around 95% of the shares tracked by an index because the UK stock market only accounts for 5% of the MSCI World, so if they need to access funds from their portfolios for retirement or other short-term goals, they may have to sell low when the pound has strengthened, which reduces their immediate returns. A currency-hedged ETF efficiently eliminates this volatility issue. 

3. Inflation hedging

Inflation has been lurking in the background for much of 2021, spooking several equities and bond ETFs as a result. Inflation has the potential to be extremely damaging to portfolios due to the fact that it tightens the correlation between stock and fixed income assets at precisely the wrong time. 

The good news is that when it comes to allocating to sections of the market that buffer against inflation risk, ETF investors have several great options. As the threat of inflation loomed this year, “inflation hedge” assets have provided protection. 

This year, inflation-linked bond ETFs such as the Schwab U.S. TIPS ETF (SCHP) and the iShares Bond ETF (TIP) have received a lot of attention. In fact, since January 1, both funds have received billions in net inflows. 

Hedging against inflation with ETFs protects against uncontrollable and unpredictable factors. Inflation has typically fluctuated in tiny bands, although it can readily swing up and down during regular or irregular economic cycles. 

Investing in commodities ETFs, such as gold or natural resources, can help you protect against inflation. 

Many investors pursue commodities as a type of inflation hedging based on the assumption that when inflation rises or is predicted to rise, so too will commodity prices. While inflation rises, other asset classes such as equities may not, which allows investors to participate in the growth of commodities investments. 

Hundreds of ETFs are available to access natural resources, precious metals, and almost any other commodity that can trade on a traditional exchange. The SPDR Gold Trust (GLD), which tracks the spot price of gold, is an example. Gold is typically praised as a proven inflation hedge; however, this precious metal hasn’t held up this year, losing 2.7% year to date. 

Interestingly, some theorise that gold has lost some of its lustre as an inflation hedge due to the increasing acceptance of bitcoin and other such cryptocurrencies. While there isn’t enough data on bitcoin futures ETFs to determine their efficacy as an inflation hedge, the WisdomTree Enhanced Commodity Strategy Fund (GCC) was is in fact the first ETF to add a 3% allocation to bitcoin futures, which happened in October of this year.

Conclusion: To limit market risk, consider hedging your stock portfolio.

When it comes to financial markets, risk and uncertainty are unavoidable. While risks may rarely be totally avoided, portfolio hedging is one approach to safeguard a portfolio from potential losses. Hedging always comes with a cost, however it provides investors with peace of mind. This can assist investors in taking on enough risk to meet their long-term investment objectives. Hedging can also protect you from catastrophic losses in the instance of a black swan event. 

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