{"id":38053,"date":"2020-03-12T12:41:00","date_gmt":"2020-03-12T16:41:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=38053"},"modified":"2023-02-10T12:40:17","modified_gmt":"2023-02-10T17:40:17","slug":"an-introduction-to-portfolio-hedging","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/financial-education\/an-introduction-to-portfolio-hedging\/","title":{"rendered":"An Introduction to Portfolio Hedging"},"content":{"rendered":"\n

Investing involves risk. Market downturns will happen. Having a sound investment strategy can help smooth out the turbulence in your portfolio, and save you from getting caught up in the herd mentality of selling low into a down market. Here we discuss hedging your portfolio with inverse exposure.<\/p>\n\n\n\n

Recent Downturns in the U.S. Equity Market<\/h2>\n\n\n\n

Since 1980, there have been numerous market corrections (defined as a drop of 10% or more),\nlasting an average of<\/p>\n\n\n\n

88 days. There have also been four bear markets (declines of 20% or more),\nwith an average duration\nof 542 days\u2014nearly a year and a half.\nIn the 1980s, we had the Latin American debt crisis and the stock market\ncrash of 1987. While there weren\u2019t\nany bear markets in the 1990s, we had the technology bubble and the real estate\nbubble and financial\ncrisis in the 2000s.<\/p>\n\n\n\n

In late 2018, the equity market battled a correction that nearly entered bear market territory as it digested Fed rate hikes, trade tensions between the U.S. and China and renewed volatility.<\/p>\n\n\n\n

As we enter a new decade following the longest expansion in U.S. economic history, there are reasons to be optimistic about continued growth, but investors may also want to prepare for a downturn.<\/p>\n\n\n\n

\"S&P<\/figure>\n\n\n\n

Portfolio Hedging<\/h2>\n\n\n\n

A hedge, in its simplest\nform, is an investment intended\nto move in the opposite\ndirection of an asset in your portfolio that you consider to be at risk. A hedge provides\ninverse exposure. If the at-risk\ninvestment should decline\nin value, the hedge is\ndesigned to increase in value and offset potential losses in your portfolio.<\/p>\n\n\n\n

Hedging is a flexible strategy. You can apply it broadly in an effort\nto help minimize loss across\nentire asset classes in your portfolio, to help shield\nyour equity, fixed income, commodity or even currency\nallocations. Or you can hedge narrowly to help shield\nindividual sectors or even specific\nstocks. There are a number\nof hedging strategies available, and the best one for you will depend on your\nspecific needs, goals and tolerance for risk.
<\/p>\n\n\n\n

Used strategically, portfolio\nhedging can become\npart of your long-term investment strategy. Deployed tactically, a hedge can be applied and removed as needed, without\ndisturbing your core strategy or long-term goals, to help provide short-term shelter from adverse market\nevents. Hedging your portfolio can provide you with an alternative\nto selling in a down market,\nrealizing investment losses and potentially generating significant redemption fees,<\/p>\n\n\n\n

transaction\ncosts and tax consequences. Of course, hedging\nstrategies have unique risks, costs and consequences of their own (e.g.,\nfund management fees,\nrebalancing costs, taxable\nevents). It\u2019s important that you fully\nunderstand the strategy you\nplan to use and read the prospectuses for any investments you intend to use as\na hedge.<\/p>\n\n\n\n

Hedging with Inverse Exposure<\/h3>\n\n\n\n
Short Selling <\/td>\n  <\/strong>\n Short selling involves borrowing securities from a lender, typically for a small fee,\n with the intent to sell them at market value and then buy them back at\n a lower cost to return to the lender (known as covering the short).Used as a hedge,\n if the securities fall in value\n between their sale\n and re-purchase, the profit offsets losses in a declining investment.\n \n <\/td><\/tr>
Buying Put Options <\/td>\n A\n put option is a contract between two parties in which the buyer of the put\n has the right (but not\n the obligation) to sell a security at an agreed-upon price to the\n seller of the put, regardless of its market price.Used as a hedge,\n if the value\n of the security falls below the specified price\n (known as the strike\n price), the owner\n of the put can sell the security for a profit\n and offset losses in the original position in the security.\n \n <\/td><\/tr>
Selling Futures Contracts <\/td>\n A\n futures contract is an agreement, facilitated through a futures exchange, to\n buy or sell an asset at a predetermined price on a predetermined date\n in the future\n (the expiration date).Used as a hedge,\n selling a futures contract allows investors to offset the\n risk of a de-\n cline in the price of an asset.\n \n <\/td><\/tr>
Using Inverse ETFs <\/td>\n Inverse ETFs are designed to move in the opposite direction of a benchmark or index,\n by the inverse (-1x) or by\n multiples of the inverse (-2x or -3x).Used\n as a hedge, if an investment based on an index declines 1% on a given day, for example, a -1x inverse ETF is designed to rise by 1% that day (before\n fees and expens- es),\n thereby offsetting the loss.\n \n <\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n

Pros and Cons of Different Hedging Strategies<\/strong><\/h2>\n\n\n\n

While short selling, buying put options and selling\nfutures contracts are widely used hedging techniques, they are quite\nsophisticated and have drawbacks that may place them beyond the reach of many\ninvestors. All three may involve the need for margin\naccounts, and they generally require\nspecial brokerage approval\nthat not all investors can qualify for. They also have strict collateral and other requirements that may necessitate sizable cash reserves. Further, these strategies can come with substantial costs and risks.\nPossibly the most significant drawback\nof short selling\nand selling futures is that an investor can lose more than invested.\nIn fact, the potential for loss is unlimited\u2014you can lose\neverything you invested and more.<\/p>\n\n\n\n

ETF investors, on the other hand, aren\u2019t required to set up a special account or meet any collateral requirements. Additionally, you can\u2019t lose more than the value of your ETF investment. And, since there are inverse index funds ranging from those based on asset classes down to ones based on smaller segments of the financial markets, a wide array of investments can be hedged this way. There are, of course, disadvantages and risks with inverse ETFs too, and you should carefully read the prospectus for any ETF you are considering for a more complete description.<\/p>\n\n\n\n

A Closer Look at Inverse ETFs<\/h2>\n\n\n\n

The concept behind inverse ETFs is not difficult to understand, so let\u2019s see how they work in general. Take, for example, an inverse\nS&P 500 ETF designed to move directly opposite the market (-1x to the S&P 500)  on a daily basis. If the S&P\n500 declines 1% on a given day, a -1x inverse\nS&P 500 ETF is designed to rise by 1% that day (before fees and expenses). Of course, one of the\nrisks is that the opposite can be true. If the S&P 500 should gain 1%, a -1x S&P 500 ETF would lose 1%. If you have a greater risk tolerance, or if you\u2019re\ninterested in using\nless capital when hedging an investment, you can magnify these effects,\nup and down,<\/p>\n\n\n\n

by using an inverse ETF with a multiple of -2x or -3x the exposure.<\/p>\n\n\n\n

\"On<\/figure>\n\n\n\n

One-Day Investment Objectives<\/h3>\n\n\n\n

Conventional index funds are designed\nto match the performance of an underlying index over any time period. Most\ninverse ETFs, however,\nare designed to meet an investment objective, or multiple, for a single day only. This is to ensure that no matter when you invest, an inverse\nETF can be expected\nto deliver its stated multiple\nfor that day.<\/p>\n\n\n\n

Without this one-day objective, gains and losses might result in compounded returns, which could cause the ETF\u2019s exposure to its benchmark to float unpredictably. To maintain their investment objectives, inverse ETFs rebalance their exposure to their underlying benchmarks each day by trimming or adding to their positions.<\/p>\n\n\n\n

Holding Inverse ETFs for Longer than One Day<\/h2>\n\n\n\n

As a result of daily fund rebalancing, if you hold an inverse ETF for longer than a day, to maintain a hedge position, for example, it\u2019s unlikely you will continue to receive the ETF\u2019s inverse multiple times the benchmark\u2019s returns. As long as you hold the ETF, compounding can cause your exposure to the underlying benchmark to continue to deviate from the ETF\u2019s stated objective. In trending periods, compounding can enhance returns, but in volatile periods, compounding may hurt returns. Generally speaking, the greater the multiple or more volatile an ETF\u2019s benchmark, the more pronounced the effects can be.<\/p>\n\n\n\n

Rebalancing Strategies for Using Inverse Funds Longer-Term<\/h2>\n\n\n\n

As we mentioned earlier, rebalancing involves periodically increasing or decreasing an investment in a fund, in this case an inverse ETF, to realign its value to the position originally intended. This process may involve fees and tax consequences. Prudent portfolio managers do much the same thing to manage portfolio weights. They will sell positions when weights get too high and buy positions when weights get too low in order to maintain their weighting targets.<\/p>\n\n\n\n

There are two common rebalancing strategies: trigger-based and calendar-based. In a trigger-based approach, you would rebalance anytime the difference between the desired\nhedge exposure and the ETF\u2019s current value reaches\na predetermined amount or percentage. How often you need to rebalance a\ntrigger-based hedge can depend on several factors:<\/p>\n\n\n\n