Hedging with ETFs: a cost-effective alternative

Exchange-traded funds (ETFs), once primarily used as alternatives to mutual funds, can now help investors achieve a variety of different financial goals: cross-industry investments, participation in niche markets, and stocks, bonds, currencies, real estate, and commodities.

Versatility means that ETFs are attractive to all sizes and varieties, allowing investors to place bullish or bearish bets, and even hedge their portfolios to ensure safety. In this article, we will study some strategies of exchange-traded funds that can protect or hedge investor portfolios from different types of risks.

Benefits of using ETF hedging

Hedging has historically been limited to the use of derivatives-based securities such as futures, options and over-the-counter securities. Since the pricing mechanism of derivative securities is based on advanced mathematical formulas, such as the Black-Scholes option pricing model, hedging is mainly the field of large mature investors.

Key points

  • Exchange-traded funds can be used for hedging purposes.
  • One strategy is to buy the reverse S&P 500 ETF that is the opposite of the stock market.
  • Some exchange-traded funds track the performance of the U.S. dollar against other currencies, which provides opportunities for hedging exchange rate risks.
  • Buying ETF stocks that hold commodities (such as gold or natural resources) can be a way to hedge against inflation.

Due to the high minimum requirements associated with traditional protection strategies, the ability to buy and sell a small number of ETFs is attractive for smaller investors who were previously unable to obtain hedging opportunities. In fact, individual investors can now use ETFs to hedge their portfolios in a variety of ways.

Stock market hedging

Investors often use futures and options to hedge their positions in stocks and bonds. For example, one of the most common and actively traded instruments in the stock market is the S&P 500 Index futures, which is widely used by large institutions, including pension funds, mutual funds, and active traders.

ETFs such as ProShares Short S&P500 (SH) and ProShares UltraPro Short S&P500 (SPXU) are contrary to the S&P 500 index and can be used to replace futures contracts in the general stock market short positions, making these positions simpler, cheaper and more liquid .

Some inverse ETFs are leveraged and will have greater volatility than the overall market because the volatility of these funds is twice or three times that of the overall market (inverse).

Although the mechanism of using a short stock ETF is very different from using futures, and the matching of hedging positions is not accurate, buying a short ETF provides a simple way that can be used as a means to an end. In other words, if the stock market falls, the share price of the reverse fund will appreciate, and the appreciation can help offset the loss of the stocks in the portfolio.

Currency hedging

Just like stock market hedging, before ETFs were widely accepted, the only way to hedge non-US investments was to use currency forward contracts, options, or futures. Forward contracts are rarely available to individual investors because they are usually agreements between large entities that trade over the counter.

Like interest rate swaps, forward contracts allow one party to take the risk of a long position and the other party to take a short position in a certain currency, in order to compare their special needs to hedging or betting. By design, participants rarely make physical delivery of currency positions, and choose to cash out the ending value based on the closing currency exchange rate. During the validity period of the forward contract, there is no currency exchange, and the valuation is usually based on the appreciation/devaluation of the swap or holding at cost.

Smaller investors can try to hedge the exchange rate risk of long non-US investments by buying a corresponding amount of short US dollar funds, such as Invesco DB US Dollar Bearish (UDN). On the other hand, investors outside the United States can invest in stocks of funds such as Invesco DB US Dollar Bullish (UUP) to hold long US dollar positions and hedge against exchange rate fluctuations.

ETFs that track the performance of the U.S. dollar (such as Invesco DB US Dollar Bullish) aim to replicate the performance of the U.S. dollar against a basket of other major currencies and therefore will not effectively hedge any associated exchange rate risks. Single currency.

Just like replacing futures and options in the stock and bond markets, the accuracy of matching the value of the portfolio to the hedged position depends on the investor. But due to the liquidity of ETFs and (unlike options and futures) the fact that ETFs never expire, investors can easily adjust as needed.

Inflation hedge

Inflation hedging using ETFs can hedge against unknown and unpredictable forces. Although inflation has historically fluctuated within a small range, it is easy to fluctuate up and down during normal or abnormal economic cycles.

Many investors are based on the theory that if inflation rises or is expected to rise, commodity prices will also rise, thus using commodities as a form of hedge against inflation. In theory, while inflation is rising, other asset classes such as stocks may not rise, and investors can participate in the growth of commodity investment.

Although gold and other commodities have historically increased with inflation, this relationship is not accurate, and other factors (such as changes in supply and demand) will also affect commodity prices.

There are hundreds of ETFs that can be used to obtain precious metals, natural resources, and almost any commodity that can be traded on traditional exchanges. Examples include the United States Petroleum Fund (USO) and SPDR Gold Shares (GLD). There are also a wide range of commodity ETFs, such as Invesco DB Commodity Index Tracking (DBC).

Bottom line

There are many benefits of using ETFs for hedging. The first and most important thing is cost-effectiveness, because ETFs allow investors to establish positions with little or no entry fees (commissions). In addition, since stocks are traded like stocks, the buying and selling process is a simple process for most individual investors. Finally, ETFs cover many markets, including stocks, bonds, and commodities.

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