Hedging a Mutual Fund Portfolio with Inverse ETF’s

It would be nice if the stock market went up in a straight line and no unexpected events occurred to send stock prices down. The world just does not work that way. Negative events occur almost daily which could affect the stock prices. Investment managers deal with the potential of negative events by Hedging their portfolios.

Hedging can be thought of as insurance against losses due to negative events. This will not prevent the negative event from occurring, but it reduces the effects of the event on the portfolio. For example, when people buy car insurance, they are hedging themselves against the possible loss due to a car accident.

Customary Hedging of a Mutual Fund Portfolio

Hedging a mutual portfolio means using certain securities in the stock market to offset the risk of a drop in prices. If one mutual fund is held, this fund could be hedged by making another offsetting investment. The offsetting investment would have a negative correlation to the fund that is being hedged. In other words, if the price of the fund should drop, the price of the offsetting investment should go up, thereby reducing the amount of loss on the fund.

Hedging is not an attempt to make profits. It is a technique to reduce losses in a stock or fund portfolio. However, hedging a portfolio comes at a cost. If the potential negative events never occur, a hedged portfolio will have lower profit than a portfolio that is not hedged.

Hedging techniques normally involve the use of complex financial instruments called Derivatives. Two of the most common are options and futures contracts. Without going into the details of how these instruments work, investors normally hear the advice on CNBC to buy Puts or Calls to hedge their portfolio. These are options to sell (Put) or buy (Call) a stock or index at a particular price. If the owner of a stock fund is worried that the price of the fund will fall due to a potential negative event, he can buy a Put which will go up in price should the fund price fall. However, if the negative event does not occur, and the price of the fund instead goes up, the cost of the Put will reduce the amount of profit earned.

Most average investors do not use Puts and Calls for several reasons:

  • If these investors feel the stock market will fall, they will just sell all or a portion of the funds they own. However, this can be tedious if the investor owns many funds.
  • Average investors do not understand Puts and Calls sufficiently to make use of these derivatives.
  • IRA portfolios are not permitted to use derivative investments.

Using Inverse ETF’s to Hedge a Portfolio

Most investors are now familiar with ETF’s or Electronically Traded Funds. These funds hold baskets of stocks depending upon the objective of the fund and the funds trade like stocks on the exchanges. Funds have been created to track almost all stock indices and investment sectors. An investor can buy a fund that tracks the Dow Jones Average, or S&P 500 average, or Gold prices. The investor can also buy funds that track indices of Autos, or real estate, or industrial companies. ETF’s have become extremely popular in recent years since investors are buying whole baskets of stocks rather than having to choose individual stocks.

Inverse ETF’s make use of derivatives to move in the opposite direction from the index they track. For instance, one ETF may track the S&P 500 index. There are Inverse ETF’s that will go in the opposite direction from the S&P 500 fund. So, if the S&P 500 fund goes up by 3%, the Inverse ETF will go down by roughly 3%.

There are a number of investment companies that offer Inverse ETF’s. Two of the most popular are Proshares funds and Direxion funds.

How to Use Inverse ETF’s

If an investor has all of their equity holdings in one or two mutual funds, say an S&P 500 fund and a Large Cap Growth Fund, they probably will not want to use Inverse ETF’s to hedge these funds. If they feel the market will go down, they will simply sell some or all of their mutual fund holdings.

If a more active investor has his assets spread among 10 – 20 mutual funds of various sectors and sizes, he may want to use Inverse ETF’s if he feels the market may go down. Having to sell all or a portion of many funds requires calculating how much to take out of each so that the remaining assets are still in a desired balance.

Such an investor can hedge his portfolio by buying one or two Inverse ETF’s. These inverse funds will rise in price should the prices of his mutual funds fall.

A big advantage of Inverse ETF’s is that these funds may be bought in IRA’s. So, IRA investors have a method of hedging their portfolios without having to sell their holdings.

How Long to Use Inverse ETF’s

Inverse ETF’s should be used as a short term insurance strategy. The investor is guarding against particular events such as government defaults in Europe, or the stock market has hit a new high and is due for a pullback in prices.

Inverse ETF’s should not be used for long term strategies due to profit erosion in the portfolio. If an investor is constantly worried about a drastic fall in stock prices, he should not be in the stock market to start with.

Investors also need to be aware that there are leveraged Inverse ETF’s offered by investment companies. These funds will return 2X or 3X the performance of the index they are tracking but in the opposite direction. So, if the S&P 500 fund returns 3%, a leveraged Inverse ETF will return -9%. Investors should avoid these leveraged funds due to the extreme volatility and risk of large losses.