While the broader U.S. market is flashing upside action recently, it’s too soon to declare the bout of volatility “over,” and it’s worth considering portfolio hedging strategies.
While current events in the U.S. and the world may cause you to feel as if markets are in uncharted territory, that’s actually not the case.
Market downturns are normal. In fact, the risk investors take is exactly what leads to reward during market uptrends.
But that doesn’t mean you should just sit back and wait out market volatility.
Even in a longer-term allocation, there are ways to mitigate losses in a market downturn with portfolio hedging strategies.
Portfolio Hedging with Inverse Funds
Portfolio hedging, at its most basic, is making an investment with a strong probability of moving in the opposite direction of other securities you hold. That’s also sometimes called an investment with low or inverse correlation to another.
For example, you could simultaneously own both the SPDR S&P 500 ETF Trust ETF (SPY) and the ProShares Short S&P 500 ETF (SH), as a way of hedging downside risk, while still getting exposure if (and when) the S&P 500 rises.
But is that a practical strategy? Would that mean you are hedging away any advantage of owning the S&P 500 fund?
As you see in the above charts, SH moves in the opposite direction of the S&P 500, posting strong gains in February as its underlying index skidded on concerns about the Russia/Ukraine war.
To preserve capital and even book some profits, buying shares of SH can be a solid strategy as a short-term hedge in qualified accounts where you can’t short sell or use options.
For example, your large-cap U.S. allocation could break down along the following lines:
- 75% SPY
- 25% SH
While it may seem as if you’re betting against yourself, you’re actually just putting a potentially more lucrative spin on the old strategy of going long in the S&P 500 with 60% of your allocation, while holding the rest in cash as a protective measure.
I first learned trading by using a system that encouraged investors to sell out and go into cash in a market downturn. While that may have been good advice a few decades ago for use in qualified accounts (where there is no capital-gains consequence for cashing out stocks), inverse ETFs mean that strategy is now outdated. Inverse ETFs make it extremely easy to protect your capital while potentially profiting at the same time.
What are the risks of inverse ETFs?
For starters, avoid the leveraged inverse ETFs that are designed to return double or triple the return of an underlying index. These ETFs use debt and derivative instruments to boost the return.
That adds too much risk if market direction changes quickly, as it often does. Even a one-day reversal can wipe out previous gains. In my view, it’s simply not worth the very real potential of losing a lot of money by trying to outsmart the market.
That’s related to another risk of leveraged inverse ETFs, which is that they become “buy and hold” investments, either deliberately or through neglect. It’s easy to forget what’s in your portfolio as life gets busy. Pretty soon, what was intended as a short-term hedge against market weakness has become a long-term hold that tanks your entire portfolio.
Avoiding leveraged inverse ETFs can mitigate those risks.
Of course, while it’s always smart to monitor your portfolio, use of hedging techniques makes it even more crucial to have a regular understanding of the broad-market trend. While the old-school strategy of holding cash in a downturn will limit your upside, the use of inverse ETFs as hedges carries the potential to damage your return if you are not vigilant.
Despite those risks, I do like the flexibility and upside potential inherent in hedging against a broad market downturn. It’s even OK to hold a small stake in an inverse ETF at all times, as a way of hedging against quick, unexpected downturns.
Be careful not to overweight your portfolio in a short or inverse ETF because you believe a bear market is inevitable. Nothing in the market is inevitable, so don’t make large bets on a hunch or something you read, even if it’s backed up by a poll of investment bankers and former Federal Reserve officials. They can be just as wrong as anybody else.
Always stay diversified. The percentage allocations I used above, as examples, referred to one asset class: Large U.S. stocks. That was not a suggestion for allocating your entire portfolio.
It’s also possible to hedge against other indexes, not just the S&P 500. For example, the Direxion Daily CSI 300 China A Share Bear 1X Shares ETF (CHAD) returns the inverse of the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange.
At a glance, you can see how it’s been outperforming the iShares MSCI China ETF (MCHI), which tracks an index of Chinese equities available to international investors.
Think of inverse ETFs as insurance against downturns. Learn how they fit into your portfolio before a downturn happens and consider adding a small amount of hedging even during roaring bull markets.
What are your favorite hedging strategies, and what indicators do you follow to trigger them?