Hedging portfolio risk

Given the bearish movements of late, I have had a few enquiries as to how one could hedge their portfolio to reduce downside. As I noted on my last blog – a break of 2800 on the SPX is worrisome. If the break lasts more than a few days – one would be forgiven for becoming bearish. My downside target lies around 2600 if this break lasts.  After a few days of sub-2800 – we may want to raise cash. Or, we may want to hedge against positions we hold to effectively create a “neutral” return – or close to it.

Here’s how it works:

Effectively, if you own a portfolio that more or less performs inline with the market, that is considered a “Beta 1.0” portfolio. If your portfolio moved 20% more than the market (ie market makes 10%, you make 12%)–it is Beta 1.2. When we use hedge instruments, they are “Beta -1.0”. The negative beta means they are exactly negatively correlated to the stock market. You can see how adding a bit of hedge with -1.0 beta securities could offset your stocks with +1.0 beta. Todays blog is a reprint of a hedging blog I wrote in January 2016. It explains how a few hedging securities work.  I haven’t updated the charts, as the principle remains identical no matter what the markets have done since I wrote it. Please feel free to forward this blog to others who might be interested. I think that the topic is of interest to many investors – and its a subject that isn’t covered enough in my profession.

Here goes:

This blog briefly covers some of the basic differences between buying an inverse ETF (non leveraged) and an ETF that shorts stocks – and finally shorting a stock or an index ETF outright. I will not describe other hedging tools such as options, futures, VIX tracking ETF’s or non-correlated assets such as gold or bonds in this blog.There is enough to cover on the 3 vehicles noted.

To be clear–I will not be as thorough in this blog as you will need to be if you truly wish to fully understand the risks and rewards associated with these strategies. I recommend you visit the websites for the providers of the ETF’s mentioned and read the prospectus before making an investment decision. As far as outright shorting a position, I also recommend you discuss the strategy with your brokerage firm or Investment Advisor to fully understand this strategy as ETF’s mentioned are not suitable for everyone*.

Inverse ETF’s

In Canada, the only provider of this type of ETF is Horizons. They offer an inverse ETF that plays against the TSX (HIX-T) and the S&P500 (HIU-T). Below is a chart of HIU against the S&P500. Note the correlation panel below the price chart of HIU – black line. This indicator shows you how negatively correlated to the S&P500 the HIU shares are. The relationship is -0.98 correlated, where -1.0 is a perfect negative correlation. Thus, at -0.98, HIU is pretty darned perfectly negatively correlated to the S&P500!

In order to understand the risks associated with inverse ETF’s, I copied this excellent description from Wikipedia- as seen below.

If one invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value changes to $80 and then to $60, then the value of the inverse ETF position will increase by 20% (because the asset decreased by 20% from 100 to 80) and then increase by 25% (because the asset decreased by 25% from 80 to 60). So the ETF’s value will be $100*1.20*1.25=$150. The gain of an equivalent short position will however be $100–$60=$40, and so we see that the capital gain of the ETF outweighs the volatility loss relative to the short position. However, if the market swings back to $100 again, then the net profit of the short position is zero. However, since the value of the asset increased by 67% (from $60 to $100), the inverse ETF must lose 67%, meaning it will lose $100. Thus the investment in shorts went from $100 to $140 and back to $100. The investment in the inverse ETF, however, went from $100 to $150 to $50.

An investor in an inverse ETF may correctly predict the collapse of an asset and still suffer heavy losses. For example, if he invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value crashes to $1 and the following day it climbs to $2, then the value of the inverse ETF position will drop to zero and the investor would completely lose his investment. If the asset is a class such as the S&P 500, which has never increased by more than 12% in one day, this would never have happened.

Short ETF

The only true “shorting” ETF that I am aware of is that offered by AdvisorShares in the USA. The Ranger bear ETF (HDGE-US) shorts a collection of stocks that the managers deem as  having “low earnings quality or aggressive accounting which may be intended on the part of company management to mask operational deterioration and bolster the reported earnings per share over a short time period. In addition, the Portfolio Manager seeks to identify earnings driven events that may act as a catalyst to the price decline of a security, such as downwards earnings revisions or reduced forward guidance.”

An attractive feature of HDGE is that you are participating in a true short strategy without the unlimited loss potential of an outright short executed by yourself. Further, its diversification – often in about 40 stocks or so of the S&P500 listings- provides less individual security risk when compared to individual stock shorts. Further, the fund not only utilizes a fundamental analysis approach to identifying the most overvalued stocks within the S&P500 index, it also incorporates a separate technical analysis overlay to look for the least technically attractive stocks within the fundamentally overvalued list.

The chart below shows us the performance of the ETF vs. the S&P500. The bottom pane is again the correlation line. Note again the strong negative correlation (almost perfectly negatively correlated to the S&P500 at -0.97).

Shorting stocks

Not all stocks can be shorted. Your brokerage must be willing to lend the stock to you to sell. You will be charged margin interest on stocks you short, which are executed through a specific short margin account. You will also be on the hook for dividends or rights issued during the time you are short the stock. Ideally, you will want to profit on the stock falling by buying the stock back at a lower cost than when you sold it–taking into account the various interest costs, dividends paid etc. Should the stock go the other way (up) – you do have unlimited loss potential. Stocks could, theoretically, go up forever–assuming you hold the stock forever. Risk, therefore, is theoretically infinite on a short sale if you short a rising stock forever.

Another factor to consider on an individual stock short is the potential of  short squeeze. Stocks in downtrends are often heavily shorted. At some point, somebody with serious capital behind them gets wise to the short volume and can “squeeze” the shorts by buying the stock, causing mass panic by the shorters to cover their positions. This ultimately results in a strong positive move for the stock, potentially causing a margin call or an unprofitable trade for you. For this reason, if you really like the idea of shorting, I favour shorting an eligible market index ETF. Having said that, at ValueTrend we tend to focus on the above two strategies rather than direct shorting.

Keith on Bloomberg/BNN: Monday June 3rd at 6:00 PM

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*ETFs mentioned are not suitable for investors that are not interested in short-term trading and do not have good investment knowledge. These ETF’s mentioned may have exposure to aggressive investment techniques that may include leveraging, which magnify gains and losses and can result in greater volatility in value and be subject to aggressive investment risk and price volatility risk. ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing.