Investors worried about how badly coronavirus will hurt stocks might consider hedging their portfolio. And hedging like a pro trader these days can be as easy as buying an exchange- traded fund.
ProShares, for instance, offers “geared” ETFs. In this context, that means leverage. Financial leverage magnifies the ETF’s assets under management with complicated financial products, so that an ETF with $100 million under management, for example, could hold financial contracts worth $150, or $200 or even $300 million.
The bottom line is that gains and losses per dollar of invested money are bigger than they would be in an ETF without leverage.
Two hedging ETFs to consider are the ProShares Ultrapro Short S&P 500 ETF (ticker: SPXU) and the ProShares Ultra VIX Short Futures ETF (UVXY). Ultrapro Short S&P is designed to return negative 300% of the return of the S&P 500. If the S&P drops 1%, the ETF is expected to rise 3%. That’s a hedge for the overall direction of the stock market. The ProShares Ultra VIX is designed to return 150% of the return of short-term VIX futures. VIX is a volatility index that rises when stocks start swinging more violently day to day; the ETF does better the wilder trading gets.
Using a geared ETF means small investors can get more bang for their buck. It’s easier to hedge an overall portfolio with a small ETF position. But financial leverage isn’t for everyone. It can create a lot of problems, as anyone who sold a house around the time of the financial crisis knows all too well. Debt leverage magnifies gains as well as losses. The ProShares website, in fact, warns that geared funds aren’t for everyone. It advises investors to watch their positions every day, and to make sure they don’t become a large part of a portfolio.
Hedges aren’t investments. That’s the first thing investors seeking protection need to realize. Hedges are risk-mitigation tools.
Take Bridgewater Associates, the giant hedge fund run by Ray Dalio. It made a splash when the The Wall Street Journal reported it was making a billion-dollar bet against markets. The hedge fund bought put options—which give the holder the right to sell an asset at a fixed price. It’s a bearish bet, but Bridgewater didn’t like how its trade was characterized because it was a hedge. “The way we manage money is to have many interrelated positions, often to hedge other positions, and these change often, so that it would be a mistake to look at any one position at any one time to try to deduce the motivation behind that position,” a spokesperson told Barron’s reporter Connor Smith back in November.
Dalio, for his part, said in a LinkedIn post “We don’t have any such net bet that the stock market will fall.”
Bridgewater manages more than $100 billion. A billion-dollar hedge is a small portion of the whole. The way Dalio hedges is a lesson for less expert investors. Hedge positions should represent only a small portion of the overall value of a portfolio.
But why hedge at all? After all, the easiest way to hedge is to reduce one’s holdings, selling stocks and hanging onto the cash.
For starters, there are tax consequences to selling positions. Just as important, however, are the psychological consequences. It can be hard to buy a stock again after it rises or after it falls. Human nature fears both buying too high and trying to catch a falling knife. Hedging, in its best sense, keeps investors in markets for the long run. And staying invested for long stretches has been a reliable way to generate wealth for generations.
Buy why should hedges remain small? If an investor finds themselves with a huge hedge position, then they likely have too much invested in the market. It’s a balancing act, but the desire to hedge a lot should be a signal to anyone playing the stock market to take some exposure off the table.
Geared ETFs are a simple way to hedge. But not everyone likes the products. The Securities and Exchange Commission is proposing changes requiring brokers to assess clients’ ability to understand geared ETFs. The changes would put in place a system like the one that requires people to fill out options-trading forms when signing up for a brokerage account. Investors need to show brokers they have a basic understanding of options before being allowed to trade them.
That would be a hurdle, but not an insurmountable bar. And the changes aren’t in effect yet. Right now, investors can still hedge with ProShares or similar ETFs, but they shouldn’t forget the common-sense rules.
The ProShares Ultrapro Short S&P 500 ETF is down about 46% over the past year. That makes sense because the S&P 500 is up about 23%. The Dow Jones Industrial Average is up 16%. The ProShares Ultra VIX Short Futures ETF is down 73% over the past year. Stock volatility has trended down.
The returns of the ETF don’t match the stated goals exactly. There are transaction costs to consider. The ETF managers have to buy and sell futures contracts. That costs money.
In the end, losing money on a hedge means the market is doing well. That’s a good thing. Hedges are just a way to help investors sleep at night when some ugly, hard-to-quantify risk pops up.